Reigniting Emerging-Economy Growth

Michael Spence

Indian day laborers around fire

HONG KONG – It is no secret that emerging economies are facing serious challenges, which have undermined their once-explosive growth and weakened their development prospects. Whether they return to the path of convergence with the advanced economies will largely depend on how they approach an increasingly complex economic environment.

Of course, these economies’ development path was never simple or smooth. But for most of the post-World War II period, until as recently as ten years ago, it was relatively clear-cut.

Countries needed to open their economies at a sensible pace; leverage global technology and demand; specialize in tradable sectors; pursue a lot of investment (some 30% of GDP); and promote foreign direct investment, with appropriate provisions for knowledge transfer.

Throughout this process, the emerging economies recognized the importance of allowing market mechanisms to work, guaranteeing property rights, and safeguarding macroeconomic and financial stability. Perhaps most important, they knew that they had to focus on generating employment, particularly in urban areas and modernizing sectors, and on inclusiveness more broadly.

As they pursued this agenda, emerging economies experienced stuttering starts and numerous crises, often associated with excessive debt, currency traps, and high inflation. And, upon reaching middle-income levels, countries confronted the policy and structural pitfalls that accompany the transition to high-income status. Nonetheless, in an increasingly open global environment, characterized by strong growth (and demand) in the advanced economies, the emerging economies managed to make huge and rapid progress.

That all changed after the 2008 global financial crisis. To be sure, the core of the development agenda remains the same. But it is vastly more complicated.

One set of complications arises from external global imbalances, distortions, and heightened volatility in capital flows, exchange rates, and relative prices. Given that such challenges are essentially new, there is no proven roadmap for overcoming them. After all, the developed economies have not previously engaged in the kind of unconventional monetary policy seen in recent years – a period characterized by ultra-low interest rates and ultra-fast cross-border capital flows.

For the emerging economies, with their relatively illiquid financial markets, such trends encourage over-dependence on low-cost external capital, which can be withdrawn in a heartbeat. Rock-bottom borrowing costs also spur excessive reliance on leverage, weakening the will to undertake reforms needed to boost potential growth – and further exacerbating the economy’s vulnerability to a shift in interest rates or investor sentiment.

Making matters worse for the resource-rich emerging economies, commodity prices have plummeted since 2014. After a prolonged period of accelerating demand growth, notably from China, governments came to regard high commodity prices as semi-permanent – an assumption that caused them to overestimate their future revenues. Now that prices have dropped, these countries are facing huge imbalances and fiscal strain. And governments are not alone; the private sector, too, relied on rosy assumptions to justify imprudently high levels of leverage.

Slower growth in the advanced economies has also weakened trade flows, adding to the headwinds. As Mohamed El-Erian has observed, in the global economy, your neighborhood – the economies to which you have economic or financial links – matters. That is all the more true for the emerging economies, which have become highly dependent on their neighbors.

In short, emerging economies have been challenged by externally generated macroeconomic shifts, unconventional monetary policies, widespread volatility, and slow growth in developed markets. Without much of a playbook to guide them, it is unsurprising that their ability to cope with these challenges has varied considerably.

Generally, those that have fared better, such as India, have combined sound growth fundamentals and reforms with pragmatic and activist measures to counter the external sources of volatility. India has also, of course, benefited from lower oil prices.

Commodity exporters like Brazil have struggled more, but not just because of falling natural-resource prices. In fact, the decline in prices, together with the reversal of capital flows, exposed weaknesses in the underlying growth patterns that had previously been masked by favorable conditions.

Now there is yet another challenge, which is becoming larger by the year. Whichever path emerging economies choose for addressing these challenges must also account for the fundamental shift driven by digital capital-intensive technologies. While digital technologies have created new kinds of jobs in high-tech sectors and the sharing economy, among others, they have been reducing and dis-intermediating “routine” white- and blue-collar jobs.

Here, rapid advances in robotics are particularly relevant, as increasingly sophisticated machines threaten to supplant low-cost labor in a variety of sectors. The high fixed and low variable costs of these technologies mean that once robots become more cost-effective than human labor, the trend will not reverse, especially given that automated assembly can be located close to markets, rather than where labor is cheapest.

Jobs in electronics assembly, which plays a huge role in global trade and has helped to drive growth in many emerging economies – notably, China – are particularly vulnerable. While trades involving sewing – textiles, apparel, shoes – are not yet being automated much, it is probably only a matter of time before they are.

As the classic sources of early comparative advantage dwindle, countries – particularly earlier-stage developing countries – will need to implement policies that feature services (including tradable services) more prominently; they will also need to adjust their investment in human capital. Whether this amounts to removing the bottom rungs on the ladder of development remains to be seen. The relatively unconventional growth pattern in India, with its early emphasis on services, may hold important lessons.

In any case, the developing countries – and especially the emerging economies – clearly have a lot on their plates. As these economies add items – protecting themselves from volatility, countering unfavorable external conditions, and adapting to powerful technological trends – to their core structural growth agendas, they will invariably make mistakes, and even stumble.

This will produce high variance in performance across countries and probably reduce the average pace of convergence. But it will not, in my estimation, derail convergence completely.

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