Emerging Vulnerabilities in Emerging Economies

A. Michael Spence

By A. Michael Spence

To be sure, capital markets are not the enemy. But the alignment of interests between external investors and domestic policymakers is imperfect, at best.

By A. Michael Spence

Just before the collapse of the US investment bank Lehman Brothers triggered a financial crisis that would engulf the world economy, the Commission on Growth and Development published an assessment of emerging-economy growth strategies, aimed at drawing lessons from previous research and experience. Over a decade later, many – if not most – of those lessons remain unheeded.

In emerging economies, sustained medium or high GDP growth is the key to advancing development and raising incomes. Of course, crises inevitably produce major setbacks with long recovery periods, drastically reducing growth in income and wealth. But ten years is a long time, and the gap between what experience dictates emerging economies should do and what they have been doing remains large.

While some countries have achieved sustained medium or high growth, they have relied on high levels of public and private investment, financed mainly by domestic savings. By contrast, running persistently large current-account deficits creates vulnerabilities and often leads to disruptions, as external financial conditions change. Borrowing in foreign hard currencies is particularly risky, as depreciation of the local currency can cause liabilities to surge. Emerging economies thus should be working to constrain debt levels, though the extent to which this is needed depends on growth, as strong and resilient increases in GDP reduce leverage ratios.

Read the full article as published in Project Syndicate.

A. Michael Spence is a William R. Berkley Professor in Economics & Business.