In today's world economy, many old certainties have been swept aside. The adjectives ‘fragile' and ‘robust' have been switched between developed market (DM) economies and emerging market (EM) economies. Remarkably, the EM economies have contributed over 70% of global growth during the recent cyclical recovery and have done so without any hiccups from macro fundamentals or markets. Effectively, the title of this study is a question about whether EM economies can be the next long-term drivers of global growth and about the convergence of standards of living around the world. In this first of two notes, we examine this question from a high level of aggregation, splitting the world into DM and EM economies (see the Appendix for the list of countries). In a companion note, we will discuss the same issues at the country level.
Is the EM-DM reversal of fortune really so stark, and is it durable? Depending on whether it is EM stock markets or European peripheral spreads soaring on the day, the phrases "EMs are the new DMs" or "DMs are the new EMs" can be heard quite commonly in the financial world. Though the latter phrase is used almost as dark humour, there is bright conviction about the former. We think that the broad structural story behind EM growth includes a variety of supports, many stronger now than in past decades - catch-up potential, favourable demographics, low debt burdens, sounder policies/institutions, better social capabilities and ‘self-insurance' from sizeable FX reserves. But where exactly are the EM economies in their drive to become DMs?
Are EMs the New DMs?
Our short and simple answer to that question... is yes, but the transformation is not yet complete.
The longer and not-so-simple answer... In terms of growth, EMs have significantly outperformed DMs in almost every respect. Yet, EMs have yet to catch up in terms of levels. However, the fact that there is this gap between EM and DM economies also means there is scope for improvement, and therefore for sustained EM growth. There are risks to this convergence, however, from the DM and the EM side, which will likely take serious effort and considerable time to correct.
The Good, the Bad and the Ugly of the EM-DM Divide
We divide our analysis of the EM-DM divide into ‘narrow' (one based on more or less standard macroeconomic metrics such as growth, inflation, debt, etc.) and ‘broad' (based on socio-economic and political economy considerations) buckets. Our key conclusions on the EM-DM divide are as follows.
The (really) good... The quality of growth in EM economies has been staggeringly better of late. While DM economies have actually regressed, with lower and more volatile growth, EM growth has improved dramatically and on a steadier trend than in the past. In fact, macro-stability has improved in general. On the inflation, indebtedness and self-insurance fronts, for example, the success of EM economies has been remarkable.
More interestingly, and in our opinion more importantly as well, EM economies have narrowed the gap between themselves and DM economies on many of the ‘deep' social indicators that are important for sustained growth. The deep determinants of longer-term growth such as life expectancy, schooling and economic and political freedom have improved in EM as well as DM economies, but by a much greater degree in the EM economies.
...the bad (well, not so good)... Even though the variability of GDP growth has not improved and the variability of inflation has continued to fall, in level terms, there is still clear daylight between EM and DM economies. A similar story exists for the deep parameters, like the political and economic freedoms and social indicators. But there is actually a silver lining here. With plenty of scope for improvement, the medium-term picture for EM growth remains well supported if reforms and investments continue.
...and the ugly: Despite all of the achievements we have outlined above, inequality in EM economies has actually worsened during a golden era of resilient development and income growth. Unless the rising tide eventually starts to lift most boats, there is a risk that a significant fraction of the EM world's population ends up being excluded from the benefits of growth and convergence. As we know from history, such a trend could pose a political and economic threat to the case for a sustained structural EM advantage.
For the DM economies, the list of ‘ugly' issues is much longer than it was half a decade ago. The risks to sustainable growth, a razor-thin margin for manoeuvre for policy-makers, adverse demography and high debt burdens mean that it may be the DM economies that pose the biggest threat to global and EM growth.
Mind the gap: Overall, EM economies have narrowed the gap between themselves and DM economies dramatically, but the emphasis on improving the quality of growth needs to be pressed further. Maintaining that pace may not be as easy or smooth going forward, but EM economies certainly have the momentum in their favour.
What Are ‘Emerging Markets'?
That the EM world could survive intact the largest economic and financial crisis that investors have witnessed in their lifetime, and then go on to power global economic growth in a time of continued strain, speaks volumes for the EM success story. It is safe to say that, ex ante, such an unusual reversal of fortune had not been widely anticipated, and even ex post it remains a challenge to fully explain it. This, in turn, begs the broader question as to what it means to still refer to emerging and developed economies as two distinct groups.
