Monday, April 27, 2009

Developing economies may recover in 2-3 years

ADB paper hammers the final nail in the decoupling theory as it underlines the severe dislocations that have taken place in emerging market economies as the fallout of the crisis in the West.

Institutions such as the World Bank and the Asian Development Bank (ADB) are getting more and more pessimistic about the prospects for the global economy and for emerging markets.

ADB has recently come out with a discussion paper titled Global Financial Turmoil and Emerging Market Economies: Major Contagion and a Shocking Loss of Wealth? The paper hammers the final nail in the decoupling theory as it underlines the severe dislocations that have taken place in emerging market economies as the fallout of the crisis in the West.

How have the developing economies been affected? One of the channels has been the huge destruction of wealth. The paper estimates that the loss in global wealth as a result of the crisis has been at least $50 trillion (Rs2,590 trillion), equivalent to one year of world gross domestic product (GDP). The figure is arrived at by adding up the fall in the capitalization of stock markets, the loss in the value of bonds supported by mortgages and other assets, and the depreciation of many currencies with respect to the US dollar.

In developing Asia and the newly industrialized countries of the region, the paper estimates the loss in wealth in 2008 to be $9.6 trillion, or the equivalent of 109% of GDP. What will be the impact of this huge loss in wealth? The paper points out that “such losses will have an enormous impact on domestic expenditure. The terms of trade/export decline effect will aggravate the situation, as it will reduce incomes by 2-2.5% of GDP. Thus, emerging market economies’ growth in 2009 will decline by at least 3 percentage points”.

Three percentage points doesn’t sound too bad if calculated from the high rates of growth notched up by the region before the crisis. For India, a three percentage point fall from the high of 9% growth would imply a growth rate of 6%, which isn’t bad at all considering that GDP growth in the December quarter was 5.3%. But perhaps the ADB paper is merely pointing to the impact in 2008—its prediction for Indian GDP growth in 2009 is 5.1%, which implies that there’s still a lot of pain left for the economy. Incidentally, Chinese growth in 2009 is projected to be 6.7%, well below its 11.4% rate in 2007.

The significant loss of wealth in the Asian region, says the paper, is because between 2003 and 2007, the value of financial assets in the region rose from 230% of GDP to 370% of GDP. Globally, the ratio of financial assets to GDP rose to 490% by the end of 2007, clearly reflecting the increased degree of financialization of the western economies. But as the increase in the ratio shows, increased financialization has affected Asia as well, with the result that the financial crisis will extract a heavy toll on the region. In contrast, the increase in financialization of Latin America during this period was a modest 30%.

The other ways in which emerging market economies will be hurt by the crisis are well known. Both the World Bank, in a paper titled Swimming against the Tide: How Developing Countries are coping with the Global Crisis, and the ADB paper point to falling foreign direct investment, declining remittances and the difficulties of rolling over debt and financing infrastructure projects. The World Bank paper warns that “investments in private infrastructure projects in East Asia and Latin America declined substantially after the late 1990s crises in developing countries and had not recovered their pre-crisis levels by 2007”. World Bank projections suggest that remittances to developing countries will fall at least 5% in 2009. The Institute of International Finance estimates that net private flows to emerging economies declined from a record $930 billion in 2007 to below $470 billion in 2008 and is projected to be only $165 billion in 2009. Net flows are projected to decline by 80% from their 2007 peak for Emerging Asia and by 75% for Latin America.

Won’t the fiscal stimulus packages being rolled out by governments across the emerging economies help? Ah, there’s the rub.

The ADB paper says, “In the end, emerging markets economies only have limited room for domestic expansion. Thus, they will also have to rely on the effect of the stimulus packages of the larger economies, in addition to the effect of their own actions. These will inevitably include in some cases currency devaluation, and mainly a prudent, but active use of domestic fiscal stimulus, and of monetary policy, where margins may be greater.”

India, in particular, is unable to provide a large fiscal push because its government deficit is already very high and government borrowing is already pushing up interest rates.

What about the longer run? The ADB paper points out, “Over the last quarter century, trade in goods and services, remittances and capital flows to and among emerging regions have risen significantly. Without question, their economic and trade growth have constituted the most dynamic aspect of globalization in recent years. The current crisis may slow down the process, but it is unlikely that a recovery will take more than two-three years.”

Two-three years is longer than most mainstream economists are predicting and the very fact that it’s now being mooted in a discussion paper put out by ADB underlines the heightened concerns that economists now have about emerging market economies.

Manas Chakravarty
looks at trends and issues in the financial markets.