2010 Economic Predictions for Middle and High Income Countries

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1 UNITED NATIONS DEVELOPMENT PROGRAMME Economic Growth in the Transition from the 20 th to the 21 st Century A UNDP/ODS Working Paper By Heloisa Marone Office of Development Studies United Nations Development Programme, New York October 2009 Note: The views expressed in this paper are those of the author and do not necessarily reflect those of UNDP. The section Growing Unequally? is an updated shortened summary of Conceição and Dervis (2008). The author especially thanks Pedro Conceição for helpful comments and suggestions. She also thanks Nina Thelen and Yanchun Zhang for comments and Ezequiel Aguirre and Raul Sanchez for excellent research assistance. Please send comments and suggestions to the following address: heloisa.marone@undp.org

2 Economic Growth in the Transition from the 20 th to the 21 st Century This note aims to provide an overall view of global economic growth, the macroeconomic and financial imbalances that emerged during the last decade, and the subsequent crisis resulting in part from these imbalances, in addition to the mismanagement of risk. The note also analyzes the potential features of the recovery from the crisis. The first part comprehends a historical perspective with a bird s eye view of global growth trends, its main drivers, and the increase in cross border trade and capital flows. The goal is to characterize the growth of imbalances and the build up of bubbles. The second part of the study focuses on the financial and economic crisis that started in 2007 and the last part discusses recent recovery efforts with an emphasis on the underlining vulnerabilities originated from the imbalances discussed in the first part. Part I Growing Apart but Not Independently Since the early 1990s, real growth rates of low and middle income countries have been growing increasingly apart from those of high income countries. Figure 1 plots the (rolling) cumulative real GDP growth over five year periods. While the lines representing growth for the world and all income categories are roughly coincident up to the mid 1990s, growth in low income countries accelerated by more than threefold, from around 10 percent in the five year periods ending in early 1990s to almost 35 percent in the five year period ending in The rate of growth in middle income countries also surged in the last years. In contrast, growth rates in high income countries remained lower, from around 9 percent in the five year period ending in the early 1990s to around 11 percent in the five year period ending in The outlook going forward suggests that while all groups of countries will face a collapse in growth rates in 2009 and 2010, the gap in growth rates between high and middle and low income countries will likely remain. Low and middle income countries are expected to maintain relatively high rates of growth at around 20 percent in the five year period ending in The collapse in growth rates in high income countries, on the other hand, would push the five year cumulative real growth rate ending in 2010 down to around 0.4 percent. Although low and middle income countries growth rates are expected to continue to exceed those in high income countries, it is worth considering that the symbiotic relationship between China centric Asia and the US has been one of the main feeders of the global macroeconomic imbalances, as reflected in large and persistent current account deficits in the US financed by large surplus in China. These imbalances, which will be described in more detail later in the paper, have been one of the main pillars of the world s growth engine in recent years. Many argue that these macroeconomic imbalances facilitated the build up of large credit bubbles in many countries by enabling access to cheap capital. These dynamics, in turn, inflated growth in both the developing and developed world. 1

3 Cumulative Real GDP Growth, E (5-year rolling, constant 2000 US$) 35% Low income 30% 25% 20% Middle income 15% 10% 5% High income World 0% Figure 1 Cumulative Real GDP Growth by Income Groups, E (in %, 5 year rolling, constant 2000 US$) Source: Own computation based on data from the World Bank WDI. Note: Projections and estimates for the period between 2008 and 2010 are based on UN DESA WESP 2009 (May 2009). We estimate, based on the World Bank data, that the US that has absorbed in terms of government spending, investment, and private consumption between one fourth to almost one third of global demand in the last 10 years. Up to 2007, this absorption was pushed mainly by private household consumption, which since 1995 has contributed at least two percentage points to US real GDP growth (see Figure 2). This, in turn, has in great part been based on increasingly indebted American consumers, who saw their liabilities increase from about 1.1 to more than 1.4 times their disposable income (Figure 3). The increase in consumption and indebtedness of American consumers was supported by raising asset values up to 2006, with the net worth of household sector as a percentage of disposable income increasing in parallel with the indebtedness of the US consumer up to that year (see also Figure 3). Borrowing was facilitated and financed in great part by foreign and especially Chinese savings, with the expansion of these and export led economies, in turn, added by demand coming from the US and other current account deficit countries. This brief summary description naturally omitting much detail and heterogeneity across countries highlights nonetheless the global intertwined relationship between current account deficit and surplus economies. 2

