Are Emerging Markets Still On the Receiving End?

By Aseel Almansour, Aqib Aslam, John Bluedorn and Rupa Duttagupta

(Version in EspañolFrançaisРусский中文 and 日本語)

The recent slowdown in emerging market growth is fueling a growing mania across markets and policy circles. Some worry that a large part of their stellar pace of growth over the 2000s (Figure 1) was due to a favorable external environment—cheap credit and high commodity prices. And, therefore, as advanced economies gather momentum now and begin to normalize their interest rates, and commodity price gains begin to reverse, emerging market growth could slip further.

Others instead contend that internal or domestic factors have played a role, with improved standards of governance and genuine structural reforms and robust policies, driving a fundamental transformation in the sources of emerging market growth towards a lower yet more sustainable trajectory.

Figure_1[1]

The truth lies somewhere in between.  What is clear is that emerging markets contribute to a significant share of the global economy, and what matters for them matters increasingly for the global outlook.

And what matters for emerging markets over the coming years depends on the extent to which external and internal factors tend to foster or hinder their growth.

Chapter 4 of the April 2014 World Economic Outlook focuses on how external factors have driven growth in emerging market economies in  the past 15 years. The analysis suggests that emerging market growth, while still strong, has been slowing in the last two years driven as much by domestic conditions as by external circumstances.

How external factors influence emerging market growth

We find that a strong recovery in advanced economies is on balance good for emerging economies, despite being accompanied by a rise in advanced economy interest rates. Specifically, a 1 percentage point increase in the U.S. growth rate typically raises emerging market growth by 0.3 percentage points in the same quarter, and the cumulative effect stays positive beyond one-to-two years.

To understand why, let’s consider the various forces at play. First, higher growth in advanced economies should boost exports from emerging markets. Second, global capital would flow back from emerging markets to advanced economies to take advantage of the higher growth and interest rates. For emerging markets that trade more with advanced economies (e.g., Malaysia and Mexico), the first effect would dominate; and for emerging markets that are more open to capital flows (e.g., Chile and Thailand), the second effect could partly or fully offset the first. Our results suggest that for emerging markets as a whole, the impact of the first likely outweighs the second.

Not surprisingly, if emerging markets’ external financing conditions tighten by more than what can be explained by the recovery in advanced economies, emerging markets tend to suffer, as observed during bouts of market turbulence at the start of 2014. When capital flows out, emerging markets experience a depreciation of their exchange rates that likely helps the competitiveness of their exports. At the same time, they typically raise domestic interest rates to try to stem the capital outflow, an action that hurts growth. Our results suggest that the hit to emerging markets from higher domestic interest rates tends to offset the benefits from the exchange rate depreciation.

So we see that how these economies perform depend not only on their exposure to external factors, but also on whether and how they use domestic policies to respond to the changes.

So how have internal factors influenced emerging market growth?

External environment versus internal factors

As previewed in an earlier blog, the deviation of emerging market growth around its average over the last 15 years can be viewed as driven by either external or internal factors.

Which one dominates—external or internal factors? We find that external factors explain one-half or more of the growth deviation on average, although with important differences over time and across countries. For instance, the sharp downturn at the peak of the global financial crisis was almost fully accounted for by external factors for most countries.

Internal factors dominated in the strong growth uptake in emerging markets in 2006-07.  And the pullback in growth since 2012 is also largely attributable to internal factors.  These findings resonate well with recent studies that have underscored constraints from domestic structural factors and policy uncertainty as becoming more binding for growth in many larger emerging markets (see blogs by Anand and Tulin 2014 and Dabla-Norris and Kocchar 2013). For some large or relatively less open economies, such as China and India, internal factors—more than the external environment—mostly explain the fluctuations in growth from the average level over 1998-2013.

Figure_2[1]

What about China’s role as an external factor for other emerging markets? We would expect the world’s second largest economy to also play an important role in determining growth in other emerging markets, and indeed it does. We find that many emerging markets were able to ride on the coat tails of China’s strong expansion during the crisis. But China’s recent slowdown has also acted to soften their growth (see Figure 3).

Figure_3[1]

Shifting gears: adjusting to lower level of emerging market growth

Forecasts of emerging market growth starting in 2007, and conditional on the path of external conditions, reveal that some of the larger emerging markets have grown at lower rates than expected since 2012 (see Figure 4). This suggests that, other, mostly internal, factors are holding growth in many emerging markets, including constraints from domestic structural factors . And if the dampening effects from these internal factors persist as they have over the past year or so, emerging market growth will remain lower for some time, affecting growth in the rest of the world as well.

Figure_4[1]

Keeping the house in order

There is no doubt that the external environment will continue to have a strong impact on emerging market growth. And so policymakers must remain vigilant and sensitive to external developments. Many concerns about the ramifications of external shocks are justified. A sharp tightening in external borrowing rates, without a proportionate improvement in advanced economy growth, would hurt emerging markets. China’s adjustment to a slower, even if more balanced, pace of growth, will inevitably alter prospects for other emerging markets. And, if advanced economies do not recover as currently expected, emerging markets will feel it too.

That said, internal factors are currently suppressing growth below levels expected given even current external conditions. Thus, the recent slowdown in emerging markets appears to be as dependent on internal developments as those from abroad. And the priority for policymakers now is to better understand the role of internal factors and assess whether there is scope for policies to improve these economies’ resilience regardless of the external backdrop.

The IMF will publish its global forecasts from the World Economic Outlook on April 9.

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