Why the emerging markets are so important
Global economic growth last year was 4.7%, maintaining the extremely strong pace of the last four years. The main impetus for that growth came from the emerging markets. Growth in the US was just 2.2% and 2% in Japan, the first and second largest economies in the world, respectively. With consensus forecasts for 2008 suggesting that these two economies will expand at an even slower pace, 1.6% in the US and 1.4% for Japan, the question is what will happen to global growth? One worry has been that, with the US skirting recession, will the world economy experience recessionary conditions as well? Our view is that the world economy will be able to absorb the slowdown of the US, and a number of other developed economies, including the UK. There will be a slowdown in the global economy, but growth should still be a respectable 4.3% because of the strength of emerging market growth. What has changed to make emerging market growth so stable and less dependent on the US?
Economic growth is strong…
The first point is that robust economic growth, as shown in chart a, has given rise to an improvement in a range of macroeconomic debt and stability indicators: effectively a reduction in risk. These include a rise in official reserves, hence a rise in the ability to meet debt repayments, and a fall in external debts, in absolute terms and as a share of export earnings. All of this has meant a greater degree of stability, in which to deliver the benefits of lower inflation through lower interest rates, see table 1. The latter has helped to fuel faster domestic demand growth, and so recently to strong rises in import demand, see table 2. But it has also meant a fall in sovereign risk, which in turn has meant a big inflow of long term capital into these economies, making them stronger.
…and so stability has improved…
The support that this lends to currency, stock market and bond and equity investment flows should not be underestimated. Even with a strong rise in import demand in recent months, in aggregate the emerging markets are still running large external current account surpluses with the rest of the world. The question of whether this is likely to persist as they grow more quickly will partly depend on the sustainability of the rise in commodity prices. The rise in commodity prices, for oil, metals and a range of agricultural goods will clearly benefit those emerging markets that are net exporters of these goods, and damage those that are not. In aggregate, the emerging market economies are net exporters of the commodities that have seen strong price increases, so will be big beneficiaries of more favourable terms of trade, effectively raising their income. And since the new demand, at the margin, for these goods is not coming from the developed economies, then this makes the net benefit even more likely to persist. The strong demand for commodities that lies behind their price rise is coming from the big population centres of India and China, who can afford the increase in prices as they are amongst the fastest growing of the emerging market economies.
…allowing the room for faster growth and greater flexibility to respond to crises…
With faster growth occurring in an environment of greater economic and policy stability, the second point is that room for policy to adjust to deal with more difficult conditions is much improved. Many of the emerging markets have central banks that are focused on inflation targets, and the fiscal situation is also greatly improved. This gives scope for interest rates to be lowered if growth were to falter, as inflation would likely weaken. Generally, with better economic conditions and better macroeconomic policy, emerging market currencies are strong but not overly so, meaning there is scope for devaluations that would leave many of these economies in a position that would not be too damaging to stability. So there is scope for interest rate cuts, increased government spending and currency depreciations in the emerging markets should they be required.
…this is the real change of the last decade in the emerging markets…
The third point is that stability gives the flexibility that makes continued economic growth in the emerging markets more likely in the face of a slowdown in the US. This is not to say that some emerging economies do not have big challenges, they do. Despite, or because of, fast growth, South Africa has the problem of electricity shortages to deal with. In emerging market Europe, some countries have very large external deficits alongside fiscal deficits, but these are problems of success (too fast growth combined with lack of proper fiscal policy controls) rather than failures. These issues are not as damaging for growth as the type of problems faced by emerging markets in the late 1990s, and certainly not as bad as in the 1980s when they were plagued by instability.
...but we should not ignore that the US is still critical
Of course, the US remains the world’s largest economy and the world has not decoupled (in fact, the world economy is more integrated) so that its growth rate is important to help maintain global expansion at the high pace of the last five years. Moreover, lower interest rates in the US are helping stability in the emerging markets and economies that are linked to its rates (though it is encouraging too fast growth in those with a fixed exchange rate link to the US). However, the world economy’s expansion has been fast for some time and so a period of higher interest rates outside of the US seems likely in order to slow growth, in order to keep inflation at bay and to thereby maintain the growth momentum into the next few years.
Fourth, and the really good news, is that the rest of the world - not overly impacted by the US sub prime crisis that has hit credit markets - is raising interest rates and toughening the policy stance. This action should prolong the global expansion we have experienced in the last decade by controlling inflation. A trade deal from the Doha round that freed up agricultural markets worldwide would give the global economy an even bigger boost, as it would lead to lower prices for agricultural goods through greater export opportunities.
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