4 Government consumption expenditures and gross investment Net exports of goods and services 8 Gross private domestic investment 10 Personal consumption expenditures I 2009 II 2009 Figure 2. Contribution to US Real GDP Growth (in percentage points, annual, seasonally adjusted, rates for the first two quarters of 2009). Source: US BEA. 3

5 Household net worth as percentage of disposable personal income (LHS) Household liabilities as percentage of disposable personal income (RHS) Q1 2008Q2 2008Q3 2008Q4 2009Q1 100 Figure 3. US Households Liabilities and Net Worth as a Percentage of Disposable Personal Income. Source: US Fed Flow of Funds. Emerging Giants The faster growth rate in developing countries has increased the group s share in the world GDP. Indeed, low and middle income countries are expected to account for one quarter of global GDP by 2010, surpassing EU15 s share, when using market exchange rates to convert GDP denominated in domestic currency into current US dollars. The US s share of global output has declined over the years and current forecasts suggest that it will account for around 28 percent of world s GDP in Among developing countries, Chinas has emerged as one of the developing giants: its world share of GDP has gone from less than one percent in 1960 to a projected 8 percent in 2010, which would position China only four percentage points shy of Japan s share of global output in market exchange rates (Figure 4). In Purchasing Power Parity (PPP) terms, it is estimated that China s share of world GDP reached 11 percent in 2008, almost twice as much as Japan s 6 percent share (Table 1). 4

6 40% 35% 30% United States 28% 25% 20% EU 15 25% 23% Low & Middle income 15% 10% 5% 0% Japan China 12% 8% India 2% Figure 4. Share of World s GDP (in %, constant 2000 US$) Source: Own computation based on WDI. Note: Projections and estimates for the period between 2008 and 2010 are based on UN DESA WESP 2009 (May 2009). The strong growth in developing countries has also translated into a shift in the balance of contribution to growth after the 1990s (Figure 5 in market exchange rates and Figure 6 in PPP) and, especially, into a large contribution of this group to growth in the period between 2005 and 2009E. Between 2008 and 2009E, it is projected that the world economy will slump by 3 percent in market exchange rates (Table 2). Middle and low income countries are expected to offset about 40 basis points of the negative global growth: in other words, if middle and low income economies were not to grow between 2008 and 2009, world growth would be projected to fall by an extra 0.4 percentage points to a total of 3.4 percent. Still, this offset, even if substantial, is not sufficient to prevent a contraction in the global economy, in great part because middle and low economies also suffered sharp slowdowns, given that they are very much vulnerable to the performance of high income economies. The enormous shock to the external demand led by the collapse in private consumption in the US has come as a big blow to export led economies including China. The financial and economic shock that kick started in the developed world rapidly spread to the developing world in great part because of the large interdependency between the world s economies through cross border capital, labor, and trade flows, as discussed in the following sections. 5

7 Share of the World GDP (PPP) E United States 24% 21% 20% Japan 4% 8% 6% EU 15 25% 23% 19% Other high income 7% 8% 13% Low & Middle income 38% 38% 41% China 5% 5% 11% India 4% 4% 5% Soviet Union - CIS 10% 7% 4% LD C 2% 2% 2% Table 1 Share of World GDP, PPP (in %, constant 2005 US$) Source: Own computation based on the World Bank's World Development Indicators. Note: Projections for 2008 are based on UN DESA World Economic Situation and Prospects (WESP, May 2009 update). 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% E High income Low income Middle income Figure 5 Contribution to World s 5 year Cumulative GDP Growth by Income Group (in %, constant 2005 US$) Source: Own computation based on the World Bank's World Development Indicators. Note: Projections for 2008 and estimates for 2009 are based on UN DESA World Economic Situation and Prospects (WESP, May 2009). 6

8 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% High income Low income Middle income Figure 6 Contribution to World s 5 year Cumulative GDP Growth by Income Group (in %, PPP, constant 2005 US$) Source: Own computation based on the World Bank's World Development Indicators. World's Cumulative Growth and Contributions (market prices, constant US$) E E 2008P-2009E World's Cumulative Growth 232% 62% 7% -3% Contributions (in percentage points): United States 62% 17% 1% -1.0% Japan 47% 3% -0.5% -0.9% EU 15 60% 9% 0.7% -0.8% Other high income 21% 10% 1.2% -0.2% Low & Middle income 42% 23% 5.2% 0.3% China 5% 10% 2.5% 0.5% India 3% 2% 0.6% 0.1% Soviet Union - CIS.. 0% 0.2% -0.1% LDC.. 1% 0.2% 0.0% Table 2 World s Cumulative Growth and Contributions (in %, constant 2000 US$) Source: Own computation based on the World Bank's World Development Indicators. Note: Projections for 2008 and estimates for 2009 are based on UN DESA World Economic Situation and Prospects (WESP, May 2009). 7

