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Ruchir Sharma on latest turmoil in Emerging Markets

Ruchir SharmaRuchir Sharma, EM analyst and author of Breakout Nations: In Pursuit of the Next Economic Miracles (Norton/Allen Lane, 2012), wrote recently for the Wall Street Journal:

The Emerging Market Comedown

The beguiling idea of “convergence” still lives. But it shouldn’t. The basic notion of convergence is that incomes in poor nations will rapidly catch up—or converge—with those in rich nations. This argument gained a popular following over the past decade when emerging economies were growing three times faster than the world’s leading economy, the U.S. However, after the average annual GDP growth rate in emerging nations peaked at 8.7% in 2007, it tumbled to roughly 4% in 2013. Yet to many observers, that pace still appears fast enough for these countries to catch up to the U.S., now growing at an annual pace of just over 2%.

Look closer, however, and the picture changes dramatically. Once you exclude China, GDP growth over the past two years has been no higher in emerging nations than in the U.S. Convergence has halted across a broad front, and after losing ground for much of the last decade, the U.S. share of global GDP has stabilized since 2011 at 23%, while the share held by emerging markets excluding China has stabilized at 19%.

Some of the biggest emerging market stars of the last decade, including Brazil, Russia and South Africa, are now growing at a pace that is slower than that of the U.S. This trend is unlikely to change in the foreseeable future. These countries are in fact “deconverging.” Even China’s reported 2013 growth rate of 7.7% looks increasingly unsustainable given the amount of debt it is taking on to hit this ambitious target.

None of this should be surprising because economic history shows convergence is largely a myth. The tailwinds that stir up periods of rapid convergence—including easy money and booming commodity prices during the past decade—never last. Emerging economies rarely grow fast and long enough to rise into the developed world. There were at least as many nations losing ground as catching up in every decade but one since 1960. The exception was the past decade. Between 2005 and 2010, only three countries did not increase their GDP per capita relative to the U.S.: Niger, Eritria and Jamaica.

The tailwinds that produced this rare mass convergence are now gone, and the emerging world is returning to its normal state, with just a few nations on a rapid convergence path. The current stars include countries such as the Philippines, Colombia and Peru. But these catch-up stories are unlikely to last indefinitely, because hot growth streaks rarely run for more than a decade. Often, rapid expansions have ended in a crisis or contraction, wiping out much of the gains made during the boom.

Catch-up is hard to sustain, and one popular answer for this difficulty is the middle-income trap. This theory has it that a poor nation can grow at catch-up speed through simple improvements such as paved roads, but will find it difficult to continue at catch-up speed when it hits the middle-income level and needs to develop advanced industries. Today, there is much speculation that emerging markets—including Brazil, South Africa and Russia—are losing catch-up momentum simply because they are in or approaching the middle-income level.

New research, however, shows that “development traps” can knock countries off the catch-up path at any income level. The challenges of developing industry—backed by better banks, schools and regulators—do not accumulate and confront an economy all at once. They continue to harass an aspiring nation every step up the development ladder. In a September 2013 paper, World Bank researchers found many examples of economies that have suffered setbacks at the threshold of every per capita GDP level, from lower to middle to upper incomes. Their analysis of these transitions found “little support for the idea of a middle income trap.”

In some cases, development traps can drag newly rich countries back to the middle-income ranks, as has happened to Argentina and Venezuela in the past century. Since the late 1950s, many nations have also slid back from the middle to the lower-income class, including the Philippines in the 1950s, and Russia, South Africa and Iran in the 1980s and 1990s. Every decade tosses up new convergence stars—from Iraq in the 1950s to Iran in the 1960s and Malta in the 1970s—that flame out in the next decade.

Nonetheless, boom periods are often misread as a sign that developing nations are successfully working their way up the development ladder. Many emerging markets rely heavily on commodities for the bulk of their exports, and they grow at catch-up speeds—at a rate faster than the world’s leading economy—only when commodity prices are rising.

Commodity prices rose 160% in the 1970s, and the number of nations that were rapidly catching up to the West rose to 28, compared with the average of 22 in the typical decade. In the 1980s and 1990s, when commodity prices stagnated, the number of rapidly converging nations fell to just 11. Commodity prices then doubled in the 2000s, another golden age for convergence, with 37 nations catching up at a rapid pace.

But commodity-driven economies such as Russia and Brazil tend to stop catching up as soon as commodity prices spiral downward. According to the World Bank, of the 101 middle-income economies in 1960, only 13 had become and still remained high-income by 2008: Equatorial Guinea, Greece, Hong Kong, Singapore, Ireland, Israel, Japan, Mauritius, Portugal, Spain, Puerto Rico, South Korea and Taiwan. Of those 13, only Equatorial Guinea is a commodity-dominated economy.

Last decade’s mass convergence was a freak event that caught the world’s imagination. However, it never pays to extrapolate from the recent past into the distant future. That is particularly true in the emerging world, where economic growth is characterized by sharp but short booms, often fueled by unstable commodity prices. Don’t assume all emerging markets are destined to grow faster than the U.S.—or that some mythical force called “convergence” will carry every emerging nation on a straight path to prosperity.

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