The Analysis of Global Economic Structure

The general term of advanced and emerging economies refers mainly to economic stages of development in a country and corresponds to the country’s residents median standard of living, with advanced economies being generally the Western European economies and the USA, the Advanced Capitalist Countries(ACCs) as opposed to the emerging market economies (EMEs) being generally from anywhere else including the BRIC countries of Brazil, Russia, India and China. Over the last two decades, the EMEs have become a dominant presence in the world economy. They now account for a substantial share of world output and, with their rapid growth rates, have become a major driver of global growth during the past decade. Trade and financial linkages between advanced economies and EMEs have also become much stronger, speeding up the process of global integration. The replacement of the US with these EMEs as the drivers of economic growth have prompted questions about the relevance of the conventional wisdom that when the U.S. economy sneezes, the rest of the world catches a cold.

Sustainable is a key parameter especially considering the penchant for debt driven over-leveraged growth in Asia as seen with the Asian Financial Crisis and later in some cases the global financial crisis of 2009. Sustainable growth refers to a model of growth that is not risky or prone to external shocks and is at the same time broad based and long term. An example of this would be the growth model pursued by the Newly Industrialising Countries of Taiwan, South Korea and Singapore. These countries had a 4 step pathway to sustainable economic growth, first creating Import Substitution Industrialization, then moving to Export Oriented Industrialisation(EOI) and then to Deregulation and Diversification. (Kim, Jong-Il & Lau, Lawrence, 1994)

The global financial crisis changed the perception of this model being universally applicable and cast a shadow over the ability of the EMEs to insulate themselves from shocks in advanced countries especially considering the export oriented industrialisation which required a growing consumer base for the products produced in the country as a fall in economic growth would result in a shrinking market for those goods and prevent the infant industries in the EMEs from growing. It is important the infant industries are allowed to grow as that would be crucial for those industries to not just pursue internal economies of scale but also develop technological and marketing skills specific to the industry and gain a brand name as a reputable source of such goods. For example the period in the 1960s to 1980s saw a continuous upward trend in growth among ACCs and this period of growth was essential to the growth of Taiwan in its EOI stage and the development of Taiwan’s brand name as being a reputable source for semiconductors and electronics.

However the global financial crisis in 2009 has forced economists all around the world to consider just how intricately the economies of EMEs and ACCs were intertwined. After all, the problems in the financial systems of advanced countries rapidly spread to a number of EMEs during the last quarter of 2008 and the first half of 2009, disrupted their asset markets and stunted short-term growth prospects. While these countries did not experience the banking crisis that the ACCs experienced it must be noted that many countries saw their exports drop by 50 or more percent and this situation caused many countries including the Asian NICs to have negative growth rates in 2009 and 2010. Moreover, as the global financial crisis has vividly shown once again, financial and goods markets around the world are closely tied together and shocks in one part of the global financial system can and often do have large and immediate effects on other parts. Moreover, the crisis has been a bitter reminder that, for all their benefits, deeper trade and financial linkages can serve as a mechanism for magnifying shocks and intensifying their effects on the real side of the economy. Raising the question of whether EMEs should in fact pursue such trade linkages with the ACCs. However we must thus understand that in this current globalised goods and financial market it is essential that the ACCs perform well and not have a global crisis as in 2009 which would affect the EMEs considerably as well.

As a significant fraction of EMEs followed the advanced countries into recession, the crisis called into question the notion of greater resilience of EMEs to advanced country shocks. This was not altogether a surprising outcome as past episodes of boom and bust business cycles, as in the 1997 Financial crisis, the 2001 dot-com bubble, suggest that deep and highly synchronized recessions in advanced countries tend to have much larger spillovers to the EMEs. It must however also be noted that remarkably, however, a number of EMEs including Singapore bounced back briskly from the global recession since mid-2009 and, as a group, the EMEs have weathered the crisis much better than the advanced economies registering high single digit and in some cases double digit growth rates in 2010 and 2011. As such, there is of course significant variation in the degree of resilience displayed by different groups of emerging markets. For instance, Asian emerging markets, especially China and India, have done far better than the economies of Emerging Europe.

Nevertheless, the core fundamentals of the EMEs suggest that most of these countries have the potential to generate sustained high growth over the longer term, and it is likely that the shift in the locus of global growth from the advanced economies to the EMEs will continue. Moreover it must be noted that in the current situation the salaries and personal incomes of Asian families while rising quickly are still depressed generally and unable to support a significant part of the market production and thus domestic demand is not enough to sustain economic growth or production in most EME. On the other hand however in the near to mid future, as we see signs of the burgeoning middle and upper middle class in China and India these markets will be a huge market for goods and firms in these countries would be able to shift from simply EOI to also being able to rely on domestic demand for goods as affluence increases in these countries.