9 Trade China and many of the economies in the developing world still depend very much on exports as an engine of growth. The IMF estimates that in China, during the period from 2001 until 2008, net exports and investment, which, according to the IMF is predominantly linked to building capacity in tradable sectors, have accounted for over 60 percent of China s growth (Guo and N'Diaye, 2009). A recent study by Prasad (2009) shows that the share of private consumption in GDP has dropped by about one third between 2000 to 2007 in China, while the share of exports increased from about 10 percent in the mid 1990s to more than 30% in 2007 (Figure 7), showing the smaller role of domestic consumption in the Chinese economy compared with the role of domestic investment and trade. About one fourth of all the exports originated in China go to the US alone ( 01/22/content_ htm). Other Asian economies are even more dependent on exports: in 2008, for instance, exports represented more than two times the size of the Singaporean economy and the size of Hong Kong s GDP (see again, for example, Prasad et al.). 45% 40% Share of household consumption 35% 30% 25% 20% Share of exports of goods and services 15% Share of imports of goods and services 10% 5% 0% Figure 7. GDP Shares for China (in % of GDP) Source: Own calculations based on World Bank WDI data. Over the last 15 years cross border trade volume increased significantly. Volume of trade which includes both exports and imports of goods and services accounted for almost 60 percent of world s GDP in 2006 in 8

10 contrast to only 24 percent in 1960 (Figure 8); thus in a period of 56 years total volume of trade increased by 32 percentage points. More than one fourth of this increase occurred in the 3 year period between 2003 and 2006; and more than half of the increase happened in the 13 year period between 1993 and The IMF estimates that trade to GDP will drop from the projected peak of 64.2 percent in 2008 to around 54 percent in 2009, which is equivalent to the 2004 ratio level. Trade became important for both low and middle income economies. Between early 1970 and 2007, trade to GDP ratio more than doubled in the developing world, with the largest growth in trade to GDP ratio, more than threefold, being observed in middle income countries. Trade to GDP is estimated to have reached 70 percent for low income economies, 64 percent for middle income economies, and 61 percent for LDCs in This is in contrast to the early 1970s, when trade to GDP was around 30 percent for low income and LDCs and 19.5 percent for middle income countries (Figure 9). 70 World's Trade to GDP IMF World Bank Figure 8. World s Trade to GDP Ratio (in %) Source: World Bank WDI and IMF WEO April Note: Trade is defined as the sum of exports and imports of goods and services. Much of the increase in the importance of trade in the GDP of middle income countries, especially in the mid to late 1990s, was driven by Asian developing countries, that adopted export led growth strategies, also to spur the accumulation of precautionary savings (e.g. building up of foreign reserves), namely as a response to the East Asian crisis in and other financial crisis in developing countries. China, 9

11 although it did not suffer as much with the East Asian crisis, also adopted a strong export led growth strategy. The World Bank has seen the rapid expansion of China s trade not only as a driving force to China s continuous high growth, but also as a key driving force behind the integration of its trade partners in East Asia and Pacific in the global manufacturing sector (2006, Middle Income Low Income Least developed countries Figure 9 Trade to GDP Ratio by Income Group (in %) Source: World Bank s World Development Indicators. Capital and Financial Flows Similarly to trade, cross border capital flows (which include net foreign direct investment (FDI), net portfolio investment in equity and debt and net of other investments) have also risen significantly in the past 10 to 15 years. In fact, capital flows grew from less than 3 percent of GDP in mid 1990s to around 20 percent in 2007, before dropping to an estimated 17 percent of GDP in the first quarter of 2008 (Figure 10). Since the mid 1990s, aside from the increase in the level of cross border capital flows, capital started flowing from developing economies to developed economies. This pattern challenges the predictions of simple models of capital flows that suggest that capital flows to where returns to capital are higher that is, where there are more and better opportunities for investment. Given that capital to labor ratios in 10

