The Future of Emerging Markets: Prospects for Global Economic Convergence

This article is contributed by The Insight Bureau. Called the 'GEMS Bellwether Report', these reports take a succinct but penetrating look at the current state of the global economy and the emerging markets. This particular report was jointly written by Dr Yuwa Hedrick-Wong who is a member of The Insight Bureau network of economics speakers.

By Dr Yuwa Hedrick-Wong


Divergence versus Convergence: the Big Picture


The “great convergence”, the closing of the gap between emerging markets and the developed economies that captured the public imagination in the past decades, has become a great deal less compelling since the 2008/09 global financial crisis. Both China’s and India’s real GDP growth has since dropped by half from its peak in 2007. The slowdown in growth is even more precipitous for Brazil and Russia, plunging from a peak of 6.1% in 2007 to 0.9% in 2012 in Brazil, and from 9.0% to 3.4% in Russia; and both suffered negative growth in 3Q 2013 . The pattern is similar for other large emerging markets such as South Africa, Turkey, Indonesia, and Poland. At best the great convergence can no longer be held up as a self-evident truth. At worst, it is seen to be on the wane and moribund. What is the future for emerging markets, and of global economic convergence?

Before the great convergence, however, there was the “great divergence”. And in order to gain better clarity on what the future of convergence may look like, we need better clarity on the big picture: what created the great divergence to begin with, as well as the great convergence that followed, in the context of the last two hundred and fifty years? 
To the extent that GDP and per capita GDP data can be estimated historically, different parts of the global economy appeared to be quite similar prior to the 18th century. Per capita GDP was estimated to be roughly the same between Britain, China and India over the 1500 to 1600 period.  By the 18th century a hundred years later, however, the great divergence started to gather momentum when Britain, followed by northwestern Europe and North America, pulled away from the rest of the world. The impact of the great divergence on global inequality is startling. Around the end of the 18th century, the average per capita GDP of the richest countries of the world was about four times that of the poorest countries. By 1950, the gap between the richest and the poorest had increased by a factor of twenty. In 1820, the per capita GDP of the West (approximated by the average of Britain, US, and Germany) was 2.2 times that of China and 2.5 times that of India . By 1950, it rose to 15.5 times that of China and 11.0 times that of India. Great divergence indeed.
In the past half a century or more, however, a trend reversal happened, at first in East Asia led by Japan, then followed by South Korea, Taiwan, Hong Kong and Singapore. In 1950, per capita GDP of the West was 3.5 times that of Japan. By 1998, just before Japan slipped into its two-and-a-half-decade long stagnation, it was close to parity .  Alongside Japan, South Korea and Singapore are now members of OECD, among the richest countries in the world . 
But it is China’s rise since the early 1980s that has been the major strand in the convergence story by virtue of its population being the largest in the world. Between 1950 and 1998, the ratio of per capita GDP between the West and China was reduced from 15.5 to 6.8; and further to 4.6 in 2012. India, with the second largest population in the world, became part of the convergence narrative in the 1990s, and between 1998 and 2012 the ratio of per capita GDP between the West and India fell from 12.2 to 10.9. It was therefore a small step to add Brazil and Russia, with the biggest populations in Latin America and Europe respectively, to create the BRIC acronym, and spinning it into a story of the unstoppable rise of the emerging markets. Thus the great convergence arrived.
The great convergence narrative became positively captivating in the mid-2000s with China’s double-digit real GDP growth, followed by record growth rates in India, Brazil and Russia. Investors jumped on the band wagon. BRIC investment funds as well as more general emerging market funds mushroomed and CEOs of multinationals scrambled to come up with their versions of a BRIC strategy. In that febrile atmosphere, few managed to keep their heads to ask some basic questions: do the BRIC countries really have anything in common, apart from their large populations? Do the BRIC countries share the same economic fundamentals in their strong growth, and if not, then what make them a meaningful grouping and what is propelling their collective rise? Similar questions can be re-phrased for emerging markets generally. However, instead of asking these questions, for many it became an article of faith that emerging markets were destined to emerge and that the BRIC countries were the unstoppable juggernauts leading the charge in converging with the developed economies .
What many also forgot to take into account was the fact that, in the decade before the 2008/09 global financial crisis, it was not just the BRIC countries, or the emerging markets generally for that matter, that were fast growing. A tsunami of easy money and credit flooded every nook and corner of the global economy, pushing up growth everywhere. For example, Angola’s real GDP growth repeatedly reached 18% in the mid-2000s. In fact, during that time a country had to work really hard in order not to grow at all; by 2007, only three countries in the world failed to grow – Fiji, Zimbabwe, and the Democratic Republic of Congo. In that decade, the world became one giant bubble economy and in that context the growth record of emerging markets was entirely unexceptional.  
Nevertheless multinational companies and international investors were genuinely enthusiastic about the emerging markets, and to be fair, there is some justification for it. Global companies measure market size of countries in nominal US dollars, which they then adjust for inflation to compute the “real” growth. They do this because their sales are conducted in US dollars. In addition, most countries’ ability to service their foreign debts is also calculated in terms of US dollar, hence their risk profile is affected by the size of their GDP expressed in US dollar. In an intriguing and insightful analysis, Ricardo Hausmann at Harvard University points out that in the decade of 2002 to 2012 the growth of emerging markets generally and of the BRIC countries in particular was greatly distorted when measured in US dollar (let’s call it “US dollar GDP”), which in many cases bore no resemblance to real growth in output in these countries. For example, cumulative growth of “US dollar GDP” from 2002 to 2012 is estimated at 420% for Russia, 290% for Brazil, 395% for China and 206% for India. These are very impressive numbers which turned heads in corporate board rooms and business conferences everywhere. But much of this growth came from changes in their terms of trade and the appreciation of their currencies against the US dollar, as opposed to expansion in real outputs. 
For instance, over this time period, it is estimated that the terms of trade improved by 154% for Russia, 48% for Brazil, and 55% for India (China is the exception where the terms of trade deteriorated by some 30% because the average price of Chinese manufacturing exports declined against that of Chinese commodity imports). Similar terms of trade improvement were seen in many other emerging markets; 190% for Venezuela, and 56% for South Africa, for example. In lockstep with improving terms of trade the currencies of emerging markets appreciated against the US dollar because of booming exports and stronger capital inflow.  As a result, the “US dollar GDP” of emerging markets skyrocketed. 
Stripping away the effects of improved terms of trade and currency appreciation, however, the growth of real output (which is what really counts) becomes much more down to earth. It turns out that in Russia only 14% of the total cumulative growth of its “US dollar GDP” in the decade of 2002 to 2012 can be accounted for by an expansion in real output. In Brazil it is only 12%, and about half in India and two-thirds in China . Since terms of trade and currency movement exhibit strong trends of means reversal (and they have been reversing since 2012), they cannot be counted on as a sustainable basis for convergence. Sustainable convergence requires that emerging markets have the ways and means to increase their real output consistently over long periods of time in spite of the ups and downs of the business cycle. It means returning to the basics of working harder and working smarter. It means getting the economic fundamentals right.      

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