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Lost in Transition

WASHINGTON, DC – Financial markets and the news media have one thing in common: they tend to oscillate rapidly between hype and gloom. Nowhere is this more apparent than in analyses of emerging economies’ prospects. In the last few months, enthusiasm about these countries’ post-2008 economic resilience and growth potential has given way to bleak forecasts, with economists like Ricardo Hausmann declaring that “the emerging-market party” is coming to an end.

Many now believe that the recent broad-based growth slowdown in emerging economies is not cyclical, but a reflection of underlying structural flaws. That interpretation contradicts those (including me) who, not long ago, were anticipating a switchover in the engines of the global economy, with autonomous sources of growth in emerging and developing economies compensating for the drag of struggling advanced economies.

To be sure, the baseline scenario for the post-crisis “new normal” has always entailed slower global economic growth than during the pre-2008 boom. For major advanced economies, the financial crisis five years ago marked the end of a prolonged period of debt-financed domestic consumption, based on wealth effects derived from unsustainable asset-price overvaluation. The crisis thus led to the demise of China’s export-led growth model, which had helped to buoy commodity prices and, in turn, bolster GDP growth in commodity-exporting developing countries.

Against this background, a return to pre-crisis growth patterns could not reasonably be expected, even after advanced economies completed the deleveraging process and repaired their balance sheets. But developing countries’ economic performance was still expected to decouple from that of developed countries and drive global output by finding new, relatively autonomous sources of growth.

According to this view, healthy public and private balance sheets and existing infrastructure bottlenecks would provide room for increased investment and higher total factor productivity in many developing countries. Technological convergence and the transfer of surplus labor to more productive tradable activities would continue, despite the advanced economies’ anemic growth.

At the same time, rapidly growing middle classes across the developing world would constitute a new source of demand. With their share of global GDP increasing, developing countries would sustain relative demand for commodities, thereby preventing prices from reverting to the low levels that prevailed in the 1980’s and 1990’s.

Improvements in the quality of developing countries’ economic policies in the decade preceding the global financial crisis – reflected in the broad scope available to them in responding to it – reinforced this optimism. Indeed, emerging countries have largely recognized the need for a comprehensive strategy, comprising targeted policies and deep structural reforms, to develop new sources of growth.

It has become apparent, however, that emerging-market enthusiasts underestimated at least two critical factors. First, emerging economies’ motivation to transform their growth models was weaker than expected. The global economic environment – characterized by massive amounts of liquidity and low interest rates stemming from unconventional monetary policy in advanced economies – led most emerging economies to use their policy space to build up existing drivers of growth, rather than develop new ones.

But the growth returns have dwindled, while imbalances have worsened. Countries like Russia, India, Brazil, South Africa, and Turkey used the space available for credit expansion to support consumption, without a corresponding increase in investment. China’s non-financial corporate debt increased dramatically, partly owing to dubious real-estate investments.

Moreover, nothing was done in anticipation of the end of terms-of-trade gains in resource-rich countries like Russia, Brazil, Indonesia, and South Africa, which have been facing rising wage costs and supply-capacity limits. And fiscal weakness and balance-of-payments fragility have become more acute in India, Indonesia, South Africa, and Turkey.

The second problem with emerging-economy forecasts was their failure to account for the vigor with which vested interests and other political forces would resist reform – a major oversight, given how uneven these countries’ reform efforts had been prior to 2008. The inevitable time lag between reforms and results has not helped matters.

Nonetheless, while emerging economies’ prospects were clearly over-hyped in the wake of the crisis, the bleak forecasts that dominate today’s headlines are similarly exaggerated. There are still a number of factors indicating that emerging economies’ role in the global economy will continue to grow – just not as rapidly or dramatically as previously thought.

This summer, the mere suggestion of a monetary-policy reversal in the United States sparked a surge in bond yields, which triggered an asset sell-off in several major emerging economies. Perhaps that experience will serve as a wake-up call for these countries’ leaders. Only by recognizing the weaknesses of old growth patterns and pursuing the needed structural reforms can emerging economies achieve strong, stable, and sustainable GDP growth – and fulfill their potential as the global economy’s main engines.