POVERTY THE WORLD BANK REDUCTION AND ECONOMIC MANAGEMENT NETWORK (PREM) Economic Premise SEPTEMBER 2010 · Number 33 JUNE 2010 · Number 18 56829 Toward a Switchover of Locomotives in the Global Economy Trade and the Competitiveness Agenda Otaviano Canuto José Guilherme Reis and Thomas Farole The recovery in advanced economies is now exhibiting several signs of fragility and the medium-term growth prospects for The economies also look difficult. Could major rethinking of the respective become locomotives in the markets in the these global economic crisis has forced adeveloping economies "switch over" toroles of governments and global economy, processes of trade and growth. Indeed, industrial policy The view taken here fashion--or, at least, talking domestic providing a countervailing force against downward trends? seems to be back in says, yes, as long as appropriateabout it is. But a renewed "activism" by government in countries. and growth agenda need not mean a return to old-style policies and reforms are pursued in developing the trade policies of import substitution and "picking winners." Instead, it may mean a stronger focus on competitiveness by unlocking the constraints to private sector­led growth. This note discusses the renewed role of government in trade and growth policy from the competitiveness angle, and it suggests some priorities for the new competitiveness agenda. Developing countries as a whole have been growing faster than rience a renewed downward "recoupling" as a result of a low- advanced economies, even before the start of the current global growth scenario in advanced economies? Or, on the contrary, economic crisis. In 2007 and the first three quarters of 2008, could developing countries "switch over" to become locomo- as the signs of increasing financial fragility and economic stag- tives in the global economy, providing a countervailing force Export-Led Growth, economies were becoming clear, nation in the major advancedthe Crisis, and the End against a slowing-down policy pacts of the crisis on thetrain? environment regarding trade of an Era much was said about a possible "decoupling" of emerging mar- In the were becoming more apparent. Indeed, in addi- and growthview presented in this note, there is indeed a scope for kets. This was just as promptly followed by talks of a downward a to raising where developing global commitment to on a tion switchoverconcerns over the countries as a whole taketrade The dramatic expansion in emerging markets recent decades "reverse coupling," when theseglobal trade over and other de- greater role the crisis has also led to some serious rethink- liberalization,as a global locomotive and move global growth for- has contributed significantly to diversification, growth, veloping economies were also impacted by the near collapse ofand ward, offsetting those forces moving toward negative recou- ing of some of the conventional wisdoma regarding the poverty reduction in many developing last quarter of 2008 finance and international trade during the countries. This period pling, which are derived important result in the advanced growth agenda--the mostfrom less buoyancy of which is the of in early 2009. andrapid export growth has been enabled by two critical countries. Nevertheless, a comprehensive homework activist likelihood that governments will play a much morein terms structural changes in globalgroup have the vertical and spatial Developing countries as a trade: (1) also been recovering of domestic policies and reforms will be principal reasons role in the coming years. There are threefundamental to ac- complishing that are likely why governments mission. to be more actively involved in 1 fragmentation of economies, while also highly integrated faster than advanced manufacturing into maintaining the "global production networks," and prior to the of services positive growth premium that emerged(2) the rise global fi- industrial and trade policy in the coming years. on the Legacy of the Global Financial Crisis nancial crisis (figure 1). Indeed, growth in developing countries trade and the growth of "offshoring." Both of these, in turn, First, the T Growth crisis has undone faith in markets and discred- rends of Advanced Economies were made possible by Bank technological revolutions; is projected by the Worldmajor to reach 6.0 percent in 2010and ited laissez-faire approaches that rely simply on trade policy and 5.9 percent in 2011, while corresponding figures are 2.2 they were supported by multilateral trade policy reforms High-income countries are facing and local markets the liberalization. Instead, governmentsstrong headwinds inhave percent andliberalizations in domestic trade and investment and broad 2.4 percent for high-income countries. Almost wake of the global In this sense, the demand for activist been "rediscovered."financial crisis. It is still an open bet as to half of global gross domestic product (GDP) growth is current- environments worldwide. whether the likely to go well beyond financial in private ab- government is promptness and strength of recovery markets and ly coming from economic crisis came crashing into the middle The global developing countries. sorption (consumption and investment) will be sufficient to regulation, and it will affect the policy environment in which The current recovery in advanced economies is now exhib- of this long-running export-led growth party during 2008 render industrial the current life support provided by aggres- trade andunnecessarystrategies are designed. iting 2009. Between fragility and the medium-termthe second and several signs of the last quarter of 2007 and growth Second, the and fiscal highlighted the critical