IMF Survey Magazine: Policy
Emerging Markets Need ‘Second Generation’ of Reforms
October 10, 2013
- Emerging markets more resilient compared to earlier crises
- But changing global conditions are exposing problems in emerging markets
- Next generation of reforms vital for lasting growth
After years of strong performance, emerging economies are experiencing a slowdown, and a new round of reforms will be necessary if growth is to be sustained in the face of a more challenging external environment, panelists told a seminar at the IMF-World Bank Annual Meetings.
At “Emerging Markets: Restoring the Momentum,” a group of experts observed that most emerging economies have reaped substantial benefits over the past decade from cheap capital, high commodity prices, and strong growth in China.
But a tightening in global financial conditions in recent months is exposing a divergence in these economies—some have strengthened economic fundamentals, while others simply rode the wave of good fortune.
Thanks to reforms pursued after the financial crises of the 1990s, many emerging economies are now more resilient and better able to avert any problems that arise as a result of a reversal of the positive external conditions. In order to boost their growth potential, however, these countries may now need to pursue a second generation of reforms, the panelists said.
“It is important for policymakers to recognize the changing dynamics of the global economy and design economic policies accordingly,” said Naoyuki Shinohara, IMF Deputy Managing Director.
Joining Shinohara on the panel were Tim Adams, head of the Institute for International Finance; Luis Miguel Castilla, Finance Minister of Peru; and Nouriel Roubini, Co-founder and Chair of Roubini Global Economics.
Cyclical or permanent?
It is difficult to quantify how much of the slowdown in emerging markets is permanent or temporary, panelists said. Some of the factors affecting the prospects of emerging markets include the slowing of China, the end of the commodity price boom, and the tapering of unconventional monetary policies in some advanced economies. “How much of these factors is structural and how much is cyclical is ambiguous,” said Roubini.
The good news, he said, is that emerging markets have become more resilient in recent years, with a “war chest” of reserves, more flexible exchange rates, and stronger financial systems. But policy decisions will not be easy, he cautioned: “Whether you tighten monetary policy or ease it, each choice has its tradeoffs.”
Castilla observed that Peru was set to grow at rates over 6 percent—double the Latin American average—over the next few years. With the changing global circumstances, the question is how to maintain this momentum in the future, and that entails reforms, he said.
His country is in a better position than its neighbors, Castilla said. Although richly endowed with gold and copper resources, Peru is not particularly threatened by the prospect of a change in external conditions. “Our dependence on tax revenues coming from commodities is 4 percent of GDP,” he said, noting that this level is much lower than that of other commodity producers in Latin America. “We have been able to diversify our economy, and we are increasingly dependent on domestic drivers of growth,” he said.
Markets will increasingly distinguish between the emerging economies that have sound fundamentals, like Peru, and those with budding vulnerabilities such as large current account deficits, large fiscal deficits, sharply slowing growth, and rising inflation, Roubini noted.
Cause for concern
While most emerging markets have tools such as flexible exchange rates to help them cope with the slowdown, there is no room for complacency, said Adams. More worrisome than the changing external factors is emerging economies’ rising level of private and public indebtedness, he stressed.
“We’ve had growth, but it’s come at the expense of more credit. We have to ask the question, what is the marginal efficiency of continuing to extend that credit?” Emerging economies are becoming increasingly leveraged, but they’re getting less and less for it, he said.
Moderator Zanny Minton Beddoes of The Economist asked the panelists to cite examples of emerging economies that had responded well to the turmoil of recent months.
Indonesia has taken two important steps, Roubini said. The first was to tighten monetary policy significantly—by 150 basis points—and the second was to begin phasing out its huge energy subsidies.
“In June, seeing the pressure coming from financial markets, they were able to convince their parliament to start phasing out energy subsidies and reduce the budget deficit, therefore making fiscal policy more credible,” he said, noting that sometimes countries need the threat of a crisis to spur action on politically unpopular measures.
Getting to the next level
Panelists agreed that a “second generation” of structural reforms to increase productivity and boost competitiveness were necessary if emerging markets hoped to achieve sustained high growth rates, even in less favorable global conditions. More investment in human capital and in physical capital is crucial, as is more efficient delivery of public services, said Castilla.
Such reforms are necessary to increase emerging economies’ potential growth, agreed Roubini, but countries have to find the fiscal resources to carry out the needed increase in investment—and that is the politically tricky part.
Shinohara noted that there are economies that suffer from what is known as the “middle-income trap,” when an emerging country’s per capita income stops converging to that of advanced economies. This happens when a country is unable to move into higher value-added production, and at the same time is no longer able to compete with countries with cheaper labor costs. This is not an easy problem to solve, Shinohara said, but the change in global dynamics presents the opportunity put more emphasis on structural reforms.
Comparing the current environment with the situation in the 1990s prior to the Asian financial crisis, Shinohara said he was “cautiously optimistic.”
“The economic fundamentals are much stronger today, but at the same time, no two crises are identical,” he observed. “We have learned lots of lessons from past crises, but unfortunately booms and busts continue. So we need to be vigilant.”
The seminar followed a closed morning session on the issues facing emerging markets, where presentations were made by David Lipton and Kalpana Kochhar, among others. Lipton is the IMF’s First Deputy Managing Director and Kochhar is Deputy Director of the IMF’s Strategy, Policy, and Review Department.