‘Emerging markets' may be defined as economies in transition towards a high standard of living.
In a narrow sense, they will have demonstrated the ability to generate rapid growth in potential output. EM economies typically have a low starting point in terms of how efficiently they allocate and use the resources available to them. They may also have a scarcity of resources per person, for example, physical or human capital. It is the reallocation of the factors of production and the increase in their efficiency, combined with further capital accumulation, which can allow for the rapid growth of potential output in the future.
How can this come about? In a broader sense, the EM economy in question must also have some claims to have put in place the deeper, fundamental political and legal reforms (such as enhanced rule of law, stronger property rights, lower corruption, better governance, etc.) or socio-economic reforms (such as health and education improvements, monetary and fiscal stability measures, better infrastructure, removal of trade barriers, etc.) needed to bring about a permanent upshift in its long-run development trajectory.
Are DMs the New EMs?
The proposition may seem darkly humourous, or at least cheeky, rather than a serious question; but even so it is not hard to find investors who believe that some DM economies are now worse prospects than many EM economies. While they have a valid point on the growth prospects of these economies, the absolute standard of living in DM countries is still high enough to keep them from slipping into the EM bucket. In a subset of DM economies, to be sure, adverse fundamentals (e.g., demographics and debt) may put medium-term growth at risk, and there the difference between them and the upper echelon of EM economies could then fade faster than anticipated.
A Gradated Scale
Clearly, neither EMs nor DMs are what they used to be. The EM-DM divide is thus perhaps not as stark as we once thought. Korea and Chile are already part of the OECD, and a clutch of others might be knocking on the door relatively soon. In contrast, Europe's periphery is stuck in reverse gear. DM economies have been losing ground, relatively speaking, to EM economies for a while now. Recently, however, some DM economies have lost ground even on an absolute basis, thereby speeding up the EM-DM convergence.
On a gradated scale, DM economies that have emerged from the Great Recession relatively unscathed and are already plugged into EM growth in some way are likely at the top of the heap. Those that have lost significant ground with relatively weak prospects for the medium term would likely come next. Close behind would be EM economies that have raised their standard of living to a high level and whose growth prospects are strong, with some catching up still to go. Following in their footsteps are the high-growth EM economies that are still a couple of notches lower in terms of the level of their development. And finally, and worryingly, is a category of developing countries that would have hoped to ‘emerge' in much the same way as some of the EM success stories, but will now have to find a new strategy for growth, given the decline of the DM consumer.
‘Models' no more: In terms of economic philosophy, an important development is that DM economies are no longer seen as ‘targets' or ‘models' to aspire to. Their recently proven fallibility means that EM economies are trying to chart their own sustainable path forward, using the DM model more as a ‘reference' but not blindly following the same development path recipes.
Growth and Macro-Stability: A ‘Narrow' Look at the EM-DM Divide
The Really Good
There are many reasons to wax lyrical about EM economies, but less to say about DM economies here. Better growth and inflation, lower indebtedness as well as higher FX reserves bringing about an improved outlook for sovereigns, and better demographics all argue for continued outperformance of EM economies in their quest to mature into developed markets. The historical performance and our economics team's outlook that we discuss below support this thesis. We start with the areas where the relative economic strengths of the EM world seem most apparent.
Its all about the quality of growth: Looking at GDP growth versus its standard deviation on a 10-year rolling basis, aggregated using PPP GDP weights, the remarkable ‘U-turn' that EMs have achieved from the 1980s contrasts sharply with the ‘one-way' traffic in DM growth which has been falling the 1980s. Around 1980 (just before its ‘lost decade'), the EM world offered higher growth but higher variance than the DM world. From a risk/reward standpoint, this advantage was tempting to some. But in the 1980s and early 1990s this advantage evaporated. DM growth slowed, but EM growth collapsed and became more volatile. Slowly, by the late 1990s and 2000s, the EM turnaround began. And now, after the crisis, it is the EM world's turn to post stronger growth, just as DM volatility has mounted. In relative terms, the risk/reward picture now appears to strongly favour EM again, even more starkly than it did in the 1970s.