importance sive monetarycrisis has policies, before their unwinding of this prospectsof 2009, global trade contracted by 36 percent. But quarter for these economies also looks difficult. In this envi- support becomes inevitable. products, and trading partners) of diversification (of sectors, If postwar recessions in Organisa- ronment, two questions arise:strengthen in 2010 (at least until as the recovery started to Will developing economies expe- tion of Economic Co-operation and Development (OECD) in reducing the risks of growth volatility. The recent era of the clouds began to form over Europe), the longer-term im- globalization contributed to substantial specialization of 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise 1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 1. World Output Growth, 1961­2012 10 ad vance d countries 8 develo ping coun tries percentage of change 6 4 2 0 -2 1961 1964 1967 1970 1973 1976 1985 1979 1982 1997 1991 1994 1997 2009 2012 2000 2003 2006 -4 -6 Source:World Bank WDI and DEC Interim Forecasts April 2010. countries serve as a template, the switchover from public to pri- growth in the medium term. First, at some point, fiscal consoli- vate sectors will not be automatic, because recessions associated dation will become a major issue among advanced economies with credit crunches, house price busts, or equity price busts once--or even before--recovery is fully established. Many ad- tend to be both deeper and longer than typical recessions. In vanced economies entered the crisis with weak structural fiscal fact, very few OECD recessions in the postwar period--4 out of positions, and these have been eroded further, not only by anti- 122--have occurred with a credit crunch, a housing bust, and crisis measures, but also by underlying spending pressures. an equity bust: the present crisis combines all three, and in a Structural primary deficits in advanced countries are expected severe form (Claessens, Kose, and Terrones 2008). to have worsened by 4 percentage points of GDP between 2007 Several factors point to a reduction of actual and potential and 2010. Even with the reversal of temporary anticrisis measures, public debt in advanced G-202 economies is expected to reach Figure 2. General Government Gross Debt Ratios 118 percent of GDP by 2014 (figure 2). According to the International Monetary Fund (IMF), "simply 120 letting the stimulus expire would still leave the gov- G-20 advanced ernment debt of many advanced countries on an ex- plosive path" (IMF 2009). Stabilizing debt at postcri- 100 all advanced sis levels will also not be enough because it will reduce the ability of fiscal policy to deal with future 80 low income shocks and will push postcrisis real interest rates percent of GDP much higher. 60 On average, according to the IMF, bringing gov- G-20 emerging ernment debt-to-GDP ratios in advanced economies 40 to a prudent level below 60 percent by 2030 would emerging require steadily raising the structural primary bal- (borad sample) ance from a deficit of 3.5 percent of GDP in 2010 to 20 a surplus of 4.5 percent of GDP in 2020--an 8 per- centage point swing in one decade--and keeping it at 0 that level for the following decade. 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2000 Thus, even considering that different features of national fiscal packages will have corresponding dif- Source: IMF staff estimates based on IMF (2010). ferent consequences in terms of long-term growth 2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise drivers, some future fiscal contraction negatively affecting the Fourth, all financial sector reregulation proposals under dis- private sector will be the price paid for the role of fiscal stimu- cussion point to higher costs of financial intermediation. After lus in rescuing advanced economies from the brink of the all, the general purpose is to curb the unbridled "endogenous abyss during the crisis. And even if monetary policy maintains liquidity factories" and the excessive leverage that led to wide- its current accommodative stances for some time and manages spread asset bubbles in the run up to the economic crisis. to sustain basic short-term interest rates at low levels, the yield Recoupling or Switchover curve on public debt may still steepen. Secondly, the deleveraging and adjustment of U.S. house- The recent improved growth performance in developing holds' balance sheets are far from complete. Consumption countries is not just a reflection of strong performance by the spending growth is likely to remain weak and/or wobbly in the two largest developing countries, China and India. Figure 4 absence of large, renewed hikes in asset prices. In the past, shows the frequency distributions of individual country strong U.S. consumer spending was buttressed by rising hous- growth rates in 2009, the expected trough of the crisis. Medi- ing prices, allowing rising household debt and reduced per- an growth in developing countries was substantially higher sonal savings (figure 3). Lower savings were reflected in a rising (2.13 percent) than in advanced economies (-3.72 percent). U.S. current account deficit, a major source of U.S. domestic And a much larger proportion of developing countries have demand and of export demand for the rest of the world. Now, continued to enjoy positive growth than among advanced or as housing and other household assets prices have fallen sub- high-income countries. stantially, deeply indebted households are unlikely to under- Most of the developing countries situated at the right side take a new spending spree any time soon. Rebuilding house- tail of their distribution benefited from better macroeconom- hold balance