The Rest and the West

Is the debt crisis shifting economic growth to developing countries?

May 12, 2010

Is the debt crisis shifting economic growth to developing countries?

In early May 2010, European authorities were feverishly putting in place an intervention mechanism to preserve stability in the eurozone. In order to continue consultations over the crisis, Italian Prime Minister Silvio Berlusconi and French President Nicolas Sarkozy cancelled trips to Moscow to mark the anniversary of the end of World War II.

Perhaps that was only appropriate. As Greece’s debt turmoil spreads to Portugal, Spain and across the Atlantic, the postwar economic order is fading into history.

Today, the sources of global growth are shifting from the advanced economies to the large emerging economies — for all practical purposes, from the West to the East.

Debt in the West

As the recent volatility of the stock exchanges indicates, the Greek debt crisis is only a prelude of what is to come. In the coming years, the vicious debt circle of the advanced economies will be difficult to contain and, in the absence of dramatic policy changes, is likely to escalate. Drastic changes are waiting behind the door. Life will no longer be the same.

From the 1980s to the fall of 2008, privatization, deregulation and liberalization dominated fiscal and monetary policy in the advanced economies of North America, Western Europe and Japan. As the global financial crisis triggered a massive negative demand shock, it was contained with colossal public debt.

When Iceland (with a 2009 GDP of €12 billion, or over $17 billion) was swept by turmoil in fall 2008, it was perceived as something of a curiosity. Next came the case of Ireland (€227 billion, $325 billion), which was also considered an isolated case. Then came Greece (€240 billion, $331 billion) with its problems.

In the past few days, European authorities have argued that the proposed €110 billion bailout package is adequate. As investors have not shared their confidence, the euro has plunged. Many Greeks believe that the package is too harsh, while many Germans see it as too costly.

Ultimately, it will not resolve Greece’s problems. Nor can Athens expect to avoid debt restructuring. As a result, the economic crisis is testing Europe’s political unity.

As the realization grows that Greece’s debt crisis is just the tip of the iceberg, the spotlight will shift toward Portugal and Spain. The debt burden of Spain alone is €225 billion — about the size of Ireland’s economy.

The most powerful economies of Western Europe are sinking in debt. In 2009, even Germany’s debt-to-GDP ratio amounted to 77%, more than that of the UK. In France and Italy, the ratios were 85% and 124%, respectively. These countries’ deficits tell the same story of excessive indebtedness.

The debt turmoil has laid bare the cracks in the core of European integration. According to the Maastricht euro convergence criteria, the ratio of gross government debt to GDP should not exceed 60%, while the ratio of the annual government deficit to GDP must not exceed 3%. Yet even the largest member states have violated these criteria.

From the 1950s to the early 2000s, the global economy was fueled not just by Western Europe, but by the United States and Japan. Today, the fiscal deterioration extends from a few eurozone member states to the fiscal balance of the United States and the UK. Last year, the U.S. debt-to-GDP ratio was 84%, whereas in Japan it amounted to a whopping 189%.

What makes things worse is that these figures severely underestimate the true level of debt, which should also include the debt of the entire public sector, the role of the central bank, as well the projected aging-related social and health expenditures, which are about to escalate.

If these trends are not adjusted or corrected, then by 2020 the debt ratio would exceed 300% in Japan and 200% in the UK. In France, Italy and the United States, it would be more than 150% — and even in Germany over 100% of GDP.

Growth in the East

Despite excessive debt, advanced economies suffer from slowing growth. In contrast, the largest emerging economies could enjoy high growth for another decade or so. The discrepancy signals a structural transformation that precipitated the global crisis.

From 1945 to the 1970s, globalization boosted primarily the fortunes of the advanced economies — the United States, Western Europe and Japan.

The reduction of trade barriers contributed to increasing globalization, while greatly expanding international specialization. For the industrial world, the resulting liberalization unleashed a “golden age” of growth and prosperity. However, that was not the case with the developing countries.

The past three decades have witnessed a reversal of fortunes. Starting with China’s economic reforms in the 1980s, India’s in the 1990s, and the eclipse of the Cold War, a large group of developing countries has broken into global markets.

Their export-led growth model was not new. It had been pioneered by Japan and the newly industrialized countries of East Asia. What was new was the sheer scale of change. As China, India and Russia have joined the world economy, the size of the global labor market has effectively doubled.

