Bleak prospects almost everywhere

Even a moderate slowdown in China could bring an end to the boom in a broad range of commodities.

Global economic conditions continue to have a strong bearing on production, trade and investment in developing economies. In this respect the current landscape is not very encouraging. After three years of recovery the world economy still remains highly fragile.

The short-term outlook predicts contraction in several advanced economies in Europe. Growth in others, including the U.S., is weak and erratic. But more importantly, medium term prospects are bleak almost everywhere.

There is considerable uncertainty in global financial markets. Asset and commodity prices, risk spreads, capital flows and exchange rates are highly susceptible to sudden swings with devastating consequences for growth and employment.

At a first glance, the recent record looks very promising for developing economies. The new millennium has witnessed a staggering rise of the South. During 2003-08, the average growth of developing economies exceeded that of advanced economies by some five percentage points, compared to around one point in the 1980s and 1990s. The difference widened during 2008-11 as most developing economies proved resilient to the crisis while advanced economies collapsed.

This growth divergence has widely been interpreted as the South decoupling from the North. However, the evidence does not show the desynchronisation of cycles between developing and advanced economies, and deviations of economic activity from underlying trends continue to be highly correlated.  A closer look suggests that the growth surge in developing economies owes more to exceptionally favourable international economic conditions than improvements in their underlying fundamentals.

Favourable environment

Until the financial crisis, the credit, consumption and property bubbles in advanced economies generated a highly favourable global economic environment for developing economies in trade and investment, capital flows and commodity prices. At least one-third of pre-crisis growth in China was due to exports, mostly to advanced economies, and the ratio is even higher for smaller Asian export-led economies.

From the early years of the 2000s, low interest rates and rapid expansion of liquidity in the US, Europe and Japan triggered a boom in capital flows to developing economies. This was supplemented by a surge in workers’ remittances, which exceeded three per cent of gross domestic product in India and reached double-digit figures in some smaller developing economies. Commodity prices rose strongly, largely thanks to rapid growth in China. With the financial crisis the global economic environment deteriorated in all areas that had previously supported expansion in developing economies. However, developing economies showed resilience and were able to rebound quickly, particularly where a strong countercyclical response was made possible by favourable payments, reserves and fiscal positions built up during the preceding expansion. As a result, the growth impulse in some leading Southern economies has shifted to domestic demand, including in countries which had previously been export-led.

At the same time, short-term, speculative capital inflows surged with sharp cuts in interest rates and monetary expansion in advanced economies in response to the crisis.
These have been more than sufficient to meet growing deficits in several major developing economies including India, Brazil, Turkey and South Africa. But they have also widened deficits by leading to currency appreciations.

This rapid domestic demand-led growth has now come to an end. China cannot maintain investment-led growth indefinitely. But it also faces hurdles in shifting rapidly to consumption-led growth. Even a moderate slowdown in China, towards seven percent, could bring an end to the boom in a broad range of commodities. This can be aggravated by a rapid exit of investors and traders in commodity derivatives as happened in 2008 after the collapse of the Lehman Brothers.  

Developing countries are also susceptible to a sudden reversal of capital flows. These have shown a high degree of volatility since last summer and there are now signs of flight to safety. The immediate threat is not a hike in interest rates in the US and Europe, but the deepening of the eurozone crisis, triggering a rapid exit, very much like the collapse of Lehman Brothers.

In conclusion, the world economy is no less fragile today than it was on the eve of the United Nations Conference on the World Financial and Economic Crisis and its Impact on Development that took place in June 2009 in New York. And developing economies are just as exposed to downside risks from advanced economies as they were then, but their policy space has narrowed in the interim.

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