sheets will be a lengthy process. ic, structural, and other policies adopted over the last couple of A third aspect to weigh against a return to a high-growth path is the likely jobless nature of the current recovery in many decades. They had the capacity to resort to fiscal, monetary high-income countries. Slow-to-reverse shocks--a financial cri- and financial countercyclical policies, as well as the ability to sis combined with a housing price bust and cross-sector differ- use foreign exchange reserves and exchange rate fluctuations as entiated job creation/destruction--have been in play and con- elements of their responses to the shock. On the left side of the tinued macroeconomic uncertainty is countering employment distribution are countries that had combined financing via growth (IMF 2010, ch.3). The share of temporary workers has "bubbles" in high-risk lending in advanced economies with been on the rise in most advanced economies for years, reflect- shaky domestic growth foundations--as in several Eastern Eu- ing institutional changes in labor markets. But recent crisis-re- ropean and Central Asian countries. There are also some cases lated increases in temporary employment will tend to have a in which trade and financial integration led to severe impacts-- limited effect in enhancing expenditures, while uncertainty such as in Mexico and some Central American and Caribbean regarding macroeconomic and sectoral prospects remains high. countries. In any case, the performance of developing coun- tries overall has been high, before and during the crisis, mostly reflect- Figure 3. United States: Personal Savings Rate and Current Account Balance, 1960­2009 ing an improvement in the quality of the economic policies in the previous 12.5 decade or so. As one can see in figure 1, there 10.0 has long been a close correlation be- 7.5 tween economic cycles in advanced and developing economies. But look- 5.0 ing only at global aggregates may ob- percent of GDP scure an emerging story about trend 2.5 decoupling between advanced and 0.0 developing countries. Since the early 2000s, the cyclical synchrony has -2.5 been combined with systematically 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 2005 2008 higher growth rates in developing -5.0 relative to advanced economies. personal saving rate While before the early 2000s the -7.5 current account balance trend growth in developing countries was close to that in advanced coun- Source: U.S. Bureau of Economic Analysis. tries, since then it has become sub- 3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise Figure 4. Frequency Distribution of GDP Growth in 2009: Developed and Developing Countries negative recoupling, but there can also be a switchover, where develop- 35 ing countries become the global high-income OECD (25) median growth: -3.72% growth locomotives and partially 30 rescue advanced economies. 25 developing countries (122) Developing economies as a whole median growth: +2.13% do not yet have a size big enough to 20 rescue the entire world economy from percent 15 the scenario of low growth in ad- vanced economies. In terms of levels, 10 the size of G-73 economies at market 5 prices is still 60 percent of world GDP, and the major potential new poles of 0 < -6 -6 to -4 -4 to -2 -2 to 0 0 to 2 2 to 4 4 to 6 >6 growth (China, India, and Brazil) -5 GDP growth in 2009 (%) might account for up to 30 percent. As time passes by, however, the ab- Source: World Bank. solute size of the two groups of coun- tries is poised to reverse positions be- cause the growth premium exhibited by developing countries stantially higher: a cyclical coupling has arguably continued as since 2000 is expected to remain (figure 1). Recent IMF fore- in the past, along with some trend decoupling in underlying casts for global GDP with purchasing power parity (PPP)­ad- rates of growth. justed exchange rates indicate developing countries as a group as Three questions then arise: bypassing advanced economies before 2015. Although develop- 1. How sustainable is the trend decoupling exhibited by de- veloping countries in figure 1? 2. How high can actual and potential growth rates of develop- Figure 5. Growth Interdependence ing countries remain as advanced economies continue to face recovery challenges? DC1 3. To what extent can a high-growth performance by develop- DC0 ing countries provide a positive feedback loop for advanced AC0 economies, helping to avoid a situation where even though AC1 developing countries continue to grow faster than ad- vanced economies, both grow at relatively low rates? Figure 5 provides a simplified illustration on the growth C interdependence between the two groups of economies. Channels for growth interdependence may be interpreted as A trade and corresponding investment prospects, as well as fac- tor incomes abroad (return on foreign assets, remittances). The steepness of the lines for advanced countries (AC) re- flects the up until now smaller weight of developing coun- B tries (DC) for their performance, whereas the greater sensi- tivity of DC to variations in AC growth rates is expressed in the slopes of its corresponding lines. The legacy of the crisis on AC is shown by the shift from AC0 to AC1. The adverse impact of slower advanced country growth on developing countries--which we call the negative recoupling of develop- ing countries--is reflected in a global move from point A to A B reverse coupling point B. However, if new autonomous sources of trend B C locomotive switchover growth in DC--growth that does not depend directly on growth in advanced economies--can be tapped and DC0 Advanced countries (growth rates) shifts to DC1, then the global economy can settle at point C. Here, not only can developing countries escape from the Source: Author's illustration. 