There is something amiss with a forest in which every tree grows to the sky. Yet few of us stopped to question the magical boom that hit virtually every country in the world, beginning in 2003. There was some skepticism about the housing-led growth spurt in the United States, but now it is increasingly apparent that the simultaneous acceleration from Brazil to India and even China was also rooted in a global credit bubble.
This is a particularly painful realization for the developing world, which came to believe that the
boom was testament to the power of globalization, increased urbanization and better macroeconomic policy management. While there is more than an element of truth in those arguments, it's hard to escape the conclusion that the growth leap was mainly due to easy access to cheap money.
The trend growth of developing economies showed a marked increase beginning in 2003, with the average rate doubling to 7.3 percent from 3.6 percent between 1980 and 2002. It was no coincidence that this levitation act got underway just when the U.S. housing sector started to boom. Following the tech bust in the preceding years, the U.S. Federal Reserve cut interest rates aggressively to engineer a new growth cycle.
But the Fed was not just setting U.S. interest rates—it was also determining the global price of money. Capital gushed into many developing countries, and the cost of capital went down universally. In a world of global capital flows it's difficult to run an independent monetary policy. Net capital flows to emerging markets rose to 7 percent of emerging markets' GDP during the 2003–07 period, up from an average of 4 percent from 1980 to 2002. As a result, equity and debt liabilities to foreign investors rose to more than $5 trillion by 2007, or 40 percent of the developing world's GDP, compared with 22 percent in 2002.
Given the easy availability of credit, companies in the developing world sought to fund ambitious growth plans with debt and equity capital from Western financial institutions. Last year was a bumper year, with $435 billion in new overseas syndicated loans, $150 billion in external corporate bonds issuances and $210 billion of foreign IPO money heading to emerging markets. The role of foreign capital flows in boosting economic growth goes beyond the raw numbers. Such flows also helped growth in a qualitative way by increasing domestic confidence regarding future growth prospects, spurring on the entrepreneurial spirit by providing the risk capital for large projects and bolstering exchange rates.
Now Western banks in some regions are drawing down cash balances at their emerging-market subsidiaries, driven by a need to shrink the size of their balance sheets at home. The global liquidity tap has in effect been suddenly turned off, leaving several emerging-market companies high and dry.
The fundamental problem with the growth model of many emerging markets stands exposed. These economies rely too heavily on foreign capital to fund their growth, leaving them vulnerable to global boom-bust cycles. Similar droughts hit developing economies in the late 1980s following the U.S. savings-and-loans banking crisis and then again at the beginning of this decade when the dotcom bubble burst.
The problem is not one of low savings. Savings rates in East Asia were high before the crisis in 1997–98, and many emerging markets even now have a large savings pool. The issue is ineffective credit systems that can't put those savings to good use. The reduced availability of foreign capital in the coming years will hopefully set the stage for a change in the growth model to one that depends more on domestic rather than foreign savings. For now, emerging markets will have to deal with the harsh reality that their blockbuster growth over the past few years was a liquidity mirage.
Average growth of developing countries is likely to revert to the 1980–2002 pace of 3.5 to 4 percent for the foreseeable future. That is not too bad at a time when the United States and much of the developed world, hobbled by the ball and chain of high indebtedness, face an extended period of sub-par growth. This sluggishness in the West should increase the relative appeal of investing in emerging markets, particularly in contrast to the 1980s and '90s, when the U.S. was growing at 3 percent—nearly as fast as the developing world—and looked much less risky.
Emerging markets have then achieved at least some sort of decoupling. Trade links are not as strong with the developed world; developing countries currently trade more among themselves than with the United States. Still, recent events show how crucial foreign capital was in lifting growth in the developing world. The broader implication of the radically changed environment for capital flows, with major Western financial institutions firmly in deleveraging mode, is that the golden era of high economic growth that spanned five years from 2003 to'07 is now over. Growth expectations for emerging markets need to be reset to pre-2003 levels.
Sharma is head of emerging markets at Morgan Stanley Investment Management.