After a decade of high growth and a swift rebound after the collapse of US investment bank Lehman Brothers, emerging markets are seeing slowing growth. Their average growth is now 1½ percentage points lower than in 2010 and 2011. This is a widespread phenomenon: growth has been slowing in roughly three out of four emerging markets. This share is remarkably high; in the past, such synchronized and persistent slowdowns typically have only occurred during acute crises.
Our analysis attributes the slowdown in part to cyclical forces, including softer external demand and in part to structural bottlenecks, for example in infrastructure, labor markets, power sector. And this has happened in spite of supportive domestic macroeconomic policies, (still) favorable terms of trade, and easy financing conditions, which only began to tighten recently. However, a non-trivial portion of the slowdown remains unexplained, suggesting that other factors common to emerging markets are at play.
Is lower growth here to stay?
The current slowdown raises the question of whether emerging markets can bounce back to the growth rates seen in the last decade, or if their prospects are dimmer than we thought a few years ago. Strong external demand and developing supply chains brought higher growth through trade and specialization in the 2000s. And prudent policies paid off. Countries that managed their economies well in the “good times” had more firepower to deal with the global financial crisis. Conversely, economies with large external and financial imbalances, including much of emerging Europe, are going through a painful deleveraging process and have experienced a more protracted recovery since Lehman.
Whether this slowdown is long lasting depends on how much of it is considered structural - jargon used by economists to reflect fundamental changes in an economy’s growth potential. But growth potential is an unobservable metric. Taking into account the fact that cheap financing and rising commodity prices over the past decade raised investment and growth in many economies, and the fact that those favorable tailwinds are fading, we estimate that emerging market’s “potential” growth needs to be revised down. IMF forecasts for growth five years ahead are down by 0.7 percentage points compared to October 2012. Market analysts have made similar downward revisions.
What this means is that policymakers in emerging markets need to recognize that they will grow at lower rates than in the past. Otherwise, they risk over stimulating their economies and generating imbalances that will come back to haunt them. But there are things that they can do to generate higher sustainable growth.
Back to the future - renewed emphasis on old challenges
This discussion takes on added significance when we take into account the imminent tightening of global interest rates. Following the US Fed’s tapering announcement, some emerging markets have seen large and disruptive capital outflows. And more vulnerable emerging markets, i.e. those with high and growing current account deficits and high inflation, have seen sharper exchange rate depreciation and bond-yield increases. Policies will be critical in the period ahead, as investors will increasingly differentiate between emerging market countries according to their policy frameworks and health of their balance sheets.
How can emerging markets get their groove back? At the risk of restating what may seem like “old hat,” countries will need to identify reform priorities to remove supply bottlenecks, boost productivity and move their economies up in the value chain of economic activities. This means addressing lingering barriers to long-term growth - pushing ahead with infrastructure investment and improving the business climate, for example. Countercyclical demand management policies will no longer do the trick.
The stakes are high and the need for decisive policy action is now. Given the time it takes to implement structural measures and the natural lags with which the economy will respond, emerging market rebound will not be fast or easy. But they will have to start soon if they want to avoid the risk of a lost decade.
The key challenges facing emerging markets will be discussed at a high-level seminar taking place at the IMF on Tuesday, October 8, 3:00 pm - 4:30 p.m. EST.
This report, first published on the IMFdirect Forum, is written by Kalpana Kochhar and Roberto Perrelli.