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A number of emerging market economies have been on a rollercoaster since the U.S. Federal Reserve announced last May the eventual tapering of its asset purchase program. This is another reminder of how susceptible these economies remain to economic conditions outside their borders.
Much of the market movements to date have been short term in nature. But emerging markets know the end-game – interest rates in advanced economies will eventually go up, reducing the cheap external financing they have benefited from until now. And this is not the only external factor weighing on the growth prospects of emerging markets.
A less supportive global environment
We do not expect growth in advanced economies to return to the levels of the pre-2008 credit-fueled boom. There is also little evidence that another commodity boom will boost the fortunes of commodity exporters. In short, the supportive external environment that propelled emerging markets during the pre-crisis years has either already died down or, in the case of easy external financing, will do so soon.
In a previous blog we showed that external factors account for a considerable part of the slowdown in emerging market economies during 2011 and 2012. But how will these external forces materially affect growth over the next three to five years? Which countries are most affected, and can policies play a role?
Using a large database that covers over three decades, we explored how changes in external conditions affect growth. We found that the combination of higher interest rates, lower commodity prices, and lower growth in advanced economies are likely to shave off around 1 percent of growth for an emerging market economy in the middle of the range in terms of trade and financial openness (stay tuned for more details in an upcoming paper). However, the impact will differ depending on a country’s circumstances and policies.
Growth and external conditions
Emerging market economies that derive a higher share of GDP from exports are more susceptible to changes in growth in other economies. A decline in external demand triggers a dual blow to exports and to investment into export-oriented sectors. We found that for a representative emerging market economy, growth would decline by around ¾ percent for each percent of lower growth in its trading partners.
By the same token, countries that are more financially integrated are more susceptible to changes in world interest rates. Foreign-financed expenditure dries up, dragging down the rest of the economy. The effect is sizeable—a one percentage point increase in U.S. real interest rates shaves off around 0.1 percent of growth in emerging markets.
Sudden changes or shocks in the price of imports relative to the price of its exports—known as the terms of trade— have an important medium-term effect on exporters of mineral commodities. Interestingly, countries that do rely on the export of these commodities are not affected to the same degree, which we trace to two differences.
First, mineral commodity exporters exhibit higher concentration in economic activity, and capital specific to mineral extraction cannot be quickly reallocated to other sectors in the wake of changes in commodity prices. More diversified economies, on the other hand, can cushion the blow to one sector by reallocating less specialized resources to other sectors.
Second, in the wake of a commodity price boom, few recognize that what goes up must eventually come down. The economy launches into a spending spree, often borrowing against future commodity revenues. And when export prices reverse, the country is forced to retrench dramatically, exacerbating the swings in terms of trade.
The role of policies
So the fortunes of emerging market economies shift with external conditions. But policies have a role to play in buffering the impact of these forces. Countries’ room to maneuver will depend on how they managed their economic policy during the boom years.
Countries with a floating exchange rate regime are less susceptible to changes in world interest rates. A country with an exchange rate pegged to another country’s currency and an open capital account effectively imports that other country’s monetary policy. A monetary tightening in advanced economies will necessarily translate into higher domestic rates. So the floating exchange rate is the first line of defense against external shocks.
It matters how countries manage capital flows during periods of low interest rates and easy money. We find evidence that episodes of growth financed through the deterioration of the current account are followed by periods of lower growth. The way to avoid high current account deficits and associated credit booms is by offsetting non-resident capital inflows with simultaneous resident capital outflows, which could then be drawn upon in the event of a reversal of capital inflows. The IMF’s World Economic Outlook shows that counter-cyclical fiscal policies, inflation targeting regimes, flexible exchange rates, and better overall institutions are most conducive to good management of these flows.
For commodity-dependent emerging markets, prospects will depend on how much of their windfall countries saved during the boom years. We find that once we account for the effect of public expenditure, the reaction of medium-term growth to changes in terms of trade is greatly reduced. As documented in this blog by Adler and Sosa, a more measured response of public expenditure to commodity price increases both ensures fiscal sustainability and tames the exuberance of the private sector, which prevents a hard landing when the country’s luck runs out.
The next few years present formidable challenges to emerging market economies, and one should not expect a return of the very high growth rates of the last decade. Many emerging market economies have the tools to navigate the harsher environment and make the best of it. Our upcoming paper on growth in emerging markets, which follows the emerging markets seminar at the 2013 World Bank-IMF Annual Meetings, will delve into the details.