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Recoupling or Switchover

Otaviano Canuto's picture

The current recovery in advanced economies is now exhibiting several signs of fragility. Their medium term growth prospects also look difficult. In this environment two questions arise: Will developing economies experience a renewed downward “recoupling” as a result of a low-growth scenario in advanced economies? Or, on the contrary, could developing countries “switchover” to become locomotives in the global economy, providing a countervailing force against an otherwise slowing-down train? As discussed in my new paper, here are some of the factors pushing in these two opposite directions.

Several factors point to a medium-term reduction of both actual and potential growth in most advanced economies. First, sooner or later fiscal consolidation will become a major issue among advanced economies once—or even before—recovery is fully established. Future fiscal contraction negatively affecting the private sector will be the price paid for the role of fiscal stimulus in helping rescue advanced economies from the brink of the abyss during the crisis.

Secondly, the process of US households’ balance-sheet deleveraging and adjustment is far from complete. Consumption spending growth is likely to remain weak and/or wobbly in the absence of large renewed hikes in asset prices.

A third aspect to weigh against a return to a high-growth path is the likely jobless nature of the current recovery in many high-income countries. Slow-to-reverse shocks—a financial crisis combined with a house price bust, cross-sector differentiated job creation/destruction—have been in play and continued macroeconomic uncertainty is also countering employment growth.

Fourth, all financial sector re-regulation proposals under discussion point to higher costs of financial intermediation. After all, the general purpose is to curb the unbridled “endogenous liquidity factories” and excessive leverage that led to widespread asset bubbles in the run-up to the economic crisis.

Developing economies as a whole do not have yet a size big enough to rescue the world economy from the scenario of low growth in advanced economies. In terms of levels, the size of G7 economies at market prices is still 60% of world GDP and the major potential new poles of growth (China, India, and Brazil) might count no more than 30%. As time passes by, however, the absolute size of the two groups of countries may reverse positions. However, that will depend on the ability of developing countries to tap into some possible sources of autonomous growth.

First, the fast recovery in many emerging markets has reflected the good shape and sustainability of their national balance sheets. Looking forward, there is in principle a wide range of greenfield investment opportunities in developing economies—especially in infrastructure—that may benefit from higher financial leverage by both public and private sectors. Nonetheless, public sector management capacities and appropriate governance mechanisms must be in place so as to guarantee the use of adequate criteria in project choices and designs, as well as to avoid misappropriation of returns. The current surge in private capital flows to emerging markets with a profile potentially conducive to fostering asset market bubbles, rather than to building greenfield assets, is a potential pitfall.

Secondly, most developing countries face a technological convergence gap relative to the frontier level of knowledge in advanced economies. Unexploited latecomer advantages are a venue for local productivity improvements via technology transfer and adaptation that remains open and wide even if the advance of technology frontiers slows down in high-income countries. Bur again policy challenges will have to be faced. Absence of complementary factors such as reliable infrastructure, access to finance, and provision of formally educated labor force must be gradually mitigated. Furthermore, institutional factors that negatively affect the “investment climate” tend to harm investments in technology and must be addressed.

Thirdly, provided that domestic absorption in developing countries as a whole rises relative to its own production potential and South-South trade openness is reinforced, one might see a new round of successful export-led growth experiences. After World War II, Europe and Japan sustained a long growth cycle through a process of technological and mass-consumption catching up with the US frontier. Whereas, from the 1990s onward, many developing economies achieved high growth facilitated by innovations in information and communication technologies, combined with globalization, but with an important role left to developed countries for absorption of their output. The time may now have come for better matching of increases in production and consumption within developing countries. That rebalancing in itself could become a powerful tool to fasten the speed of reducing poverty and inequality.

Programs of investment in infrastructure and human capital, poverty reduction, and social inclusion in developing countries would stimulate local consumption and investment, producing positive feedback loops. A higher role for effective networks of social protection and for active poverty-reduction policies in developing countries may therefore become a component of sustainable global growth.

Finally, natural-resource intensive 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 after the crisis will be more dependent on developing countries as a group and demand in these countries is more commodity intensive than elsewhere. Once again, as long as appropriate governance and revenue administration mechanisms are put in place, particularly to avoid rent-seeking behavior, that natural-resource availability may be a “blessing” for those countries.

The bird’s eye view taken here leads us to conclude that, yes, there is a scope for a switchover where developing countries as a whole take on a greater role as global locomotive and move global growth forward, offsetting forces toward a negative recoupling deriving from less buoyancy in advanced countries. Nevertheless comprehensive homework in terms of domestic policies and reforms will be fundamental to accomplish that mission.

To read the paper where the subject is more thoroughly discussed, please click here.
 

Comments

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Submitted by Yes on
Great article, Otaviano. I enjoyed reading your paper as well. Very timely to see the European crisis and potential opportunities in emerging markets.

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