Emerging or Submerging?

After the global financial crisis, what will be the fate of emerging economies?

October 31, 2008

After the global financial crisis, what will be the fate of emerging economies?

Author

Martin Hutchinson

Martin Hutchinson is the co-author of Alchemists of Loss: How modern finance and government intervention crashed the financial system (Wiley, 2010) and a Contributing Editor at The Globalist.

Emerging market stock markets, bond markets and currencies have suffered much more than developed country markets during 2008, in spite of the original real estate bubble and credit disaster having been contained almost entirely in rich countries.

In dollar terms, for example, China's stock market is down 76% in 2008, Russia's 72%, South Korea's 66% and Turkey's 65% — all of them more than any developed market and almost double the 37% drop in the U.S. S&P 500 Index.

Such evidence suggests that globalization, by which emerging markets gain capital and access to developed markets for their goods and services exports, may be something of a Faustian bargain.

A sudden capital shortage should have affected emerging economies less than their Western counterparts, not more. Traditionally, emerging markets have suffered from a higher cost of capital than the rich West. This compensates for their lower labor costs, allowing Western companies to survive in an environment of free global competition.

Thus, it would normally be expected that when the rich world caught a cold, emerging markets would suffer from pneumonia, as capital sources dried up and they found it impossible to fund new investment.

However, there is currently one flaw in this picture: Emerging markets today have much higher savings rates than the rich West.

The United States in particular and the West in general have gone on a spending binge that has left the majority of the world's foreign exchange reserves in the hands of Middle Eastern and Asian governments.

Far from emerging markets suffering from a smaller pool of capital, many of them today have a much healthier capital position than their Western competitors.

That suggests that competently run emerging markets should regard this crisis as a temporary hiccup, not a reason to despair, and certainly not a reason to jettison wholesale an economic model that has worked generally well for them and retreat into Third World autarky and socialism.

Countries that default owing to global conditions should not regard it as the end of the story. If they remain competently run, they will quickly be allowed back into the international financial arena.

In the long run, emerging markets' advantages of labor costs will still be there, and if they preserve the essentials of a free market system they will have in their domestic economies much of the savings base they need to succeed. The main need will be to keep open the flows of international trade, so that global markets are available to expand their businesses.

Conversely, the prospects of Western economies would appear dismal. With inadequate savings bases, they are going to be permanently capital-short in a world where capital is both scarce and more expensive. Their labor costs will remain relatively high, yet they will no longer have the advantage of capital availability over competently run emerging markets.

Eventually growth will return, but it may be at a considerably less comfortable equilibrium than today in terms of living standards.

As for emerging markets themselves, it is now clear that the advice they have received from Western institutions such as the World Bank has been largely misguided and ill-suited to a world in which the global stability they had been promised proved so ephemeral.

They need to establish quickly a new consensus that will enable them to prosper in a world where capital is no longer so abundant — and where Western countries are no longer a cornucopia of wealth and foreign investment.

Key measures would include:

Establish solid property rights. For domestic and international reasons, emerging markets need to establish solid property rights. Emerging markets see Western countries during the crisis carrying out actions that damage property rights — which makes their own respect for such rights more, not less, essential.

Encourage middle class saving. If capital is not readily available internationally, it must be found domestically. Encouragement of middle class savings is the number one requirement for economic development. However, it has been disgracefully neglected by the index-linked bureaucrats of the aid agencies.

Keep interest rates high. Interest rates need to be kept high, for two reasons. First, high interest rates encourage capital formation and saving. Second, they keep inflation under control. Big businesses will whine at the high real cost of capital — but the recent crisis has demonstrated that capital that is cheap is far less important than capital that is always available.

Control government spending. The temptation will be to indulge in government handouts or, worse still, Keynesian spending programs (where the government rather than the recipient determines the goods on which money is spent) to counter the effects of economic downturns. The fact remains that over a long period, it has been demonstrated that high government spending (as a percentage of GDP) or rapidly rising government spending are the principal factors suppressing economic growth.

Stem population growth. If population increase is too rapid (above 1% per annum approximately), steps should be taken to reduce it. The capital cost of building facilities for a rapidly expanding population, and the education cost of a bloated youth cohort, are too large for a poor economy to absorb — particularly if capital and aid flows are less bountiful than formerly. Rapid population growth is incompatible with increasing living standards, and hence should be sharply discouraged.

Finally, foreign companies and private equity operations should be free to purchase domestic companies. Their capital and expertise are important in allowing local companies to grow and bringing their operations up to the best international standards.

In the long run, well-managed emerging markets will emerge from this downturn with increased strength, both absolutely and relative to the West. However, new tricks will have to be learned.

Takeaways

Competently run emerging markets should regard this crisis as a temporary hiccup and not a reason to retreat into Third World autarky and socialism.

The recent crisis has demonstrated that capital that is cheap is far less important than capital that is always available.

A sudden capital shortage should have affected emerging economies less than their Western counterparts, not more.