Risky Growth Engines

WASHINGTON, DC – While the rich world puts its post-crisis house in order, developing countries as a whole are becoming the new engine of global growth. Increasingly, they are a force pulling the advanced economies forward. But switching locomotives is never free of risk.

As my colleague Marcelo Giugale and I argue in our recent book The Day After Tomorrow, there are at least four tracks along which this switchover is taking place. First, public- and private-sector balance sheets in most emerging economies are relatively clean. While deleveraging is ongoing in advanced economies, many developing countries will be able to explore untapped investment opportunities – infrastructure bottlenecks being a glaring example.

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Second, there is a large inventory of technologies that the developing world is yet to acquire, adopt, and adapt. Thanks to breakthroughs in information and communication, transferring those technologies is becoming cheaper and safer. Furthermore, decreased transportation costs and the breakup of vertical production chains in many sectors are facilitating poorer countries’ integration into the global economy.

Third, a flipside of the emergence of new middle classes in many emerging markets is that domestic absorption (consumption and investment) in developing countries as a whole may rise relative to their own production potential. Provided that South-South trade linkages are reinforced, one might see a new round of successful export-led growth in smaller countries.

Finally, resource-intensive developing countries may benefit from strong projected relative demand for commodities in the medium term. As long as appropriate governance and revenue-administration mechanisms are put in place – particularly to avoid rent-seeking behavior – natural-resource availability may turn out to be a blessing rather than a curse for these countries.

Most developing countries were already moving along these four tracks before the global financial crisis, owing largely to improvements in their economic policies during the previous decade. Given that these policies enabled these countries to respond well to shocks coming from the crisis epicenter, there are strong incentives to keep them in place.

There is, however, a major threat to a smooth transition to new sources of global growth: the possibility of overshooting in the inevitable asset-price adjustment accompanying the shift in relative growth prospects and perceptions of risks.

Indeed, because the creation of new assets in developing countries will be slower than the increase in demand for them, the price of existing assets in those markets – equities, bonds, real estate, human capital – are likely to overshoot their long-term equilibrium value. Recent history is full of examples of the negative side-effects that can arise.

Each and every one of the recent booms and busts – in Latin America, Asia, and Russia in the 1990’s, and in Eastern Europe, Southern Europe, and Ireland more recently – shared some combination of unsustainably low financial costs, asset bubbles, over-indebtedness, wage growth unwarranted by productivity gains, and domestic absorption in excess of production. In every case, these imbalances were fueled by easily identifiable periods of euphoria and sudden asset-prices increases.

True, external factors, such as foreign liquidity, were conducive – or at least permissive – to such periods of euphoria. Twin current-account and fiscal deficits (and/or currency and debt-maturity mismatches) were the rule. But our point is that powerful forces that drive up asset prices may be unleashed even without massive liquidity inflows. The scramble for available assets and a dangerous euphoria may occur through purely domestic mechanisms.

So what should developing countries do, aside from maintaining sound macroeconomic policies, curbing excessive domestic financial leverage, and attempting to isolate themselves from volatile capital inflows?

The most important task is to facilitate and strengthen the creation of new assets, and there is much that developing countries can do in this regard. They can take advantage of the current bonanza in available capital to build contestability, transparency, and institutional quality around markets in which greenfield investments can be implemented. They can ensure that the rules they have in place are consistent and favorable to funding investment projects with long maturities. And they can invest in their own capacity for project selection and design.

These and other internal reforms would serve to moderate the furious rise in the price of developing-country assets. For that reason, they also constitute the best way to ensure that the next locomotives of global growth – and all the economies that are pulled by them – remain on the rails.