Economic growth in the developed economies will likely be anemic for several years to come due to continued de-leveraging in the household and banking sector. By contrast, the downturn in the emerging markets (EMs) will be short-lived by comparison, and a rapid return to sustained growth in many, if not all, EMs is likely by 2011. Thanks to solid economic fundamentals, the EM-6 (Brazil, China, India, Korea, Mexico, Russia) have been (or will be) able to engineer a more or less rapid recovery by boosting domestic demand. However, due to permanently weaker global demand and hence weaker export growth, EMs will not match the above-average growth rates seen over the past few years.
Economic growth in the developed economies will likely be anemic for several years to come due to continued de-leveraging in the household and banking sector. The scope for policy mistakes is considerable as well. The policy stimulus may be withdrawn too early or too late: too early as a consequence of “free-riders” who exit expansionary policies ahead of time, or too late because governments find it politically difficult to implement adjustment policies. Policy-makers may also fail to put the banking sector on a footing that is solid enough to allow it to support a sustained economic recovery.
By contrast, the downturn in the emerging markets (EMs) will be short-lived by comparison, and a rapid return to sustained growth in many, if not all, EMs is likely by 2011. Due to weaker global demand and hence weaker export growth, EMs will not match the above-average growth rates seen over the past few years. But thanks to solid economic fundamentals, the EM-6 (Brazil, China, India, Korea, Mexico, Russia) have been (or will be) able to engineer a more or less rapid recovery by boosting domestic demand. While their ability to do so varies, all EM-6 countries retain scope to support domestic demand growth. This situation differs sharply from the past, when most EMs would have been forced into a pro-cyclical policy adjustment – just like several countries in Central and Eastern Europe (and even some in Western Europe!) are at the moment.
First, the scope for stimulating domestic demand through an expansionary monetary policy remains important, with the possible exception of Korea, where central bank rates have already fallen to 2%. A limited (or non-existent) dependence on foreign capital flows, a continued large interest rate differential vis-à-vis the developed markets and a large output gap combine to limit the risk of significant currency depreciation and inflation. The EM-6 banking sectors remain, for the most part, sufficiently well capitalised to support an increase in credit growth. Lower interest rates therefore by and large remain an effective tool to support domestic credit growth and investment.
Second, the EM-6 are also in a position to pursue counter-cyclical fiscal policies, even if the room for policy discretion varies considerably. Public-sector solvency and potential financing constraints determine the degree to which governments can support domestic demand. However, even countries with large public debt burdens and non-negligible financing constraints (due to shallow domestic capital markets) retain some leeway to implement discretionary fiscal measures, in addition to simply allowing automatic stabilisers to absorb part of the growth shock. The countries with the lowest public-debt level and/or the largest fiscal reserves (China, Korea, Russia) have scope for further support measures, if necessary.
Third, in contrast to the situation in the past, the EM-6 external position is sufficiently solid to permit an acceleration of domestic demand without jeopardizing external sustainability. External liquidity and solvency indicators are relatively strong across the board. But again, the countries with the strongest external fundamentals (China, Korea, Russia) have far greater scope to increase domestic demand than the others.
Strong fundamentals place China and Korea in a good position to boost domestic demand. Whether one should add Russia and Mexico to this group depends on one’s view of medium-term oil prices. In the short term, Russia is clearly in a better position than Mexico thanks to its large fiscal reserves. By comparison, Brazil and India are more constrained on account of their relatively high public-sector debt. (But Brazil retains considerable scope to lower interest rates, if necessary.) On the flip side, a relatively closed economy like Brazil’s gets “more bang for its buck” for the same amount of stimulus than a relatively open economy like Korea, as part of the demand stimulus will “leak” into higher imports. It is therefore just as well that the more open EM-6 economies benefit from greater fiscal macroeconomic flexibility than the less open ones!
The crisis hit the EM-6 with varying degrees of intensity via the trade channel, but also via the capital-account and the confidence channel. It is noteworthy that all EM-6 have been able– if to varying degrees – to pursue counter-cyclical, domestic-demand-oriented policies in response to the global shock. However, none of the EM-6 will be able to fully offset what is likely to be a permanent decline in external demand growth. Therefore, even if global financial conditions return to pre-crisis levels (and this is a big “if”), EM-6 economic growth will remain below its pre-crisis levels. Last but not least, it is worth pointing out that, however desirable a shift to more domestic-demand-led growth in the EM-6 is, it certainly will not pull the world economy out of the doldrums. However fast demand in the EM-6 grows, it will remain small in comparison to G-7 demand for the foreseeable future and will therefore have only a limited effect on G-7 net exports and economic growth.