Is the golden age over for emerging markets?
The answer to that question is probably yes, according to the International Monetary Fund (IMF). A chapter in its latest World Economic Outlook warns emerging economies they can no longer count on the benign external environment that had led to high economic growth in their economies in the last few decades.
It warns of “fading external tailwinds, including waning potential growth in advanced economies, slowdown and rebalancing in China, and a shift in the commodity cycle that has affected commodity exporters”. It says that, “Together with a risk of protectionism in advanced economies and tighter financial conditions as US monetary policy normalizes, these changes make for a more challenging external environment for emerging market and developing economies going forward.”
The chart paints a broad picture. It shows how the contribution of emerging markets to world growth increased from 18.2% during 1976-79 to 69.82% during 2010-15. The contribution of developing countries to world consumption rose even more markedly—from 13.9% during 1976-79 to 72% in 2010-15. But the rise of emerging markets is an old story. What’s new are the projections—the IMF forecasts that the contribution of emerging economies to both global growth and consumption will decrease during the period 2016-2021, as the chart indicates. True, the decrease is not much, but it does mark a turning point from the hefty increases of earlier decades.
How important are external conditions for growth in emerging markets? The IMF article says a 1 percentage point increase in domestic absorption by a country’s trading partners translates into around a fifth of the annual average growth in GDP per capita in emerging markets. And secondly, a 1 percentage point increase in the ratio of capital flows to GDP of emerging market and developing economies raises medium-term growth by 0.2 percentage points.
Taken together with higher growth on account of better terms of trade for commodities, the IMF estimates that over the past two decades, these factors accounted for more than half of medium-term growth, on average, across emerging market and developing economies. In turn, about half of the contribution to growth from external factors is due to higher capital inflows to emerging markets.
Will India too be affected? Well, India is one of those countries where domestic demand has been the mainstay of growth. But we shouldn’t underestimate the important part that external demand has played in supplementing that growth. One very important element of India’s liberalisation story and of its growth pick-up after liberalisation is the increase in its share of exports of goods and services to GDP from 6.8% in 1990-91 to 25% in 2013-14. The most rapid spurt happened in the early noughties, during the period of the global boom, when the ratio went up from 12.6% in 2001-02 to 23.7% in 2008-09.
As the IMF report says, “a favourable impulse from external demand and financial conditions helps medium-term growth outcomes by making growth accelerations more likely. It also reduces the likelihood of growth reversals.”
That’s not all. The rise in fund flows to the Indian stock markets during the noughties led to a boom in the secondary and primary equity markets, allowing companies to raise capital easily and lowering their cost of capital. This, in turn, sparked an investment boom and also led to higher employment, higher wages and consequently, to higher consumption. As the IMF says, “Capital inflows can enhance growth in emerging market and developing economies through various channels: augmentation of funds available for investment, transmission of crucial know-how and technological diffusion, and adoption of market discipline and better governance practices.”
Given the importance of the external sector, what then can be done to mitigate the impact of the headwinds mentioned above? The IMF believes that, faced with a potentially less supportive external environment than in the past, emerging market and developing economies can get the most out of a weaker growth impulse from external conditions by strengthening their institutional frameworks and adopting a policy mix that protects trade integration; permits exchange rate flexibility; and ensures that vulnerabilities stemming from high current account deficits and external debt, as well as high public debt, are contained.
These are all standard text-book remedies, but complying with them will be all the more important in a less benign external environment.
The markets, fixated perhaps on the short term, seem to be ignoring these long-run risks outlined by the IMF. As a recent Bank for International Settlements paper by Luis Awazu Pereira de Silva and Elod Takats says, “We are witnessing a departure from the policies of trade integration and multilateral cooperation that have been our successful recipe for the last 50 years. Is it purely rhetorical or real? Temporary or lasting? Is it linked to the current backlash against globalisation? Therefore, there is a disconnect between market exuberance and policy uncertainty. There are indeed threats to trade, financial integration and international cooperation that benefited both AEs and EMEs. These threats are increasing.”