4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise ing Asia has the lead in that dynamic, rising shares in global and communication technologies (Canuto, Dutz, and Reis GDP are also a feature of other regions. Therefore, if new, au- 2010). tonomous sources of trend growth in developing economies can But again, policy challenges will have to be faced. Comple- be tapped, then not only can developing countries escape from mentary factors such as reliable infrastructure, access to fi- a negative recoupling, but there can also be a switchover, where nance, and an educated labor force are inadequate and must be developing countries become the global growth locomotives gradually improved. Furthermore, institutional factors that and partially rescue advanced economies, thereby helping lift all negatively affect the investment climate tend to harm invest- economies. ments in technology and must be addressed. The good news is that some possible sources of autonomous Thirdly, provided that domestic absorption--public and pri- growth in developing countries can be found. However, tap- vate consumption and investment--in developing countries as a ping into those sources will depend on the ability of developing whole rises relative to its own production potential, and South- countries to implement appropriate policies: let us see why. South trade openness is reinforced, there might be a new round of successful experiences of structural change and export-led Autonomous Sources of Potential Growth in growth. After World War II, Europe and Japan sustained a long Developing Countries and Their Challenges growth cycle through a process of technological and mass con- First, the fast recovery in many emerging markets has reflected sumption catch-up with the United States. Whereas from the the good shape and sustainability of their national balance 1990s onward, many developing economies achieved high sheets--as illustrated for the public sector in figure 2. Looking growth facilitated through innovation in information and com- forward, there is in principle a wide range of greenfield invest- munication technologies and globalization, but left an impor- ment opportunities in developing economies that may benefit tant role to developed countries for absorption of their output. from higher financial leverage by both public and private sec- The time may now have come for better matching of increases tors. Take the obvious example of infrastructure: given its rela- in production and consumption within developing countries tive scarcity, social marginal returns as measured in terms of as a group, with South-South trade allowing small developing total factor productivity tend to be high in projects that address countries to also benefit (Canuto, Haddad, and Hansen 2010). the many existing bottlenecks. If projects are well designed, the The extraordinary growth performance of some Asian econ- partial monetary capture of those returns by either public or omies and China in particular--like the previous long periods private sector entities may well constitute feasible vehicles for of growth in Latin America--cannot be fully understood with- asset creation and finance. out taking into account that to a large extent they experienced Nonetheless, public sector management capacities and ap- a peculiar process of structural change (at least at the start of propriate governance mechanisms must be in place to guaran- the growth period): the dislocation of large contingents of low- tee the use of adequate criteria in project choices and designs, as skilled workers from stagnant and low-productivity activities-- well as to avoid misappropriation of returns. Furthermore, eu- such as subsistence production in many rural areas--to other phoria with recent macroeconomic successes must not lead to activities whose value at world prices is significantly higher and a careless walk on the slippery slope of increasing leverage. The where there also exists a wide scope for productivity increases, current surge in private capital flows to emerging markets with a move generally accomplished without the need for major in- a profile potentially conducive to fostering asset market bub- creases in worker skills. bles, rather than to building greenfield assets, is a potential pit- Rising international trade and the technological changes fall and must be countered with careful financial monitoring have made such structural change easier. Among technology and regulation. trends, the standardization, modularization, and codification A second potential source of autonomous growth comes of technologies, especially in the electronics and auto industries from technology. Developing countries face a technological and in some services, have made it easier to deverticalize and off convergence gap relative to the frontier level of knowledge in shore production (Yusuf 2009; Ghani and Kharas 2010). With advanced economies in the majority of economic activities. Un- fragmentation of production and trade in tasks, as well as de- exploited latecomer advantages are a venue for local productiv- creasing costs of transport and communication, the barriers to ity improvements, through technology transfer and adaptation, structural change have become relatively easier to surmount. that remains open, even if the advance of technology slows Local market size has become less of a constraint on scale and down in high-income countries. Global changes in recent years scope, while learning spillovers and coordination needs may be have been making technological transfer easier than before, found through