In the first part of a new series we will focus on two related long-term trends, economic growth and the expansion of the middle class.

We are currently in a pretty unique situation in the sense that there are large parts in the world experiencing rapid economic growth (China, India are the main ones, but populous countries like Brazil, Indonesia, Russia, Pakistan, and the like are also growing pretty healthily).

Of course, one should not take this growth for granted, especially today. But so far, China seems to hold up pretty well, growth decelerated from 10.6% in Q1 2008 to 10.1% in Q2, hardly a dramatic deceleration. Things might very well decelerate a little more though:

• The Olympic games will force a lot of factories (and traffic) to temporarily produce less to improve air quality in Beijing, which probably shows up as some form of blip in the statistics
• More importantly, inflation is a big problem and this might very well require further policy measures (the Chinese central bank is already on the case by increasing reserve requirements for banks multiple times already, restricting their ability to lend money to business)
• Exports are slowing because European economies (actually China’s most important market) and the US both are slowing down.

However, these problems are likely to be temporary (although they could last well into next year). Since this is an article about long-term trends, it’s not unreasonable to assume that things will be more or less back to normal after we leave behind the present economic troubles.

The biggest risk of the long-term growth story in our view is politics, and politics can rarely be taken for granted. Authoritarian rule might on the one hand provide the necessary longer-term outlook and policies, on the other, it can easily degenerate into catering to special interest and outright corruption, not to mention often troubled succession mechanisms.

Democratic rule, the “worst, apart from all other mechanisms”, according to Churchill, although bringing accountability and an assured succession mechanism, has it’s own potential problems. It might degenerate into populism, with wealth generating free-trade often as the first victim.

It might, even in the most advanced economies (the US is a prime example), degenerate into catering to special interest. If you don’t believe that, then realize that the two booming sectors in the world economy right now, energy and agriculture, are also the two sectors most heavily protected and provided with all kinds of tax brakes and subsidies.

Although we cannot take long-term growth for granted, in the larger scheme of things, it is likely that after the inevitable deceleration, things will return to normal (they might even get better as policy makers absorb the errors made that got us in the present mess).

The world had opened up (or ‘become flat’, if you like) by plunging telecommunication cost, decreasing trade barriers, and the revolution in container shipping. Developing nations who have made serious work of their education systems can now profit from combining third world wages with first world technology and know-how.

And some of these developing nations are going beyond that and use this the foothold they already established in certain industries as springboard by leveraging the output of their education systems. This is the way to go forward and become truly important world players.

These strategies today are both easier with global capital so mobile and footlose, and knowledge increasingly being the critical component in many sectors. Once a foothold is established in one sector on the basis of cost, the great leverage game can begin.

So the present stage in globalization offers (but by no means guarantees, hence our remark about politics above as the main potential spoiler) a faster track out of poverty than any time before. With knowledge being the most important ingredient, there is no reason why poor countries cannot pull themselves up, like Baron von Munchausen, by their own hair.

In a very simplified form, here is how it works:

• Open up and offer the domestic economy as a low-cost production base
• Use the resources to invest in education. The engineers, these education systems deliver have mostly explicit and formal knowledge, but putting them to work in the production platforms will turn that knowledge into much more valuable tacit and collective knowledge (routines and capabilities) that offer increasing returns and economies of learning, providing the potential of a self-sustaining path to improvement and add more value in what initially was a cheap assembly line, moving up the value chain
• This strategy can be applied in many sectors, but also on parts of the value chain, as these can in many cases be unbundled and moved to separate locations according to need (research in US, design in Italy, manufacturing in China, etc.)
• And a new wave of de-assembling and re-assembling value chain is already underway with companies moving to a so called ‘open innovation’ model in which they solicitate outside expertise in some of the most critical processes, like research and development. What used to be periously guarded proprietary research facilities now tapping the global knowledge base.

The big developing countries have plenty of catch-up (and then leveraging their educational systems) to do. And there are very large nations with lots of people who still have huge opportunities in front of them on this way, like China and India.

It might surprise you, but we are somewhat more optimistic about India compared to China, despite it’s rather messy politics. Why? India is facing a couple of bottlenecks that, once removed, will show it’s potential even better. Some of these bottlenecks are:

• It’s infrastructure. India needs to upgrade transport, power plants, networks, To remedy that takes investments, the economics should be sound, the politics perhaps less so (as nationalism at the state level and far left-wing politics have combined to sully foreign investment projects more than once)
• Labour laws, it’s really very difficult to fire people, which is a significant barrier to hiring them in the first place. If you cannot get rid of your workforce, hiring them really becomes a leap of faith in the future, you must be sure your business is going to do well
• It’s rarely realized, but India is a much more closed economy compared to China, which is (and this will perhaps be even more surprising) one of the most open economies in the world. There is a pretty close correlation between the size of an economy and it’s openness, which is entirely logic, as a bigger economy needs less from the outside world, transport cost increase (in general, as there are some big economies covering just a small geographical space), and more opportunities for specialization and trade exist within the national boundaries.

Growth in countries like China and India, but also the likes of Brazil, Indonesia, Pakistan, Russia means that that middle classes are growing at very significant numbers. Entering the middle classes comes with a whole new aspiration and consumption level, for instance changing diets, modes of transport, housing, medical care, fertility rates, education, recreation, the ramifications are many.

Just to illustrate what kind of numbers we’re talking about:

• The World Bank estimates that the global middle class is likely to grow from 430 million in 2000 to 1.15 billion in 2030.
• In 2000, developing countries were home to 56% of the global middle class, but by 2030 that figure is expected to reach 93%. China and India alone will account for two-thirds of the expansion, with China contributing 52% of the increase and India 12% (World Bank)
• The McKinsey Global Institute, the consulting firm’s independent economic research arm, projects India’s middle class will grow from 50 million to 583 million people in the next two decades. At the same time, the country will advance from the world’s 12th largest consumer market to the fifth. Meanwhile, China is expected to become the world’s third-largest consumer market by 2025.

What kind of impact these changes are having on the opportunities for companies is nicely illustrated by the following examples (from Wharton):

• For companies like Coca-Cola, it’s newly appointed chief executive Muhtar Kent sees this market as critical to his company’s future and describes the scale of the opportunity as equivalent to adding a city the size of New York to the world every three months.
• Bill Amelio, CEO of Lenovo, the Chinese firm that merged with IBM’s personal computer business, notes that China is now the world’s largest market for television sets and cell phones and the second-largest market for automobiles and personal computers.

One thing to keep in mind is that it is a development that contains the seeds of its own deceleration, rising economic wellbeing almost everywhere leads to fewer offspring, so sooner or later the population growth will decelerate.

That’s not a negative thing for many reasons (and this really is a change that will happen over generations), but it does mean that the population of these rapidly growing countries will start to see slower growth and might even stabilize. Which is perhaps better as there are some resources which really are finite.

We’ll have more on long-term trends in coming weeks.