The Financial
Crisis and Emerging Markets
Emerging Markets, Financial Markets, Financial Institutions, Banking, BRICs
M. Ayhan Kose, Economist, International Monetary Fund
Eswar
Prasad, Senior
Fellow, Global
Economy and Development
The Brookings Institution
http://www.brookings.edu/opinions/2008/0924_emerging_markets_prasad.aspx
September 24, 2008— Dissecting the Decoupling Debate
Emerging
markets have turned in a remarkable growth performance in this decade, even as
the advanced industrial economies were at best plodding along. This sparked a
new conventional wisdom that emerging markets had become masters of their own
destiny and “decoupled” from business cycles in industrial countries.
Consistent with this view, the emerging markets seemed to have dodged the
bullet of the sub-prime crisis. But there are now rising concerns that these
economies, already beset by oil and food price shocks, may falter if the
worsening financial crisis pushes the U.S.into a deep and prolonged recession.
In
other words, emerging markets may still be riding on the coattails of
industrial countries.
Which of these views about decoupling is true? The answer
has implications not just for the emerging markets but also for world growth
since these economies have now become major players on the global economic
stage. New research that we have just completed (along with Christopher Otrok,
University of Virginia) reveals some surprising answers to this question. And
it turns out that the issue has more subtleties than indicated by the popular
discussion.
To begin with, why is there such a heated debate about
decoupling? After all, economies around the world are becoming more interlinked
through increasing flows of goods and money across national borders. Shouldn’t
this make all economies closely tied together and more dependent on each
other’s economic fortunes? Yes, but at the same time emerging market economies
have become much larger and self-reliant than before. As a group, they have
accounted for more than half of global growth during this decade. So far, these
economies have shrugged off the effects of the financial crisis and, although
their growth momentum has eased off as industrial countries are taking in less
of their exports, they are still growing rapidly.
This raises two interesting issues. First, what is the
evidence on whether business cycles around the world are becoming more closely
correlated or not? Our research shows that in fact business cycles are becoming
more closely linked amongst industrial countries and amongst emerging markets.
Remarkably, however, there is a decoupling of common business cycles between
these two groups. This suggests that emerging markets are standing on their own
feet to a greater extent than before, even though many of them have not
entirely shaken free of dependence on exports to industrial countries. And the
huge increase in flows of goods and money among emerging markets themselves
(rather than just between them and industrial countries) has made their
economies
more dependent on each other. For instance, about two-fifths of emerging
markets’ total trade flows are now accounted for by trade with other emerging
markets, double the level from two decades ago.
Indeed, in a striking reversal of fortunes, continued
strong growth in emerging markets might help stir the industrial economies out
of their own malaise. There is a growing appetite for imported goods in
emerging markets including China and India, and their share of world GDP is
only going to increase over time.
A second issue concerns the distinction between real and
financial decoupling. Many observers argue that the decoupling hypothesis must
obviously be wrong; after all, large swings in major countries’ financial
markets almost immediately infect those markets in other countries as well.
This is most evident in the increasing correlation of stock market fluctuations
around the world. Steep drops in the Shanghai stock market now affect U.S.
stock markets. And the cataclysmic events on Wall Street are clearly roiling
financial markets worldwide.
The big question is whether these financial spillovers
affect the “real” economy—variables such as GDP, investment and household
consumption. Here the answers are less clear. So far at least, there seems to be
a dichotomy between real and financial variables in emerging markets. Their
stock markets have been infected by the turmoil in the U.S., inflation is
rising on account of worldwide food and oil price shocks, but GDP growth
continues at a reasonable clip in the major emerging markets.
How can this be? One possibility is that emerging markets
have built up enough headwind that sheer momentum will carry them forward, so
long as there isn’t a worldwide collapse of demand. But the spread of the
housing price bust in the U.S. to countries such as China does not bode well.
Another possibility is that financial markets in these
countries are still relatively small and disconnected from the real economy.
The flip side of this argument, however, is that their financial systems may
not be strong enough to cushion these economies if more negative shocks hit
them. So there could be trouble brewing.
One thing that is clear is that the structure of the
world economy is changing in important ways, with effects that are difficult to
predict. The past may no longer be a good guide to the future and relying too
much on conventional wisdom—either old or new—may be dangerous.
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