Over the past five years, developing economies have been responsible for over two-thirds of global economic growth. Over the past decade, the share of developed-country exports bought by their developing partners has increased to almost 50 percent from 25 percent. In recent years China alone has consumed about half the world's cement, iron ore, steel, coal, and lead, lifting commodity prices.
But the tide of growth has started to recede. The International Monetary Fund just cut its emerging-market growth forecast by over a full percentage point from its April 2012 report. The MSCI Emerging Market Equity Index this year has underperformed its Developed Market counterpart by more than 15 percent. The emerging-market purchasers index fell below 50 for the first time since 2009, signaling expectations of an economic contraction.
Why are emerging markets beginning to submerge? While riding the wave, some developing countries lost sight of the need to keep up reforms that boost productivity and innovation in the private sector. Five years into the crisis, they need to focus on the fundamental factors that determine economic growth, and not just on short-term fiscal and monetary stimulus.
The developing countries' basic success story over the past decade was a simple one: Good growth policies by developing countries attracted investment capital, and then the boom in asset prices pulled in more capital. The sums were significant—developing countries enjoyed capital inflows of about $1 trillion each year.
But some developing countries began to overspend. Easy credit planted the seeds of problems, just as it had done in developed countries. Others had to cope with rising currency values, which weakened export competitiveness.
When sentiment turned against developing markets, capital inflows began to retreat. Asset prices fell. Interest rates rose. Currency values tumbled, raising costs of energy and inputs for production, while increasing inflation risks. As growth prospects dimmed, more capital moved out. This cycle has not yet run its course.
Sentiment shifts have multiple causes. In this case, the relative gains of developing-world stocks over developed-world alternatives slowed and then stopped. China's demand for commodities moderated as its economy slowed. Some countries built up large current account deficits, increasing funding risks. The Federal Reserve's discussion of tapering its bond-buying caused investors to reassess how long easy money would remain available.
Brazil, India, Indonesia, Turkey, and South Africa have been hit particularly hard in the present climate. Their currencies, for example, have fallen on average by 14 percent since May.
Other developing markets—such as Korea, Mexico, and the Philippines—have had the cushion of more domestic financing and are less threatened by the reversal of capital flows. In general, developing countries are unlikely to repeat the crises of the 1980s and '90s—their flexible exchange rates, foreign-exchange reserves, and reliance on foreign direct investment limit risk.
Some experienced hands anticipated the dangers. In January, Ravi Menon, managing director of the Monetary Authority of Singapore, gave a thoughtful speech pointing to the need for productivity reforms. Unfortunately, the hype about BRICs (Brazil, Russia, India, and China) and overconfidence in the good years led some developing country leaders to assume that their countries' gains were inevitable. They aren't.
Developing countries still face big challenges. They need to develop their human capital—health, education, and skills—and draw on the talents of all their people, including women, with flexible labor markets. Many countries need to invest in solutions to overcome transport, energy, telecom, and water bottlenecks. There are too many impediments to starting new businesses. Too many public services are costly and ineffective. State-owned enterprises are often inefficient and overuse capital.
Yet there are many opportunities in these countries to boost productivity through technological improvements if markets are competitive and foreign linkages encouraged. Deeper and broader financial markets would help connect foreign and domestic savings to productive investments through a greater variety of investment channels. Greater openness through trade would drive these reforms.
The potential is there. The McKinsey Global Institute estimates that 440 emerging-market cities will account for almost half the world's expected economic growth between 2010–25. The rise of a new middle class offers opportunities for new business: Already about 2 billion people in developing countries earn $3,000 to $20,000 per year and collectively possess $12 trillion in purchasing power. There will be new patterns of south-south trade, investment, tourism, logistics and supply chains, and remittances. There will be new south-north ventures, too. Yet macroeconomic stabilization is not enough to capitalize on this potential.
Developed economies should also take note. After five years, the back-and-forth on fiscal and monetary policies risks diverting their attention from structural reforms for growth. These include encouraging flexible labor markets with better connectivity among education, skills, and jobs, along with immigration policies that better serve labor force needs. Tax reform also offers growth opportunities, as does innovation in energy markets and public-private infrastructure investments. Trade policies should encourage freer competition.
The challenges facing countries in both the developing and developed world have shifted since the crisis of 2008. Government policies need to shift, too, and it is critical that these policies put the growth of private business at the forefront.