MILAN – Over the past two years, industrial countries have experienced bouts of severe financial instability. Currently, they are wrestling with widening sovereign-debt problems and high unemployment. Yet emerging economies, once considered much more vulnerable, have been remarkably resilient. With growth returning to pre-2008 breakout levels, the performance of China, India, and Brazil is an important engine of expansion for today’s global economy.
High growth and financial stability in emerging economies are helping to facilitate the massive adjustment facing industrial countries. But that growth has significant longer-term implications. If the current pattern is sustained, the global economy will be permanently transformed. Specifically, not much more than a decade is needed for the share of global GDP generated by developing economies to pass the 50% mark when measured in market prices.
So it is important to know whether this breakout growth phase is sustainable. The answer comes in two parts. One depends on emerging economies’ ability to manage their own success; the other relates to the extent to which the global economy can accommodate this success. The answer to the first question is reassuring; the answer to the second is not.
While still able to exploit the scope for catch-up growth, emerging economies must undertake continuous, rapid, and at times difficult structural change, along with a parallel process of reform and institution building. In recent years, the systemically important countries have established an impressive track record of adapting pragmatically and flexibly. This is likely to continue.
With government policy remaining on course, we should expect a gradual strengthening of endogenous domestic growth drivers in emerging economies, anchored by an expanding middle class. Combined with higher trade among them, the future of emerging economies is one of reduced dependence on industrial-country demand, though not a complete decoupling.
Distribution as well as growth matter. Emerging economies still need to manage better their growing domestic tensions, which reflect rising income inequality and uneven access to basic services. A failure on this front would derail their strengthening domestic and regional growth dynamics. This is better understood today, with distributional aspects of growth strategy being firmly placed on emerging countries’ policy agendas.
While emerging economies can deal with the economic slowdown in industrial countries, the financial-sector transmission mechanism is more challenging. Today’s low interest-rate environment is causing a flood of financial flows to emerging economies, raising the risk of inflation and asset bubbles. The hiccups in Western banks have served to disrupt the availability of trade credits, and, if amplified, could destabilize local banks.
These risks are real. Fortunately, several emerging economies continue to have cushions and shock absorbers. Having entered the 2008-2009 crisis with sound initial conditions (including large international reserves, budget and balance-of-payments surpluses, and highly capitalized banks), they are nowhere near exhausting their fiscal and financial flexibility – and hence their capacity to respond to future shocks.
Overall, emerging economies are well placed to continue to navigate successfully a world rendered unstable by crises in industrial countries. Yet, again, the decoupling is not complete. A favorable outcome also requires industrial countries’ ability and willingness to accommodate the growing size and prominence of emerging economies. The risks here are significant, pointing to a wide range of potential problems.
The flow of knowledge, finance, and technology that underpins sustained high growth rates in emerging economies is closely linked to an open, rule-based, and globalized economy. Yet this global construct comes under pressure in an environment in which advanced countries have stubbornly high unemployment and bouts of financial volatility. The location of growth in the global economy comes to be seen as a zero-sum game, leading to suboptimal reactions.
As a result, the continued openness of industrial-country markets cannot be taken for granted. Political and policy narratives are becoming more domestic and narrow, while the international agenda and the pursuit of collective common global interests are having greater difficulty being heard.
These challenges will grow in the years ahead. And then there is the issue of global institutions and governance.
Managing a growing and increasingly complex set of transnational connections is an even bigger challenge in a multi-speed world that is being turned upside down. Such a world requires better global governance, as well as overdue institutional reforms that give emerging economies proper voice and representation in international institutions.
In the absence of such changes, the global economy may bounce from one crisis to another without a firm hand on the rudder to establish an overall sense of direction. The result is what economists call “Nash equilibria,” or a series of suboptimal and only quasi-cooperative outcomes.
Where does all this leave us?
Emerging economies will be called on to play an even larger role in a multi-speed global economy characterized by protracted rehabilitation of over-extended balance sheets in industrial countries. Left to their own devices, they are up to the task. But they do not operate in a vacuum. Emerging economies’ ability to provide the growth lubrication that facilitates adjustment in industrial countries is also a function of the latter countries’ willingness to accommodate tectonic shifts in the operation and governance of the global economy. Let us hope that these global issues receive the attention they require.
Mohamed A. El-Erian is CEO and co-CIO of PIMCO and author of the bestselling book When Markets Collide.
Michael Spence, a Nobel laureate in economics and Professor Emeritus at Stanford University, chairs the Commission on Growth and Development.