integration in cross-border networks of produc- such as through: increased international trade in goods and ser- tion. Local institutional requirements remain, however. vices; foreign direct investment; intellectual property and tech- To take additional steps up the ladder of technological so- nology licensing flows; increases in data storage and transmis- phistication, moving beyond early, easy production of tradable sion capabilities; and falls in costs and uptake of information goods and services, the economy has to increasingly develop 5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise some capabilities that transcend particular existing lines of pro- to slower growth in advanced countries. Successfully navigating duction at a given moment in time: this requires the ability to the switchover will depend upon the domestic policies and re- learn, master, and adapt technologies in a creative way; to man- forms pursued in the developing countries. age complex processes of design, production, and marketing; About the Author and more. Again, recent trade and technology trends have been favorable to latecomers from a cost-competitiveness standpoint, Otaviano Canuto is vice president and head of the Poverty Reduc- as long as the abovementioned domestic complementary factors tion and Economic Management Network at the World Bank. This necessary for creative technology absorption are in place. note is based on chapter 1 of The Day After Tomorrow: A Hand- In developing countries, programs investing in infrastruc- book on the Future of Economic Policies in the Developing ture, human capital, poverty reduction, and social inclusion World. To read the entire book, please visit: http://go.worldbank.org/ would stimulate local consumption and investment, producing TPPWANWXR0. positive feedback loops. A higher role for effective networks of social protection and for active poverty reduction policies in Notes developing countries may therefore become a component of 1. A broad landscape of those policies and reforms can be found in Canuto sustainable global growth. and Giugale (2010). 2. Group of 20 (G-20): Argentina, Australia, Brazil, Canada, China, the Finally, natural-resource intensive developing countries may European Union, France, Germany, India, Indonesia, Italy, Japan, Mexico, the benefit from the fact that the relative demand for commodities Russian Federation, Saudi Arabia, South Africa, the Republic of Korea, Turkey, tends to remain strong in the medium term, to the extent that the United Kingdom, and the United States. world growth after the crisis will be more dependent on devel- 3. Group of 7 (G-7) countries: Canada, France, Germany, Italy, Japan, the oping countries as a group and demand in these countries is United Kingdom, and the United States. more commodity intensive than elsewhere (Brahmbhatt and References Canuto 2010). Once again, quality of policies in developing countries will determine whether that may become either a Brahmbhatt, M., and O. Canuto. 2010. "Natural Resources and Development Strategy after the Crisis." Economic Premise 1, February (www.world- blessing or a curse: there is much that countries can do to ensure bank.org/economicpremise). that natural resources provide a foundation for a broadly based Brahmbhatt, M., O. Canuto, and E. Vostroknutova. 2010. "Dealing with and increasingly diversified economic growth strategy. As long Dutch Disease." Economic Premise 16, May (www.worldbank.org/eco- as appropriate governance and revenue administration mecha- nomicpremise). nisms are put in place, particularly to avoid rent-seeking behav- Canuto, O., M. Dutz, and J. G. Reis. 2010. "Technological Learning and Inno- vation: Climbing a Tall Ladder." Economic Premise 21, July (www.world- ior, natural resources should be a blessing for those countries. bank.org/economicpremise). The role of reforms to strengthen budget processes and in- Canuto, O., and M. Giugale. 2010. The Day After Tomorrow: A Handbook on the stitutions, good cost-benefit analysis, public sector manage- Future of Economic Policies in the Developing World. Washington, DC: World ment, and evaluation are all crucial. Careful fiscal policy man- Bank. agement (for example, by saving an adequate portion of Canuto, O., M. Haddad, and G. Hansen. 2010. "Export-Led Growth v2.0." resource revenues through a natural resource or wealth fund) Economic Premise 3, March (www.worldbank.org/economicpremise). Claessens, S., M. A. Kose, and M. Terrones. 2008. "What Happens during Re- can help address problems caused by real exchange rate appre- cessions, Crunches, and Busts?" IMF Working Paper 08/274, December. ciation (Dutch disease, see Brahmbhatt, Canuto, and Ghani, E., and H. Kharas. 2010. "The Service Revolution." Economic Premise Vostroknutova [2010]) and commodity revenue volatility. 14, May (www.worldbank.org/economicpremise). IMF (International Monetary Fund). 2009. World Economic Outlook: Sustain- Conclusion ing the Recovery. Washington, DC: IMF. ------. 2010. World Economic Outlook 2010: Rebalancing Growth. Washington, The view taken here says, yes, there is a way for a switchover to DC: IMF. occur, where developing economies as a whole can take on a Yusuf, S. 2010. "The Past and Future of Export-Led Growth." Growth and Cri- greater role as a global locomotive and move global growth for- sis Blog, World Bank Institute (http://blogs.worldbank.org/growth/), Feb- ward, offsetting the forces moving toward a negative recoupling ruary 24. The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduc- tion and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise. 6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK www.worldbank.org/economicpremise