Monday, 26 January 2009

A Post-Crisis Prediction For Global Emerging Markets

(This is an unpublished note that I wrote March 2008. Strictly for the buffs.)

What to expect when the recovery comes

Maybe it is time to talk about the coming upswing, whenever that is going to be. Since the previous downturn, emerging economies have come to play a far greater role in the global economy. This will change the way that the global financial system adjusts to the current crisis, and mean that the structure of the global economy will change for good.

A comparison with the recovery after the dotcom bubble burst is instructive. The ancient adage about every general fighting the previous war has been a valid criticism for forecasting the next crisis. But only the most arrogant military strategist would not try to learn from the mistakes of past campaigns.

During the dotcom crisis, the downturn in the business cycle caused the real economy to hold off on investment spending, and as a result production technologies gradually became outdated. The underlying drive to innovate, however, was not much affected by the slowdown: new ideas and solutions kept coming. So when companies could afford to invest again, and indeed were compelled to do so to keep up with the also-recovering competition, they invested in the latest technologies – and saw their productivity increase rapidly.

What we macroeconomists saw was a sudden increase in productivity, while employment was much slower to pick up; it did, eventually, once the catch-up in technology adjustment was complete.

Much of the same logic is present again now. Firms might have stopped investing, but technological innovation has its own momentum, from which they will be able to gain when they can afford to spend again. Right now, we see investment falling in response to reduced demand. We might expect, on the post-dotcom pattern, that this will be followed by a catch-up in technology investment, increased productivity growth, and finally, after some delay, a pick-up in employment.

Yet there is one major difference between this trough and the last: that is, the role of emerging markets in the global economy. The way in which emerging markets adopt, and increasingly generate, new technologies will alter the upswing after this trough significantly.

Producers in emerging markets are not suffering as much as their counterparts in mature economies in the current slowdown. Sure, their exports have been hit, but many of them have found that domestic demand is relatively buoyant. That is because their own economies are on an upwards growth path that is not so cyclical, but reflects real structural change. As a result, they do not have to simply sit out the global slowdown, but instead can turn to the domestic market and exploit pent-up domestic demand. When global demand for their products recovers too, they should find that they are better off than before the crisis. Quite likely they have access to extensive cheap labour, meaning that they can easily expand production to respond to increased demand.

Producers in emerging markets have also shown of late that they can adopt new technologies extremely rapidly. Spillover from mature markets happens much faster than it used to, and sometimes these countries are themselves the source of innovation. This too means that they have especially good potential to increase productivity quickly once the recovery comes and they can invest in new technology.

The technology catch-up effect, with companies preferring to update to the latest technologies before expanding their workforce, is likely to be repeated. However, emerging market countries are set to benefit all the more from this process, since it is in these countries that the cheapest skilled labour is to be found and the greatest productivity gains to be realised. Furthermore, for companies in developed countries, once they are in a position to start investing again, they are likely to weigh up the options and find that starting a new production unit in an emerging economy makes more financial sense than expanding existing capacities at home.

This means that the pick-up in employment in mature economies will be delayed further. Much of the job creation will be in emerging markets, with the latter seeing another big expansion boom.

Of course not all emerging markets are the same, and the recent troubles have confirmed that a separation is occurring between the more and less robust emerging economies. Those with weak fundamentals will have neither the cushion of buoyant domestic demand now nor the capacity to attract FDI when things begin to look rosier globally. However, the many emerging markets with stronger fundamentals, that have really done their homework in terms of changing the structure of their economies (or are lucky enough to sit on abundant natural resources), are about to see the benefit of all their hard work (fortune). They could be catapulted into a very strong position in the world economy within a very short time. Then we will really see what they are made of.

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