By Jan Dehn
Emerging markets experienced rapid growth over the past 15 years due to the economic and political improvements, which followed the end of the Cold War. But many emerging markets are soon going to face both domestic and external challenges to growth.
First, many are using up their underutilised factors of production, such as labour. Others invest too little to maintain growth rates. A section of emerging markets are approaching the ‘Middle Income Trap’, a tricky stage where the growth requires more total factor productivity growth and less basic factor accumulation. Moreover, more complicated investments, such as machinery and engineering are required as economies gain sophistication, and technical progress becomes the key driver of growth. Capital intensity – human and physical – inevitably increases.
Growth rates also come under pressure as the HIDCs (heavily indebted developed countries) are likely to begin to inflate and devalue their way to smaller debt burdens. This erodes the real value of emerging market reserves, strengthens their currencies, and slows their growth rates.
Emerging markets will first and foremost have to become more flexible, resources to move more quickly from less to more productive uses. Many emerging markets are already reforming, because they know a loss of growth momentum is swiftly called to account by populations hungry for progress. Global capital flows will disproportionately favour those that make the right policy choices.
Emerging markets will also have to become more productive, especially in the private sector. Greater productivity makes it possible to raise domestic demand without encountering capacity constraints as exports recede as a growth driver. Productivity is best increased by developing the domestic corporate bond markets, which can channel long-term financing to the private sector, both to finance businesses growth and employment and private infrastructure investment. Governments need to complement such investment with better public infrastructure provision and education.
The challenge facing emerging markets is not a lack of investment opportunities. The real challenge is to identify sufficient financing, particularly for less liquid, larger-ticket, longer-term investments. Emerging markets infrastructure investment needs are at least 10% of GDP, which is well beyond what governments can finance and execute. Large global pools of capital will have to be tapped, so emerging markets must attract – not block – inflows of capital from global capital markets. Global capital must overcome outdated misgivings about emerging markets and fight to overturn domestic regulatory impediments. In this regard, the UK’s push within the G8 to ease the regulations for HIDC pension funds to investment in emerging market infrastructure is welcome news. Other foreign financing targets include sovereign wealth funds, the recently established BRICS bank, and emerging markets pension funds all of which require long duration, yielding assets.
Finally, there is need for emerging market leadership. Short-term political motivations result in poor performance. Overregulating governments kill projects altogether. Weak governments give in to vested interests and corruption. What is needed is strong enlightened government, meaning governments that: (a) know they are not good at picking, managing, or financing projects; (b) understand inflow are a blessing; and (c) use their powers to let capital find its most efficient use within the economy. Sound, objective standards within a clear stable regulatory framework is essential. Then get out of the way so the private sector can get on with the work at hand.
Jan Dehn is head of research at Ashmore Investment Management
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