Will emerging markets come back?

The developed world never ‘decoupled’ from emerging markets, and this is likely to cause new degrees of problems in the next two or three years.

Watching the news on television, especially events unfolding in the Ukraine, leaves me with a sense that we haven’t figured out how to manage these pressures. The recent rout in emerging markets has left a lot of people very confused about the direction in which the global economy, and developing countries more specifically, are going, but it turns out that once again we should not have found recent events at all surprising. They are part of the globalisation cycle.

There was no “decoupling” -- but once again we wanted to argue that this time was different. For several years we had been hearing that the global crisis of 2007-08 marked some kind of inflection point that signalled the decoupling of developing countries from the advanced countries of North America and Europe. The argument, as I understand it, was that the developed countries of Europe and North America had got themselves caught up in a debt-fuelled consumption boom, of which the crisis was the culmination and the beginning of the process of reversal.

The developing world had, according to this argument, managed to untie itself from developed-country demand and its growth was now more likely to be driven by domestic demand arising at least in part from the more favourable demographics of the developing world. The growing middle classes, especially in China and India, were emerging to become a major focus of demand, and not only were other developed countries benefiting from this new source of demand, but eventually all countries would benefit from demand generated in the developing world.

I never found this thesis very convincing and completely rejected the “decoupling” argument. As I see, it the decade before the crisis was characterised by a series of unsustainable processes driven largely by structural changes in the global economy that tended to force up savings rates globally. In my view, the 2007-08 crisis was just the first stage of the rebalancing process, in which overconsumption in the developed world was forced by rising debt to reverse itself. But of course this couldn’t happen without equivalent adjustments elsewhere. The crisis now affecting developing countries is, as I see it, simply the second stage of the global rebalancing, or the third if you think of the sub-prime crisis in the US as the first stage and the euro crisis in Europe as the second stage.

To understand the link, we need to go back to the pre-crisis period. Ever since the 2007-08 global crisis, the world has suffered from weak global demand. Demand had been strong before the crisis, but this largely reflected the credit-fuelled consumption binge, combined with a huge amount of what proved to be wasteful real estate development, unleashed as a consequence of soaring stock and real estate markets that were themselves the consequences of speculative capital pouring into countries like the United States and peripheral Europe.

The crisis put an end to this. After stock and real estate markets in the United States and Europe collapsed, and once financial distress worries constrained the ability of households to borrow for additional consumption, the great consumption and real estate boom in many parts of the world also ended.

Normally slowing consumption growth should also cause slowing investment. The purpose of productive investment today, after all, is to serve consumption tomorrow, but at first this didn’t happen. Instead we saw an intensification in 2009-10 of the credit-fuelled investment binge in China, as well as in developing countries that produced the hard commodities China needed. This increase in investment was supposed to offset the impact of declining consumption in the west, and it certainly had that effect. The collapse in China’s current account surplus, for example, had almost no impact on domestic employment because it was offset by an astonishing surge in domestic investment.

This is what set off talk of “decoupling”. As weaker consumption and real estate investment in Europe and the US forced down growth in global demand, it was counterbalanced by greater demand in the developing world, driven in large part by China. Not surprisingly this meant that a larger share of total demand accrued to poor countries at the expense of rich countries.

But the process was not sustainable. In China well before the crisis we were already experiencing the problem of excess investment in manufacturing capacity, real estate and infrastructure. In developing countries like Brazil this was matched by investment in hard-commodity production based on unrealistic growth assumptions in China. Weaker demand in the rich countries, especially weaker consumption, should have reduced whatever the optimal amount of global investment might have been, especially as we already suffered from excess capacity. To put it schematically:

  1. Before the crisis the world had already over-invested in real estate and manufacturing capacity based on unrealistic expectations of consumption growth.
  2. The global crisis forced consumption growth to drop. This should have meant that if investment levels were too high before the crisis, they were even more so after the crisis.
  3. Instead of cutting back on investment, however, the developing world reacted to the drop in rich-country demand by significantly increasing investment, driven at least in part by worries that the consumption adjustment in Europe and the US would cause a collapse in export growth which would itself force unemployment up to dangerous levels. 

Clearly this wasn’t sustainable, and not surprisingly soaring debt is now forcing this investment surge to end. As a result, we are now going to experience the full impact of slower consumption growth in the rich countries, but instead of this being mitigated by higher investment growth in the developing countries, it will now be reinforced by slower investment growth in the developing world. Over the next few years demand will revive slowly in the US, not at all in Europe, and it will weaken in the developing world.

… The result is that over the next few years global demand will be even weaker than it has been since the crisis. Consumers in North America, peripheral Europe, and the newly rich middle classes around the world are still cutting back on consumption to pay down debt. Investors in China, Latin America and Asia are finally responding to overcapacity and soaring debt by themselves cutting back on investment. But if we all cut back our spending to service our debts, paradoxically, our debt burdens will only rise, and the great danger is that rising debt burdens will force us to cut back even more, thus making the debt burden worse (and, by the way, forcing at least some countries, in both the developing world and in Europe, to default).

Nothing fundamental has changed. Demand is weak because the global economy suffers from excessively strong structural tendencies to force up global savings, or, which is the same thing, to force down global consumption. Lower future consumption makes investment today less profitable, so that consumption and investment, which together comprise total demand, are likely to stagnate for many more years.

… Emerging markets may well rebound strongly in the coming months, but any rebound will face the same ugly arithmetic. Ordinary households in too many countries have seen their share of total GDP plunge. Until it rebounds, the global imbalances will only remain in place, and without a global New Deal, the only alternative to weak demand will be soaring debt. Add to this continued political uncertainty, not just in the developing world but also in peripheral Europe, and it is clear that we should expect developing country woes only to get worse over the next two to three years.

Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.