Globalization & Monetary Policy Institute
International Economic Update
Emerging Economies Suffer From a Rebalancing of Global Growth
September 20, 2013 · Update in PDF
Global growth dynamics have begun to change. The emerging economies, once leaders of global activity, have started to decelerate; meanwhile, prospects for expansion in advanced economies have been revised upward (Chart 1). Improved growth in advanced economies and a slowdown in emerging economies have caused global investment patterns to shift. Capital flows from advanced to emerging economies have reversed course, leaving emerging economies with large current account deficits particularly vulnerable.
Emerging Economies Attracting Less Investment Capital
In the aftermath of the global recession, international investment in emerging economies increased as these economies’ fast-paced growth attracted investors seeking higher returns. The influx of capital created upward pressure on the emerging economies’ currency. This is an unwanted side effect for economies with an export-oriented growth strategy, since currency appreciation increases the cost of exports and decreases export demand. Now these economies have begun to decelerate, causing capital inflows to recede.
India has been one of the hardest hit by the sudden reversal of investor sentiment. In second quarter 2013, the economy expanded at its slowest pace since first quarter 2009. Real gross domestic product (GDP) grew 4.3 percent (year over year), compared with an average of 7.3 percent over the preceding 16 quarters. Capital inflows retreated dramatically in June and July—most notably with portfolio investments (Chart 2).
Portfolio investments are highly volatile compared with foreign direct investment, and the composition of foreign investment in India has been more heavily concentrated in portfolio investment. Therefore, the changing investor sentiment quickly materialized in the currency market. Capital flows out of an economy as investors prefer to hold assets denominated in other currencies. As demand for a currency falls, it begins to depreciate. A depreciating currency threatens to worsen India’s current account deficit by raising the cost of imports and also creates upward price pressures in India’s high-inflation environment. India has taken multiple measures to combat its depreciating currency, including capital controls and monetary policy tightening (Chart 3).
Recovery Appears to Have Taken Hold in Euro Area
Recent data releases continue to support that the euro-area economy has bottomed out and recovery is underway. Real GDP growth in second quarter 2013 was 1.2 percent (quarter over quarter, annualized). This was the first real GDP expansion since third quarter 2011. Net exports were the biggest contributor toward positive real GDP growth (Chart 4).
The rebounding export sector is most pronounced among the euro-area periphery economies. This is consistent with these economies undergoing an internal currency devaluation. The devaluation is necessary to correct the structural imbalances between the core and periphery economies but has led to high unemployment and falling wages. As a result, consumer demand has remained weak, and the export demand that has led the euro-area recovery has come from outside the euro area (Chart 5). Future austerity will become more difficult because lower levels of income generate lower levels of tax revenue and because prolonged unemployment will increase the cost of government benefits.
About the Author
Mack is a research analyst in the Globalization and Monetary Policy Institute at the Federal Reserve Bank of Dallas.