(By Otaviano Canuto)
In PREM Note 141 released last week, Milan Brahmbhatt and Luiz Pereira da Silva point to several structural differences between the global economy today and in the 1930s that tend to differentiate the current crisis from the Great Depression. The larger weight of faster-growing developing countries in the current world economy is among those differences, one that bodes well for recovery prospects.
As can be seen in Chart 1, there has long been a close correlation between economic cycles in developed and developing economies. More recently, since the early 2000s, this has been combined with systematically higher growth rates in developing relative to developed economies. As the authors remark, “there has been no decoupling in the cyclical component of developing country growth”, while “there has arguably been a decoupling in underlying trend rates of growth” (p.2). A similar pattern remains even if China and India are taken out of the picture.
Source: PREM Note 141(p.3)
So much for the heated debate sparked when – in the late phase of the global financial “bubble” - some analysts announced a “decoupling” of emerging markets, to be just as promptly followed by those referring to a “reverse coupling”, when so-called “sub-merging markets” seemed to be dragging developed countries even lower, during the throes of the financial crisis! More recently, though, many emerging markets have been recovering faster than developed countries while also maintaining the positive growth premium that emerged earlier in the decade. The latest World Bank projections, for example, are for developing countries as a whole to grow by 1.2 percent in 2009, while GDP in developed countries is forecast to decrease by 4.2 percent. In fact, the true question is two-fold:
- How really autonomous (sustainable) is the “trend decoupling”; and
- To what extent can “trend decoupling” provide a positive boost or “reverse coupling” for developed countries, particularly since many analysts expect the crisis to leave developed economies with a legacy of significantly lower growth in the near future.
Several factors could lead to a reduction of both actual and potential growth in developed countries in the next few years. On the demand side, it is still an open bet whether the promptness and strength of recovery in private absorption (consumption and investment) will be sufficient to render unnecessary the current “life support” provided by stimulative monetary and fiscal policies, before the capacity for such stimulus is exhausted. Brahmbhatt & Pereira da Silva note how the combination of a credit crunch with busts in the housing and equity markets, corporate deleveraging of portfolios and rebuilding of net worth by households all make a vibrant recovery in private absorption a tall order.
On the supply side, lower investments in R&D may not be the only negative factor affecting the evolution of total factor productivity (TFP). Mohamed El-Erian, (A New Normal), for example, singles out some possible causes of lower potential output, listed in Chart 2 below. He also calls attention to the possibility of a sooner than expected need to unwind aggressive fiscal and monetary counter-cyclical policies if inflation also recurs sooner than expected, due, for instance, to a substantial decline in the path of potential output (Chart 2).
As for developing countries as a group, there are at least three reasons to believe that it is possible to sustain the “trend decoupling”:
First, the recent fast recovery in many large emerging markets has reflected the good shape and sustainability of their national balance sheets. As Brahmbhatt & Pereira da Silva remark, one hypothesis for the recent rise in developing country trend growth is that it “is mainly a payoff for the strenuous efforts by many of these countries to improve their macroeconomic, structural, and other policies over the last 2-3 decades, accompanied over the past decade with a marked improvement in country balance sheets. As such it should persist in the medium term, despite the severe negative shock of the present crisis.” (p.2).
UBS has developed a Total Emerging Market Stress Index, the components of which can be observed in Chart 3. It looks like the recent financial frenzy in developed economies has not led to a deterioration of local financial conditions in emerging markets as a whole (with several well known exceptions). It suggests that the boom in emerging markets has not been too dependent on the “hyper-bubble” financial conditions in developed countries.
One notes from Chart 3 how major emerging market crises in the 1980s and 1990s were preceded by a rise in the group’s vulnerability indicators. However, on this measure, emerging market vulnerability today is lower than ever before. On the contrary, as Chart 4 indicates, there has been a fairly steady process of financial integration of emerging and developed economies, accompanied by both a diversification in the types of developing countries’ gross foreign liabilities and a rise in their gross foreign assets relative to liabilities. Indeed, as of today, there seems to be a potential for increased leverage that may well be available to underpin a new wave of investment and growth in developing countries, even if a reduced appetite for cross-border capital flows from developed countries persists for some time.
Source: Balakrishnan et al, p. 45.
A second reason to be upbeat regarding the possibilities of “trend decoupling” has been outlined by Dani Rodrik (“Growth after the crisis”) in a recent contribution to the Commission on Growth and Development. Even if the advance of the technological frontier slows down in developed countries, developing countries still have a wide scope for technological learning and catching-up, given the existing “convergence gap”. Furthermore, “structural change – the shift of capital and labor from low-productivity to high-productivity sectors – is both a cause and consequence of long-term growth” (UNIDO, p.4). And, as extensively illustrated in UNIDO’s 2009 Industrial Development Report, there is a lot of structural-change potential still to be tapped as a source of growth in developing countries, as long as outlets for absorption of the correspondingly changing production structures can be found.
To what extent might slower growth in developed economies and an eventual adjustment of the U.S. current-account deficit in particular hinder such a process of structural change in developing economies? This leads us to the third motive why “trend decoupling” could be sustainable in principle: the structural dependence of developing countries on exports to developed countries as an outlet for their increasing GDP levels may have been somewhat overstated. According to the already referenced UBS report, once one adjusts existing cross-border trade figures to take into account only the net-of-imports or value-added contribution of exports to GDP, and once the treatment of intra-regional trade is controlled for different country sizes, emerging market economies come out as “only marginally more export-oriented than the U.S. or Europe”.
This is of course not to deny the role of extraordinary demand and rising current account deficits in key developed countries like the U.S. as an exogenous, autonomous source of impulse. Nor should one omit the importance of China’s role as a large export processing and assembly location catering for developed country markets in explaining the unfolding of “production chains” and large recent increases in trade among developing countries. Nevertheless, there are grounds to believe that fast rising absorption within developing countries can provide at least a compensating factor. See Chart 5, which shows aggregate domestic demand, savings, consumption and investment in developing countries, keeping in mind that most of the recent sharp rise in developing country savings in the 2000s - the so-called “savings glut” - is accounted for by China and some oil exporters.
(Almost) needless to say, the maintenance of “trend decoupling” presupposes the preservation of sound fiscal and monetary policies in the developing world, as well as appropriate policies regarding technology absorption and promotion of structural change. As for the positive “reverse coupling” effects on developed countries, although it is probably not large enough to compensate for the headwinds facing their actual and potential growth in the near future, certainly their prospects will be better with a new growth cycle in the developing world.
 It is worth noting that developing countries will be treated here in the aggregate, which tends to emphasize the experience of the large economies like China and India, while obscuring a great heterogeneity of conditions across countries. Nevertheless most of the important conclusions in the paper remain qualitatively correct even when China and India are excluded.