Dynamics of the Global Economy are Changing

A Commentary by Charles Collyns and Krishna Srinivasan
Published in The Business Times (Singapore)
May 9, 2008

The global economy is being buffeted by powerful crosswinds. Disruptive financial market turmoil is slowing growth in advanced economies. But emerging market economies have provided a measure of global resilience, although this has also set the stage for a boom in food and fuel prices.

The divergence in performance between advanced and emerging economies points to an ongoing shift toward a multi-polar world, with a reduced reliance on the United States as the locomotive of the global economy. Emerging economies will not decouple from the advanced economies, but neither will they be derailed, as witnessed all too often in the past.

These developments reflect three salient trends are transforming the dynamics of the global business cycle. First, strong internal growth momentum in emerging and developing economies is providing a valuable global trade shock-absorber. The U.S. downturn would be a lot steeper but for the support being given to its export sector by growth in many economies around the globe.

Can emerging economies, notably China and India, sustain this internal momentum? Inevitably, in an increasingly globalized economy, growth spillovers from advanced to emerging and developing economies remain sizeable. Indeed, both trade and financial linkages are rising as emerging economies have become more integrated into global markets.

Thus, emerging and developing economies are unlikely to be immune from the economic consequences of the financial turmoil in advanced economies. Nevertheless, improved macroeconomic policy frameworks and strong productivity growth should provide greater resilience than in the past. Sudden stops of capital flows to emerging markets are still possible when policymakers lose their footing, but seem less likely as balance sheet vulnerabilities have been lowered in many countries.

Moreover, careful policymaking has earned some room for maneuver, and many countries would be able to use countercyclical policies if growth does falter.

Second, the commodity price shock absorber is no longer working as it did in the past. Moderating demand in advanced economies has not led to the usual softening of commodity prices, in large part because the dynamism of emerging economies has sustained strong demand growth.

Instead, against the backdrop of a falling dollar and rising financial market volatility, oil prices have risen to record highs and food prices have soared. Rising commodity prices have dampened consumption in advanced economies, and even more importantly have sparked inflation pressures globally, just as activity is slowing.

Third, financial shock absorbers are working through new channels as emerging and developing economies as a group have shifted to being a net source of savings for the global economy. For many years, the accumulation of large international reserves by Asian emerging economies and oil exporters in the Middle East helped to finance the large U.S. current account deficit.

Recently, the infusion of financial resources from sovereign wealth funds to recapitalize U.S. and European banks has helped to contain the impact of the financial crisis. It remains to be seen how the dislocations in financial markets will affect the flow of funds into other markets, including emerging economies.

Policy Challenges

These changes in the global business cycle are a positive development, but they do pose challenges for policymaking in both advanced and emerging economies. An effective response to a deepening downturn in global activity would need to involve the large emerging economies as well as the advanced economies, recognizing both their increasing weight in global aggregate demand and the policy space they have earned through disciplined policy implementation.

Inflation is also a common challenge for advanced and emerging economies. For advanced economies, particularly in the euro area, rising inflation has constrained the room for monetary easing to respond to a weaker growth outlook. And among emerging markets, central banks have tightened across a broad range of countries, including Brazil, China, India and Russia to name just a few, and continued tightening of monetary policy will be needed.

In addition, fiscal restraint, flexible exchange rate management, and targeted support for lower income groups to ensure access to the food they need must be part of the policy mix.

Similarly, unlike in the 1980s, the global current account imbalances are no longer an issue for the large advanced economies alone - a development recognized by the Multilateral Consultation on Global Imbalances organized by the IMF last year, which involved China and Saudi Arabia in addition to the "G-3" economies (U.S., euro area, Japan).

What is needed is a further rebalancing of domestic demand across countries, with supporting movements in real exchange rates, notably of emerging economy currencies operating under inflexible exchange rate regimes. This would be desirable both from the individual countries' perspective as a means of reducing inflation pressures and sustaining growth, as well as for easing global imbalances.

In conclusion, the dynamics of the global economy are changing as it becomes increasingly multi-polar. Emerging economies will need to play a growing leadership role, joining with advanced economies in learning to operate in this still unfamiliar terrain.

Charles Collyns is a deputy director and Krishna Srinivasan is an advisor in the Research Department of the International Monetary Fund



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