IN THE past decade emerging markets have established themselves as the world’s best sprinters. As serial crises tripped up America and then Europe, China barely broke stride. Other big developing nations paused for breath only briefly. Investors bet heavily that rapid growth in emerging markets was the new normal, while leaders from Beijing to Brasília lectured the world on the virtues of their state-centric economic models.
Lately, though, the sprinters have started to wheeze. Last week China reported its slowest growth in three years (see article). India recently recorded its weakest performance since 2004. Brazil has virtually stalled. This week the International Monetary Fund sharply cut its growth forecast for three of the four so-called BRICs; only Russia was spared (and even there growth is vulnerable to falling energy prices). Some investors darkly recall the developing world’s crisis-prone history and wonder whether the worst is yet to come.
No crisis looms, but serious concern is justified, for the emerging world faces two distinct risks: a cyclical slowdown and a longer-term erosion of potential growth. The first should be reasonably easy to deal with. The second will not.
Revival of the fittest
By rich-world standards, the emerging markets are still doing exceedingly well. The IMF still reckons developing economies will grow by 5.6% this year. Moreover, this deceleration is partly intentional. When the global financial crisis struck, emerging economies responded energetically: China launched a huge stimulus, Brazil’s state-owned banks lavished credit, interest rates were slashed. They succeeded so well that by 2010 they were forced to reverse course. To squash price pressures they raised interest rates, curbed speculation and allowed their currencies to appreciate. With a lag, that tightening has had the predicted result.
Still, the slowdown has proved much sharper than expected. Europe’s sovereign-debt crisis is partly to blame. It has sapped demand for the developing world’s manufactured exports and restrained prices of their commodities; South Africa is a notable casualty. European banks had been conduits for foreign money flowing into emerging markets. Now they are pulling back as they grapple with the problems at home.
Fortunately, policymakers in the emerging world have plenty of scope to respond. Whereas target interest rates of central banks are near zero in America, Japan and Europe, they average almost 6% in emerging markets. Fiscal stimulus is a luxury few advanced economies, whose budget deficits average 6% of GDP, can afford; it is still an option in many developing economies, where deficits are a more manageable 2%.
Most important, the fragilities that made emerging economies so susceptible to crisis in the past are now largely absent. Banks have more capital and rely less on fickle wholesale funding than their European peers. Fixed exchange rates were once the rule for developing countries. They were a way to keep down inflation, but they also encouraged excessive borrowing in foreign currencies, creating strains that eventually broke the currency peg. With inflation under much better control, floating exchange rates (China is a big exception) and well-stocked foreign-exchange reserves now dominate in the emerging world, providing protection against falling exports and flighty foreign investors.
A slump in these countries thus looks unlikely; so, however, does a return to the past decade’s growth rates. China, for one, doesn’t want it. Its economy has become over-reliant on investment; its leaders want to usher in a phase of more sustainable but slower growth, led by consumers. Beyond China, it is increasingly clear that many emerging economies have been growing beyond their underlying potential. Optimists once thought India could sustain Chinese-style growth of over 9% a year; but that led to stubborn inflation and current-account deficits, suggesting that India’s potential growth may be more like 6-7%.
Prepare for the marathon
In retrospect, some of the emerging world’s economic record-breaking was steroid-driven. One performance-enhancer was China’s appetite for raw materials, which created a commodity boom that supercharged many emerging markets. As that boom subsides, Russia’s dependence on oil and gas makes it particularly vulnerable. Another drug was domestic credit, in particular in Brazil, Turkey and eastern Europe.
A new period of impressive paciness is possible, but it depends on policies that will make emerging markets fit for the long run. Here the signs are troubling. In Russia, where the priority should be diversification away from excessive dependence on oil and gas, President Vladimir Putin has proposed a round of social spending that in six years could cost 8% of GDP. India has an eye-watering deficit of 9% of GDP, yet Pranab Mukherjee, the recently departed finance minister and soon-to-be anointed president (see article), failed to tackle fuel subsidies that cost 0.8% of GDP. It makes sense to invest some of the fruits of growth in a better safety net for those left behind; it makes no sense to then delay, as India and to some extent Brazil have done, the investment in power and transport infrastructure that is a prerequisite for future growth.
Sadly, many emerging-world governments have interpreted the crisis in rich-world finance as a reason to preserve a more muscular role for the state. China has reserved some sectors for state-owned enterprises. In Brazil the big state-controlled oil company, Petrobras, and the state-controlled banks have become virtual appendages of government policy. Having so much leverage over the economy is indeed helpful during a crisis, but in the long run it will stifle competition, starve the private sector of capital, deter foreign investment and know-how, and breed corruption.
When the dust settles, emerging markets will still be growing faster than they did before 2003. But getting back up to the speed of the past decade will mean maintaining the macroeconomic discipline and returning to the microeconomic reforms that made it possible in the first place.