12 developed countries are much higher than in developing countries; one would expect that investment opportunities are higher in the latter group. In addition to capital labor ratios differentials, higher savings needs of ageing populations in developed countries would imply that (1) savings would be higher in developed countries and (2) capital flows would be expected to go from North to South. However, the situation has been almost the exact opposite of these simple models predictions. 25% Gross Global Capital Flows (4 quarter rolling) 20% 14,000 12,000 10,000 15% 10% As % of World GDP (left scale) 8,000 6,000 4,000 5% 0% In billions of USD (right scale) 2,000 0 Figure 10. Gross Capital Flows (4 quarter rolling, in billion US$ and % of GDP) Source: Own aggregation based on IMF IFS. Global Imbalances The most comprehensive picture of cross border capital flows comes from the analysis of the current account balance of countries or groups of countries. Since the Asian crisis in the late 1990s, current account balances have been characterized by an asymmetric pattern where advanced economies as a whole recorded current account deficits and emerging economies recorded current account surpluses ( Figure 11). The size and persistence of these asymmetries, and especially the concentration of surplus and deficits in a few countries, led to the characterization of these asymmetries as global macroeconomic imbalances. These global imbalances resulted mainly from US consumption in excess of its domestic savings, with the shortfall being financed by net savings by the rest of the world. In fact, our estimates suggest that the US was the largest importer of capital in 2006 and 2007 and they have absorbed almost the equivalent of two times the net saving of middle and low income countries in 2007 (Table 1). In 2007, the US alone absorbed 53 percent of total imported capital, followed by Spain (10 percent), and the United Kingdom (4 percent). Turkey was the most important developing country in terms of the global 11

13 share of imported capital. Among the largest exporter of capital were China, Germany, and Japan, that together accounted for almost two thirds of the world s total saving surplus in 2007 (Figure 12). Between 2006 and 2007, China s share of total saving surplus doubled from 13 percent to 26 percent; Germany was even more impressive with its share moving from 9 percent in 2006 to 19 percent in Emerging and developing economies Advanced economies Figure 11. Current Account Balances (in % of GDP) Source: IMF WEO database are IMF forecasts Current Account (USD Billion) High Upper Middle Lower Middle Low Unallocated LDC* US High minus US Table 3. Current Account Balances by Income Groups, (in USD billion) Source: Own aggregation based on data from International Financial Statistics and World Bank s income classification (2009). Data for 2007 is incomplete. 12

14 Countries that Export Capital, 2007 THAILAND 1% VENEZUELA, REP. BOL. 1% CHINA,P.R.:HONG KONG MALAYSIA 2% 2% NETHERLANDS 4% KUWAIT 4% NORWAY 4% CANADA 1% Other 7% CHINA,P.R.: MAINLAND 28% SWITZERLAND 5% RUSSIA 6% GERMANY 19% JAPAN 16% Countries that Import Capital, 2007 FRANCE 2% TURKEY 3% Other 15% ITALY 4% AUSTRALIA 4% United Kingdom 4% UNITED STATES 53% SPAIN 10% Figure 12. Major Net Exporters and Importers of Capital* in 2007 Source: Own aggregation based on IMF WEO and BOP for LDCs. *As measured by countries current account balances (assuming errors and omissions are part of the capital and financial accounts). 13

15 Much of the reallocation of savings from the South to the North has been done through central banks through foreign reserve accumulating countries such as China, Brazil, and oil producing countries such as Saudi Arabia, Kuwait, Qatar, and even Angola. Reserve accumulation in developing countries has increased tremendously since the late 1990s (Figure 13) with current account surpluses or savings increasing at a much higher rate than investment in the region. As a consequence, much of the reserve accumulation has been recycled back to the North through central banks in search of riskless assets such as Treasury bonds in the US to balance their portfolios. In contrast to the operations of central banks, private flows, which include FDI and portfolio investment, have been strongly flowing from the North to the South in search of higher return to capital whilst serving as an important source of financing for development to the South. 8,000 7,000 6,000 5,000 4,000 Middle East Developing Asia Other emerging and developing economies 3,000 2,000 1,000 0 Figure 13 Reserve Accumulation in Developing Countries since 1990 (in USD bn) Source: Own aggregation based on data from IMF WEO. Net FDI to developing countries has risen from 0.5 percent of GDP in 1989 to around 2.5 percent of GDP in 2007 and constitutes one of the largest sources of external financing for developing countries (Figure 14). Aside from FDI and portfolio investment in debt and equity, other sources of financing for development include remittances and part of aid that is not included in official flows. Net remittances to developing countries have also risen significantly from 0.6 percent of GDP in 1989 to around 1.6 percent of GDP in 2007 and they represent the second largest source of external financing after FDI. In the last almost 40 years, remittances as a source of external financing have grown in importance in particular for low income countries and the least developed countries (LDCs) (Figure 15). 14

