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It's the same old story behind today's emerging-market meltdown


Investors play cards in front of an electronic board showing stock information in Beijing

Investors play cards in front of an electronic board showing stock information in Beijing

Investors play cards in front of an electronic board showing stock information in Beijing

If you invest, you may have noticed that emerging-market stocks have done badly of late. The MSCI Emerging Markets Index, which did so well in the early 2000s, has been almost unchanged since the global financial crisis. Since this spring, though, the index has tanked.

Underperformance for emerging-market shares has been accompanied by discouraging economic data. Brazil's economy has been shrinking in the past year. So has Russia's. Economies such as those of Indonesia and Turkey have slowed. And China, the granddaddy of all emerging markets, is entering a sharp slowdown after the deflating of its housing and stock-market bubbles.

This is a dramatic reversal from the 2000s. In that decade, emerging markets grew so much that the entire global income distribution became much more equal. It seemed as if, after decades of disappointment, the world was finally starting to experience the global convergence that economists had long predicted.

Media sentiment now is as pessimistic as it was optimistic then. Bill Emmott, former editor of the Economist, recently proclaimed that dysfunctional politics had crippled the emerging market growth story:

"The main determinants of an emerging-economy's ability actually to emerge, sustainably, are politics, policy and the institutions of governance...

"Although countries can ride waves of growth and exploit commodity cycles despite having dysfunctional political institutions, the real test comes when times turn less favorable...

"Unless emerging economies can ensure that they remain flexible and adaptable, they will not continue to 'emerge'. It's the politics, stupid."

This story sounds intuitively appealing -- after all, basically everyone does believe that in the long run, institutions determine the limits of catch-up growth. So when we see emerging markets slowing, the natural urge is to shrug and say that these countries are just too dysfunctional.

The problem is, that story doesn't really hold up. The timing is too suspicious.

Emerging-market stocks flatlined right after the global financial crisis and Great Recession of 2008-9. What are the chances that this was due to a whole bunch of countries, at very different income levels, suddenly hitting the limits of their institutions all at the same time? Essentially nil.

The same is true of the more recent growth slowdown among emerging markets, and the precipitous drop in emerging-market stocks since this spring. The culprit is obvious:

China. China's stupendous industrialisation in the 2000s - probably the most rapid the world has ever seen - raised global commodity prices, funneling cash into the economies of resource exporters such as Brazil, Russia, Indonesia, Africa and the Middle East.

Now that that industrialisation has hit a roadblock, commodity prices have been falling, straining the economies of the resource exporters.

Almost everywhere throughout the developing world, the story is the same: China, China, China. The BRIC investment thesis may have stood for Brazil, Russia, India and China, but it was always mostly about the 'C'.

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In recent years, China has been responsible for more than a quarter of global growth (which includes developed and emerging markets). That is quite a powerful growth driver.

Much of the hand-wringing about emerging-market governance is therefore misplaced. Of course, it's always good to take advantage of periods of crisis to prod governments to reform their institutions for the better - as Winston Churchill said, we should "never let a good crisis go to waste." But structural reforms are slow in coming even in the best of cases, and they always take years to work. Governance reform won't fend off the China-driven slump.

In the long run, the emerging-market growth story seems strong. Now that Chinese costs are rising and growth is slowing, it opens up opportunities for other developing countries to experience their own growth spurts.

This is the prediction of one of my favorite economic ideas, the new economic geography theory of Paul Krugman and Masahisa Fujita. In this model, global growth proceeds in fits and starts. Industrialisation spreads from country to country like a glorious epidemic, and each new growth star gets rich faster than the ones before.

If you look closely, I think you can see this pattern playing out in the world around us. In the 1980s, it was Japan and Europe driving global expansion. In the 1990s, it was the Asian 'tiger' economies and China. In the 2000s, it was China, with India starting to make a contribution.

Who will pick up the mantle of industrialisation? My money is on India. Blessed with a large domestic market and vast human capital, it has weathered the China slowdown better than other emerging economies. If India begins to take off just as China settles to earth, it will become the driver of a new boom among developing nations in the next two decades.

So don't despair about the emerging-market growth story. These things come in waves.


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