The Road to Post-Crisis Growth

MILAN – It is about 18 months since the financial crisis hit, and 12 months since the panic started to recede, with asset prices stabilizing and beginning to turn up. Although recovery in advanced countries remains fragile, developing countries appear to have weathered the storm. Growth in China and India is bouncing back toward pre-crisis levels, Brazil’s growth is rising after a sharp dip, and developing-country trade is rebounding from depressed levels. Reasons for this remarkable resilience abound, and they offer guidance for advanced and developing countries alike. As the crisis struck, capital flowed out of developing countries to shore up damaged balance sheets in advanced countries. Credit tightened sharply. But rapid responses by developing-country central banks, in collaboration with relatively healthy domestic banks, prevented a severe credit freeze. Moreover, the reserves built up over the preceding decade were, in many cases, used to offset some of the capital outflows. Bank balance sheets had been strengthened after the 1997-1998 financial crisis, and were unencumbered by the overvalued securitized assets and complex derivative securities that caused much of the damage to advanced-country financial institutions. Leverage was lower in several sectors. Financial institutions – and, more importantly, households – held less debt relative to assets and income. In advanced economies, the main mechanisms for transmitting balance-sheet damage to the real economy were credit rationing and reduced consumption due to loss of net worth in households. Both factors were more muted in developing economies. Of course, rapid declines in asset values had an impact for a few months, but, with less leverage, the impact on net worth was lower and domestic consumption less vulnerable. In sum, the crisis originated in a balance-sheet shock, to which exposure was simply lower in developing countries. All developing countries witnessed a huge fall-off in trade – much larger than the declines in income and output. Trade bounced back relatively quickly in the second half of 2009, though this partly reflected the extraordinarily low base. But the immediate effect was mitigated to some extent by a sharp depreciation of almost all the currencies caused by the capital outflows. The exception was China, where the renminbi held steady against the dollar, causing an initial appreciation against almost every other currency. That configuration has largely reversed in the past nine months as international capital flows, driven by investment opportunities and returns, return to a more normal pattern. It is likely that China will shortly resume its pre-crisis policy of managed appreciation. To be sure, developing countries differed – often markedly – in their capacity for fiscal stimulus to counter the loss of external demand. Nevertheless, many were capable of at least some countercyclical measures without destabilizing their public finances. Although the resilience in emerging markets, their rapid and effective policy responses, and speedy recoveries are encouraging signs for the global economy, instability in the advanced economies and the relatively unregulated financial system remain a cause for concern. Re-regulation and international efforts to coordinate policy responses may eventually reduce the potential for instability, but will require the work to be finished and tested before real confidence is generated. In the meantime, a somewhat conservative and defensive posture is warranted. This means that developing countries are likely to retain substantial domestic ownership of their domestic financial institutions. Securitization (and shadow banking) will be kept simple and proceed at a measured pace as a new legal and regulatory framework is built and tested. Complex securities that are hard to value will be sharply limited as a matter of policy. Moreover, because dependence on foreign finance creates clear vulnerabilities, developing countries will seek to fund investment mainly from domestic savings, thereby limiting the size of their current-account deficits. And, because there is no strategic reason to run large surpluses, with an excess of savings over investment, maintaining reasonable balance on the current account appears to be the preferred course. In any case, limiting financial interdependence is the prudent strategy and the likely outcome. Nevertheless, the basic pillar of sustained high growth has been leveraging the global economy’s knowledge and demand. That remains valid. So, while a strong likelihood of diminished growth in advanced countries for an extended period means that an outward-oriented strategy may produce less-than-spectacular results for developing countries, alternative strategies are worse. Indeed, worries about rising protectionism in a low-growth environment are on target. Larger developing countries must assume an expanded role in unwinding the protectionist measures that came with their expanded use of the public purse, and reestablish forward motion. This is particularly important for poorer and smaller developing countries in which domestic consumption and investment is a poor substitute for global demand. At the same time, a renewed emphasis on maximizing the domestic market’s potential to drive growth and structural diversification – though clearly higher in the larger, higher-income developing economies – is a useful lesson of the crisis. Those developing countries that maintain a stable macroeconomic environment, a countercyclical mindset, and steady progress on governance, education, and infrastructure will thrive. Advanced-country growth may be diminished for a time, but the compensating factors that have emerged represent the most important lesson of the crisis. Developing countries’ internal trade is expanding with their economic size, and the large ones are restoring growth rapidly. Indeed, China, far from being thrown off course by the crisis, is entering a middle-income transition that over time will create considerable space in labor-intensive manufacturing and services, as the country evolves structurally and exits from these sectors. Michael Spence was awarded the Nobel Prize in Economics in 2001. An expanded treatment of the lessons and challenges of the financial crisis can be found in “Post-Crisis Growth in Developing Countries: A Special Report of the Commission on Growth and Development on the Implications of the 2008 Financial Crisis.” Copyright: Project Syndicate, 2010. www.project-syndicate.org