In the Greenspan era, low interest rates made possible seemingly solid growth. However, in reality, it was boosted by a boom-and-bust cycle. Ironically, the liquidity injections, through multinational capital investments, also speeded up the rise of the large emerging economies.

As rapid growth in the emerging markets counterbalanced moderate growth in the United States, the eurozone and Japan, the world seemed flat until the forces for economic integration were disrupted by terrorism in September 2001 — and by economic collapse barely seven years later.
Still, the foundation has been laid for a new world order.

By October 2007, the emerging economies of China and India, for the first time since the 1820s, were the largest drivers of world growth. China was the single most important contributor to world growth. Following in its footprints were Russia, Brazil, and other emerging economies.
Now Asia — particularly the large domestic demand base of China, India and Indonesia — is leading the global recovery.

Since the 1980s, emerging Asia’s GDP growth has exceeded that of advanced economies, whereas in the past global downturns, Asia’s contribution to global recovery was less than that of other regions. Nor is Asia’s recovery any longer driven by just exports, but also by domestic demand. As a result, net capital inflows to the region have surged.

The shift of economic power

After early May’s currency slide, which led to soaring bond yields in Portugal and Spain, the 16 euro nations agreed to offer financial assistance worth as much as €750 billion ($962 billion) to countries under attack from speculators.

Under pressure from the United States and Asia to stabilize markets, the European governments put their faith in the show of shock and awe they hoped would prevent a sovereign-debt crisis and deter speculation that the euro might break apart.

Despite the unprecedented loan package worth almost $1 trillion and a program of bond purchases, even more is needed in the long term. In the past two decades, the deterioration in the fiscal positions of most advanced economies has been spectacular, especially compared to the remarkable fiscal restraint demonstrated by most emerging economies.

In 2009, India was the only large emerging economy among the high-government-deficit countries. But despite its gross government debt to GDP ratio (over 80%) and its deficit (more than 10% of GDP), India enjoys a high growth rate, and most of its public debt is denominated in domestic currency and held domestically. Unlike the advanced economies, India is better positioned to manage its deficit.

In the G-7 economies, the loss of fiscal control will have substantial consequences in the coming years. At over 90% of GDP, the debt ratio will significantly slow economic growth. As the present efforts to contain the debt crisis have been inadequate until recently, the temptation will increase to manage the future debt crises through inflation and sovereign defaults.

Intriguingly, the triple-A sovereign ratings, which were long typical of the leading advanced economies, may be found only in the history books in the future. Conversely, the sovereign debt of some leading emerging market economies could soon be safer than that of any of the G7 nations.

In advanced economies, the global crisis in the private sector has caused a rapid and huge deterioration in public finances. After the crisis, many developed economies will look more impoverished, and many developing economies will look more developed.

The adjustments will be driven by the long-term impact of the crisis, the debt and the “exit strategies,” which will follow the exhaustion of the massive stimulus packages.

In the emerging new order, exceptionally high unemployment will no longer be just a lagging indicator, reflecting where the economy has been, but a signal of things to come. Severe pressure on consumption, housing, the social safety net and health services is likely to constrain consumption-driven recovery and growth.

In the postwar era, the world economy was driven by the U.S. consumer — in the coming decades, it will be fueled by the large emerging economies. Due to different levels of economic development, this also means a shift from consumption-driven growth to investment-driven growth.

During the past two years, the great global recession has been more severe than any downturn since the 1930s. However, it is laying the groundwork for a far more colossal transformation — the shift of economic power from the West to the East. Europe’s debt crisis is just one milestone in the long, complex and occasionally perilous road.

In the medium term, a world of subdued growth will be accompanied by a continuing shift of growth drivers away from the leading advanced economies and toward the leading emerging economies, led by China. In the long term, this transition will reduce risk and enhance economic opportunities. In the short term, it will contribute to uncertainty and volatility.

In the late 20th century, the West led and the Rest followed. In the 21st century, it is more likely that the Rest shall lead — and the West will follow.

Takeaways

In the late 20th century, the West led and the Rest followed. In the 21st century, the Rest shall lead and the West will follow.

The growth discrepancy between advanced and emerging economies reflects a structural transformation.

The European debt turmoil heralds the shift of the sources of global growth from the West to the East.

In the coming years, the vicious debt circle of the advanced economies will be difficult to contain and, in the absence of dramatic policy changes, is likely to escalate.

Starting with China's economic reforms in the 1980s, India's in the 1990s, and the eclipse of the Cold War, a large group of developing countries has broken into global markets.