Based on our economics team's forecast, EM economies look well set to outperform DM economies in the medium term, thanks to not just strong performance from EM economies but also from weak and uncertain growth from many major DM economies (see Global Forecast Snapshots: The Global Economy in One Place: Global Resilience, April 6, 2011).
The taming of inflation: Perhaps the central theme of recent macroeconomic history has been the taming of inflation. The eruption of price instability in the 1970s following the end of the Bretton Woods system saw inflation in DM world peak at around 10-20% per year. In the EM world, however, it was not uncommon to see inflation rates running higher, sometimes by several orders of magnitude and at hyperinflationary levels.
DM economies made serious progress in the fight against inflation by bringing inflation down from roughly 10% to close to 2% while also lowering the volatility of inflation. After the challenging 1970s and the debilitating 1980s, the EMs made rapid progress. By the late 2000s, the EM group had all but converged to DM performance in terms of inflation metrics, with mean and standard deviation of inflation both in single digits. Thus, although the inflation beast was gradually slain worldwide, the fight was certainly fiercer in the EM world than in the DM world, and the ultimate triumph therefore all the more remarkable. And too much can sometimes be made of the DM ‘advantage' of low inflation. Indeed, an entrenched low inflation regime may have been too much of a good thing as fears of destabilising deflation came to the fore, over many years in the case of Japan, and then in many other DMs during the crisis; EMs have avoided this trap.
The engine of EM growth: exports: The more outward-looking export strategy of the EM world as compared to the the DMs can be seen clearly through a much more rapid increase in the export to GDP ratio for EMs. More interestingly, the concentration of EM and DM export baskets has converged since the 1990s. After a sharp move towards diversification in the early 1990s, EM economies have reduced their export concentration to about 2-3 times the level of the DM economies - a big decline from about 4-5 times in 1990.
It should be kept in mind, however, that the course of economic development does not necessarily entail a shift towards ever more diverse and stable production structures. Indeed, there is evidence that richer countries eventually have a tendency to reverse this trend, specialising into narrow product lines as their development proceeds towards high income levels; in contrast, middle-income countries can be at a different stage where they become more diversified as they start to industrialise in new sectors.
The Not-Quite-So-Good
Is this story of an EM-DM reversal in fortune for real? While we can demonstrate the spectacular macro improvement in EM economies, it is still the case that the mean and volatility around GDP growth and inflation in the EM world are all still a significant level above their DM equivalents. Higher levels of inflation usually bring along higher inflation volatility. Reducing inflation while growth stays high is difficult for at least two reasons. First, fluctuations in growth will drive fluctuations in inflation.
Second, it is reasonable to think that the ‘sacrifice ratio' (how much growth will have to be hurt to lower inflation by 1%) becomes more penalising at low levels of inflation than at high levels of inflation. Policy-makers may be quite unwilling to hurt growth significantly at the moment (see Emerging Issues: A Macro Trinity Grips as the Impossible Trinity Ebbs, March 16, 2011) and more willing to tolerate higher volatility in the medium term as long as it also brings higher growth. This does imply, however, that uncertainty will remain high even with strong performance in the EM world.
Finally, strong export orientation could be a risk for EM economies if DM growth or EM domestic demand fail to come through in a reliable and sustainable way.
Debt, reserves and sovereign risk perception: However, in one key macro area we see signs of continued progress underway, but with still some distance to go until EMs lower macro risk to DM levels. (Or, alternatively, and more pessimistically, until DMs backslide toward EM risk levels.) And that is in the area of fiscal prudence.
We looked at the evolution of public debt relative to GDP, based on simple country averages, from 1990 to 2009. The DM group has an average level of debt higher than the EM group throughout, though, as is well known, EMs are generally more fiscally fragile than DMs (prone to default crises) even at the same public debt ratio. But the fluctuations in these levels are revealing.
The picture shows that the EM world has decoupled from DM in another favourable way, the ability to achieve a more benign fiscal stance, running down debt during booms, and thus being better placed to absorb shocks during downturns. Chastised by the debt crises of the 1980s and late 1990s, EM economies made a concerted effort to work down their debt burdens while stockpiling FX reserves as a means of self-insurance. The DM experience of the 2000s, in contrast, was of a fairly steady debt level followed by a cataclysmic increase during the Great Recession, with some DMs suffering capital market penalties (high spreads) or even denial of market access (some European peripherals). Now, looking forward to adverse DM debt levels and trends for many years, it is far from clear that DM economies will all be considered safe sovereigns by investors.
