While the recent surge in exports and strengthening demand across most economies have buoyed expectations that the global economy is on an upward growth trajectory this year, the external environment of emerging market and developing (EMD) economies is set to become more challenging in the medium term. The International Monetary Fund (IMF) in its latest outlook publication has described it as a “less travelled and complicated” external environment for the EMD economies.
It said EMD economies over a period of two decades had doubled share to more than three fourths of global growth in output and consumption. A large part of this catch-up can be attributed to favourable external conditions, coupled with supportive domestic policies and institutions that reinforced the benefits to growth derived from abroad.
External conditions Matter
Countries that experienced growth spurts, defined as achieving a real gross domestic product per capita growth of at least 3.5 per cent annually over five years and where the trend growth is two per cent higher than the earlier period, have had favourable external conditions. Their trading partners’ growth were strong with larger capital inflows, especially commodity exporters, they had better terms of trade and higher export prices relative to imports.
The benefits from a stronger growth of trading partners stem from the larger market size that enables the exporting country to achieve higher productivity gains associated with economies of scale. A larger volume of capital inflows, meanwhile, raises growth by easing credit rationing and reducing borrowing costs while a favourable terms of trade can be likened to a windfall in export earnings. These favourable external conditions helped many EMD economies at various stages of development to grow at higher rates.
The IMF study identified 95 growth acceleration episodes that were associated with favourable external conditions. Likewise, it found 125 reversal episodes related to a decline in external conditions. Malaysia was identified to have a growth acceleration episode in 2002 as it benefited from the rapid growth of the Chinese economy, strong commodity prices and rise in capital inflows.
Shifts in external environment
The tailwinds from a favourable external conditions for EMD economies have begun to wane in the post-global crisis environment as advanced economies post lower potential growth, the Chinese economy grows more slowly while being rebalanced and the commodity cycle shifts downwards. Together with the rising risk of protectionism in advanced economies and tighter financial conditions that will result from the normalisation of United States monetary policy, the external conditions for EMD economies are anticipated to turn less favourable in the medium term.
Counter to waning tailwinds
While the external conditions turn less favourable, EMD economies can still sustain moderate to high growth if they pursue the appropriate policy mix and create the right domestic conditions. These domestic policies and conditions are found to interact with the external environment in a reinforcing manner when external demand, financial conditions and terms of trade are favourable while dampening the negative effects to growth when the external environment turns negative.
One of the keys to countering the fading external tailwinds is to raise local financial depth while pursuing regional trade and financial integration. Another key is to ensure the initial conditions conducive for growth accelerations are fulfilled. These include maintaining low levels of external debt and current account balance and building stronger buffers to smoothen the impact of worsening global financial conditions.
How government can respond
The policy framework provides stability for exchange rate and monetary and improves overall predictability of the economic environment, which helps to set firms and households’ expectations and spending in response to changes in the external environment. Importantly, having larger buffers, fiscal space and a flexible exchange rate regime are helpful in adjusting to shifting external conditions and facilitating price signals to ensure that capital, labour and managerial resources are allocated efficiently:
Finally, strong institutions including high quality of governance, legal and regulatory environment, efficient public services and high education level are found to contribute to better long-term growth outcomes. Emerging market and developing economies can get the most out of a weaker growth impulse from external conditions by strengthening institutional frameworks and adopting a policy mix that fosters trade integration, permits exchange rate flexibility and ensures that vulnerabilities stemming from high current account deficits and external debt, as well as high public debt are contained.
Implications for businesses
The stronger growth of EMD economies, together with rising infrastructure needs, suggest that continuing capital inflows from the advanced economies facing population aging and excess savings. Given that China has accounted for a rapidly increasing share of global demand, Malaysia’s exposure to China has increased substantially. China’s slowdown therefore poses challenges for Malaysia and other EMD economies. Nonetheless, the transition of the Chinese economy from an export-driven to a consumption-based and its moving up the value chain will create opportunities for Malaysian firms. They can also leverage on the increase in services trade associated with China’s rebalancing and its increasing investment abroad.
This article first appeared in the New Straits Times on 4 May 2017.
