The problem with emerging markets

It was not too long ago that the emerging markets were regularly eulogised as the permanent powerhouses of the world economy. During the 2000s, with excitable neologisms like Brics (Brazil, Russia, India, China, South Africa) coined in their honour, the big emerging economies drove a boom in global output and trade.

And when the rich world suffered a dislocating shock during the financial crisis in 2008, many middle-income nations, with relatively resilient banking systems and large foreign exchange reserves, rode out the turbulence and rapidly resumed growing.

That euphoria, which has been subsiding for years, is now at a low ebb. This week the World Bank warned of a “structural slowdown” as developing nations ceded the leading role on global growth to the rich world. A decline in import demand means emerging markets subtracted from world trade growth in the first quarter of this year for the first time since 2009.

In reality, weaknesses within the emerging world have been evident for some time. Few countries have built the kind of diverse high-productivity economy that will propel them into the first rank of rich states.

According to a study by the International Monetary Fund, the slowdown in trend growth in middle-income countries has been in train since the crisis. For years, weak productivity improvements were masked by low interest rates, helped by quantitative easing in the US, and by high commodity prices.

Those props are now being kicked away and, with the US Federal Reserve yet to raise rates, there may still be a bigger squeeze to come. The growth model of countries like Brazil has been exposed. Chronic deficits, high inflation and an overvalued exchange rate have left the country with no alternative but tighter monetary policy and a recession. The evaporation of a favourable external environment exposes the past failure to reform. One or two leaders, such as Narendra Modi in India and Joko Widodo in Indonesia, are belatedly trying to reorient government spending away from wasteful subsidies and towards productive investment, but it will take time.

The process of poor countries getting rich, much of which used to be driven by export-led manufacturing, has become more complex. Emerging economies are routinely turning away from manufacturing at much lower levels of income than earlier waves of industrialisers. An apparent structural fall in trade growth relative to overall expansion, probably as a result of nations like China taking more of their supply chains in-country, means less chance for other developing countries to export their way to prosperity.

Many development economists talk of a “middle-income trap”, where economies stall at relatively low levels of per capita gross domestic product. To increase trend growth, emerging markets will have to address the full range of structural impediments to expansion. This means not just the traditional issues of streamlining regulation and building infrastructure but also the more complex challenges of improving education, promoting competition and designing regulation to develop high value-added service sectors.

Even if that happens, it is unlikely to show big improvements in the short term. Economies do not instantaneously leap on to a long-term high-growth path even if the right policies are followed. But if emerging countries are to return to leading global economic growth, there is no other way. For emerging markets, the years of easy growth from cheap money and fat commodity earnings are over. The need for reform has now become acute.