EMD economies bracing for more challenges

by: Prof. Yeah Kim Leng, Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia

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.

By Prof. Yeah Kim Leng | 4 May 2017 

Professor Yeah Kim Leng is the Director of Economic Studies Program at Jeffrey Cheah In­stitute on Southeast Asia at Sunway University and Professor of Eco­nomics at Sunway University Business School. He is also an external member of Bank Negara Malaysia’s Monetary Policy Committee. The views expressed in this article are his own.

First appeared in the New Straits Times

Modified by Low Wai Sern