While advanced economies are still recovering from the crisis, developing countries as a whole are becoming the new engine of global growth. Such perspective of a switchover of locomotives in the global economy is already leading to a substantial change in relative prices of assets in these two groups of economies. However, a possible overshooting of asset prices in developing economies along that global portfolio realignment may become a threat to a smooth replacement of engines. Requirements in terms of economic-policy making in these countries have changed as the game has moved up to a more complex stage.
From Coupling to Switchover*
Economic cycles of developing countries have for decades been, and will continue to be, correlated with those in advanced economies. There has been no “decoupling” of cycles. However, long-term growth trends did separate (decouple), almost 20 years ago, when developing nations began to grow at their own, much faster pace (Figure 1).
The weight of developing countries as a whole in the global economy has been rising steadily since 2000, and the continuation of that trajectory comes out in most GDP projections. As time passes, the absolute size of the two groups of countries seems poised to reverse positions. Although developing Asia has the lead in that dynamic, rising shares in global GDP are also a feature of other regions.
There are at least four tracks – sources of “autonomous growth” – along which most developing economies will be able to keep growing even if advanced economies remain trapped in their current quagmire. First, the balance sheets of both the public and private sectors in most emerging economies are in good shape. While deleveraging is still an on-going process in advanced economies, many developing countries will be able to explore untapped investment opportunities – infrastructure bottlenecks being a glaring example.
Second, there are increased possibilities of technological learning available to latecomers. There is a large inventory of technologies that the developing world has yet to acquire, adopt, and adapt. Thanks to breakthroughs in information and communication, transferring those technologies is becoming cheaper and safer. Furthermore, decreased transportation costs and the break-up of the vertical production chain in many sectors are allowing poorer countries to insert themselves where it is easier.
Thirdly, a flipside of the emergence of new middle classes in many developing countries is that domestic absorption (consumption and investment) in developing countries as a whole may rise relative to its own production potential. A parallel with Europe and Japan after World War II can be made. Europe and Japan sustained a long growth cycle through a process of combined technological and mass-consumption catching up with the US frontier. This contrasts with the truncated process of poverty reduction limiting growth in Latin America in the past, as well as with the important role left to developed countries for output absorption in the Asian case. The time may now have come for better matching of increases in production and consumption within developing countries as a group. Provided that South-South trade linkages are reinforced, one might see a new round of successful export-led growth experiences in smaller countries.
Finally, natural resource rich developing countries may benefit from the fact that the relative demand for commodities tends to remain strong in the medium term, to the extent world growth will be more dependent on developing countries as a group and demand in these countries is more commodity intensive than elsewhere. As long as appropriate governance and revenue-administration mechanisms are put in place – particularly to avoid rent-seeking behavior – natural resource availability may turn out to be a blessing rather than a curse for these countries.
Most developing countries were already moving along these four tracks before the global financial crisis, owing largely to improvements in their economic policies during the previous decade. Given that these policies enabled developing countries to respond well to shocks coming from the crisis epicenter, there are strong incentives to keep them in place.
Figure 2 provides a simplified illustration of how those sources of “autonomous” growth and rising global GDP shares may allow developing countries not only to escape from a negative “recoupling,” but also partially rescue advanced economies. Lines AC (Advanced Countries) and DC (Developing Countries) represent respectively how growth in each group of economies depends on the other. Trade and corresponding investment prospects, and net factor incomes generated abroad (e.g., return on foreign assets, remittances) are channels through which growth interdependence takes place.
The legacy of the crisis on AC is exemplified by the shift from AC0 to AC1. The adverse impact of slower advanced-country growth on developing countries — the negative “recoupling” of developing countries — is reflected in a global move from point A to point B. However, if new “autonomous” sources of trend growth in DC can be tapped and DC0 shifts to DC1, then the global economy can settle at a point such as C, where developing countries grow as much as before and mitigate the crisis effects on advanced economies.
Figure 2 – Re-coupling and Switchover
Asset price overshooting may be deadly
There is, however, a major threat to a smooth locomotive switchover: the possibility of overshooting in the inevitable asset price adjustment accompanying the shift in relative growth prospects and perceptions of risks. Indeed, because the creation of new assets in developing countries will be slower than the sudden increase in demand for them, the price of existing marketable assets in those markets – stocks, bonds, real estate, and human capital – are likely to overshoot their long-term equilibrium values. Recent history is full of examples of the negative side-effects that can arise.
Each and every one of the recent booms and busts – in Latin America, Asia, and Russia in the 1990’s, and in Eastern Europe, Southern Europe, and Ireland more recently – shared some combination of unsustainably low financial costs, asset bubbles, over-indebtedness, wage growth unwarranted by productivity gains, and domestic absorption in excess of production. In every case, these imbalances were fueled by easily identifiable periods of euphoria and sudden asset-prices increases.
True, external factors, such as foreign liquidity, were conducive – or at least permissive – to such periods of euphoria. Twin current-account and fiscal deficits and/or currency and debt-maturity mismatches were the rule. But the point is that powerful forces that drive up asset prices may be unleashed even without massive liquidity inflows. The scramble for available assets and a dangerous euphoria may occur through purely domestic mechanisms.
Requirements in terms of economic policy-making in developing economies have therefore changed as the game has moved up to a higher degree of complexity. In addition to those policies that have supported growth before and during the crisis, there is now a new set of challenges established by that same success.
Controls directly applied on capital inflows can only work temporarily and under certain conditions.** Their effectiveness depends on how extensive they are, whether the country has the capacity to enforce them, and on the incentives investors have to circumvent them. The more sophisticated domestic financial markets are and the higher the role played by foreign savings in the country’s growth, the lower the usefulness of those controls. Prudential regulation of the domestic financial system, combined with oversight against excessive non-financial corporate leverage, have come to the fore as main tools both to curb volatile capital inflows and to avoid purely domestic euphoria.
The most important task, however, is to facilitate and strengthen the creation of new assets, and there is much that developing countries can do in this regard. They can take advantage of the currently upbeat “animal spirits” of asset buyers to build contestability, transparency, and institutional quality around markets in which greenfield investments can be implemented. They can ensure that the rules they have in place are consistent and favorable to funding investment projects with long maturities. And they can invest in their own capacity for project selection and design.
These and other internal reforms would serve to moderate the furious rise in the price of developing-country assets. For that reason, they also constitute the best way to ensure that the next locomotives of global growth – and all the economies that are pulled by them – remain on the rails.
(*) See Otaviano Canuto and Marcelo Giugale (eds.), “The day after tomorrow – a handbook on the future of economic policy in the developing world”, World Bank, 2010, available at www.worldbank.org/prem.
(**) See Milan Brahmbhatt, Otaviano Canuto and Swati Ghosh, “Currency wars yesterday and today”, Economic Premise n.43, December 2010, available at www.worldbank.org/economicpremise.
Otaviano Canuto is the World Bank Vice-President for Poverty Reduction and Economic Management.