A powerful summary of changing investor perceptions about the relative fiscal soundness of the DM and EM worlds is shown in Exhibit 9 of our full report, which displays the S&P sovereign ratings in numerical form (+1 for each notch below AAA) for each country group from the mid-1990s until the present. The average DM rating remained remarkably steady at about 1.4, and with declining cross-sectional variation, until the crisis. Since then, the mean rating has started to climb towards 2 (AA+) and the variance has also risen (from 1 to 1.6), reflecting the downgrades of some once impeccable DM sovereigns. Meanwhile, in the EM world, sovereign ratings have been headed in the opposite direction since 2000. Prior to that, in the years of EM crises, the mean EM rating fell from BBB- in 1995 to as low as BB+ in 1999. Then, in the last ten years of progress towards macro-stability, the mean EM rating rose as far as A-/BBB+ in 2011, with variance sharply declining too.
The Ugly
Most of the news here is on the DM side, and since these issues are well understood, we only list them here. However, we do emphasise that, despite this brief treatment, we remain cognisant that these issues are easily the most worrisome for the global economy now and even in the medium term.
Sustainable growth, policy errors on either side (too loose for too long pushing up inflation and asset prices, or too tight, too soon like Japan in the 1990s) and a poor handling of the debt situation in the G4 economies all threaten the outlook for global growth. Sustainable growth is still far from assured in any of the G4 countries in what was predicted to be a BBB (Bumpy, Below Par, Brittle) recovery (see Global Forecast Snapshots: The Global Economy in One Place: 2010 Outlook: From Exit to Exit, December 9, 2009).
The ECB's earlier-than-expected move and the Fed's likely later start to the hiking cycle have still not resolved the debate about which one holds fewer risks for their respective economies and for the global economy as well. Finally, worries not just in peripheral Europe but in the US, Japan and the UK are all very much on the frontline of the risk frontier for the global economy. We do not expect most of these issues to be tackled in the next few months, which means that the uncertainty confronting policy-makers and markets will likely persist for a while.
Increasing the Quality of Growth by Rebalancing
In past notes, we have argued that the process of global rebalancing has been underway for the better part of a decade now (see Emerging Issues: The Great Rebalancing, February 16, 2011) and that there is a possibility that it proceeds in a benign but bumpy way for the global economy. An integral part of the rebalancing process entails an increase in real yields globally (but by more so in the EM world) as well as real appreciation of EM currencies (but more through nominal appreciation than via EM inflation being higher by a constant spread over DM inflation in the future). Indeed, the process of rebalancing via EM real exchange rate adjustment is already underway. If the process of global rebalancing proceeds as we expect, the nominal and real appreciation of EM currencies and the rise in real yields globally could put EM economies on a more sustainable growth trajectory while giving DM economies better access to positive spillovers from continued EM growth.
Higher real interest rates spurred by higher investment relative to savings should raise the return on capital, particularly in the EM world. The appreciation of EM currencies in nominal terms that we expect should not only boost consumption there but also raise the competitiveness of DM exports. Rebalancing should thus help EM economies generate the more domestic demand-oriented sustainable growth they need and desire while incentivising DM exporters to tap into EM growth.
If the outperformance of EM economies is successfully fuelled in part by a more domestic demand-led growth strategy, there is also likely to be a large boom in intra-EM exports. The basket of products produced by EM economies may be subject to change again. While an absolute advantage relative to DM economies may have prompted EM exporters to spread their cost advantage to a range of products, catering to other labour-abundant EM economies may mean that EM exports become more specialised, focusing on comparative advantage instead.
Deep Parameters: A Broader Look at the EM-DM Divide
Many investors would naturally focus on our ‘narrow' evaluation of the relative performance of EM and DM economies, if only because it might suggest short-horizon tradable implications for asset markets. However, we would argue that the socio-economic and politico-legal comparisons we employ below provide even stronger implications for asset markets in the medium and long term, supplying insights which may offer additional support for investments today.
Read Full Article »