In light of these developments, there is need for a deeper analysis of the implications of shifts in the global economic structure. Does economic theory provide clear guidance about the effect of ACC growth on EMEs? In fact, different classes of theoretical models have highlighted two opposing effects of rising trade integration which we have seen in the last few decades. Rising trade interdependence should result in derived demand for other products within the same zone increasing the interconnectedness of the group. For example when trade zones are liberalized companies and MNEs can detach parts of their enterprises and situate them in areas with a particular comparative advantage. This would mean that the entire region now will suffer if that one MNE suffers as many businesses would rely on such MNEs to purchase their products and this would mean that the business cycle crests and troughs should be more synchronized. On the other hand, if rising trade linkages lead to greater specialization of production, then the output of a country may not be as reliant on one company as on an entire industry and thus the comparative advantage may allow the countries to decouple their production from one company and diversifying their demand. (Copeland,2012)

Similarly economists theorize on contrasting effects of financial integration on a group like the EU free trade area or any international community. On one hand if the financial system in one area is hit the exposure other areas might have to it like in the EU community between the BNP Paribas and Deutsche Bank and other European banks, it could magnify the dampening of potential cross border economic growth and a restriction of lending as bad debt could potentially create a margin call spiral for these banks leading to a full blown financial crisis. On the other hand though, this effect could potentially be offset by greater industrial specialization, wherein if countries can use financial markets and monetary and fiscal policy to smooth consumption through interest rate cuts to keep firms able to pay back their loans allowing them to concentrate on their comparative advantage and help those industries. In short, the overall net effect of interconnectedness in between EMEs and ACCs as well as within these communities is indeterminate.

However what could help us better understand this is that the level of development also plays a role in determining the nature of the relationship between these groups. For example trade and financial integration could help low-income underdeveloped economies diversify their production base as financial and goods market integration gives them access to foreign finance for investment projects as well as access to larger foreign markets. This of course would allow the low-income underdeveloped economies to reap substantial economies of scale supplying to these richer ACCs and the greater affluence in these countries would also perhaps allow the EME companies to charge higher prices increasing revenue and profit margins. This however is predicated on domestic demand in those ACCs and a fall in the RNY of those countries could in fact lead to a fall in the production of these EME firms. Similarly the opening of financial markets would be a key movement as, previously stated this would allow short term capital flows and investments, FDI to pour into the country and improve the SOL in the country. China is not really applicable for this considering the far more state owned nature of enterprises there we should look at India. India opened up its financial markets and firms to overseas investors in the late 1990s. The result has been that India has become the number 1 destination for US FDI and has created more than 10 million jobs.

However we must also consider that during the dot com bubble and the financial crisis of 2009 the Indian economy was far more hurt than the Chinese or other state owned or supported enterprise dominant markets like South Korea. Thus a reliance on foreign direct investment while leading to accelerated rates of growth in the short term leads to a long term dependence on continuous access to foreign markets and FDI making the outcomes of growth in ACCs more important in those EMEs. For, a sudden drop in FDI due to dampening growth in ACCs could result in firms turning to debt to replace that source of capital thereby increasing leveraging and making growth unsustainable in the long term. While debt is not by itself unsustainable as most corporations, do in fact have some level of debt. However the gearing ratio of debt to equity must be kept in mind as a higher level of debt would mean that debt repayments could increase current liabilities decreasing the potential investment into production decreasing the performance of the firm in the long runocks and the form of specialization patterns.

International trade linkages are generally however agreed to generate both demand and supply-side spillovers across countries, which can increase the degree of business cycle synchronization. For example, on the demand side, an investment or consumption boom in one country can generate increased demand for imports, boosting economies abroad. On the supply side, a positive shock to output in tradable goods, like technological improvement leads to lower prices; hence, imported inputs for other countries become cheaper.However, both classical and “new” trade theories of an international nature imply that increased trade linkages lead to increased specialization. How does increased specialization affect the degree of synchronization? According to economists Stephane Dees and Zorrel Nico the answer depends on the nature of specialization (intra- vs. inter-industry) and the types of shocks (common vs. country-specific).

If stronger trade linkages are associated with increased inter-industry specialization across countries, then the impact of increased trade depends on the nature of shocks. If industry-specific shocks are more important in driving business cycles, then international business cycle comovement is expected to decrease. If common shocks, which might be associated with changes in demand and/or supply conditions, are more dominant than industry-specific shocks, then this would lead to a higher degree of business cycle comovement (see Frankel and Rose, 1998). The effects of financial integration on cross-country correlations of output growth are also ambiguous in theory. Classen and Forbes state that “financial integration could reduce cross-country output correlations by stimulating specialization of production through the reallocation of capital in a manner consistent with countries’ comparative advantage.” (see Claessens and Forbes, 2001)

Furthermore, contagion effects such as in the 1997 Financial Crisis and the 2009 financial crisis that are transmitted through financial linkages could also result in heightened cross-country spillovers of macroeconomic fluctuations. In 1997 the failure of the Thai Baht to appreciate their currency against the dollar in a measured manner caused capital flight from all ASEAN and Asian countries. This capital flight for example resulted in the depreciation of the Indonesian Rupiah to 14000 Rupiah to USD a level that it had never before or since till recently hit. This was similar to the impact on many other countries and the contagion effect even hit Singapore which went into a 2 quarter recession despite having much much better fundamentals.