16 3.0% 2.5% FDI 2.0% 1.5% Remittances 1.0% 0.5% Equity Aid Bonds 0.0% Figure 14. Resource Net Flows to Developing Countries, (as % of GDP) Source: Own aggregation based on data from the WB World Development Indicators. Net Remittances to Developing Countries (as % of GDP) 5.0 Low Income LDCs 2.0 All Developing 1.0 Middle Income Figure 15 Net Remittances to Developing Countries (as % of GDP) 15

17 Source: Own computation based on data from World Bank. Among developing countries, the picture of financial flows for Sub Saharan economies are quite distinct as aid still represents the largest source of external financing; in 2007, aid for that region is estimated to have reached around 4.2 percent GDP. Net remittances also became important for Sub Saharan economies, especially between 2003 and 2007 when it is estimated that they reached as high as 1.7 percent of GDP. Even if FDI has grown in importance, some of this FDI can be quite controversial as for its impact on development; this is the case of some FDI in land and in extractive industries. 8.0% 7.0% 6.0% 5.0% 4.0% Aid 3.0% FDI 2.0% Equity Remittances 1.0% 0.0% 1.0% Bonds Figure 16. Resource Net Flows to Sub Saharan Countries, (as % of GDP) Source: Own aggregation based on data from the WB WDI. WDI data for portfolio bond investment net inflows is not available for the years , 2002, 2004, and 2006; data for net FDI is not available for Growing Unequally? 1 The annualized average income per capita growth in the five year period between 2002 and 2006 reached around 3.7 percent, which was the largest five year average real income per capita growth since 1950 and more than seven fold the historical low rate of 0.5 percent in the five year period starting in 1989 (Figure 17). However, a closer look at this rapid increase in income per capita growth suggests that inequality remains high across countries, which implies that some countries and people have been left behind. Indeed, while 1 This section is an updated summary of Conceição and Dervis (2008). 16

18 some countries have been converging towards the income levels of rich countries, the difference in income per capita between the richest and the poorest countries seems to be widening. Table 4 shows the ratio of GNI per capita (mean income) in the 10 richest countries to GNI per capita in the 10 poorest, as well as the ratio of 20 richest to 20 poorest. Both have increased more than 40 percent between the 1980s and 2007 (Table 4). Although these ratios appeared to stabilize in the years following 2000, they remain high; indeed, in 2007, the mean income of the top 10 richest countries was around US$ 47,989 (in PPP 2008 dollars) or almost 86 times the mean income of the bottom 10 poorest countries, which was around US$ 560 (in PPP 2008 dollars). 4.0% 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Figure 17 Annual Average Real per Capita Income (GDP) Growth over Five Years Source: Own aggregation based on data from Maddison (2009). Top 10 to Bottom 10 Top 20 to Bottom s 1990s Table 4 Income (GNI per capita, PPP 1990 dollars) Ratios 1980s 2007 Source: Own calculations based on WDI (2009). A simple Gini measure of global income distribution that considers each country s mean income per capita as a unit of analysis also seems to suggest that inequality across countries has increased steadily between 1950 and 2000 with inequality increasing more rapidly between 1982 and This trend does not 17

19 depend on the use of GDP or GNI per capita measured in PPP or market exchange rates. Since 2000, however, there appears to have been stabilization with a marginal decline. The Gini coefficient (measured in GDP or GNI PPP) seems to have stabilized at around 0.57 (Figure 19). The levels of inequality using market exchange rates are much higher than those using PPP, which reflects mostly variations in the exchange rates (Figure 19). The stagnation of the Gini beginning in the late 1990s and early 2000s reflects in part the dramatic growth in income per capita of some middle and also low income countries that have converged towards the income per capita levels of high income countries at the same time that they have diverging away from the income per capita levels of lower income countries. The group of converging countries is usually referred in the literature as convergence clubs. We construct a specific measurement to access the existence of convergence clubs among developing countries based on the concept of distances. The more countries are clustered around a given point, the smaller is the distance between these countries, thus by computing distances to a certain reference point we can track the formation of convergence clubs. In particular, our measure seeks to identify the possible existence of clusters of countries converging toward high income countries and diverging away from low income countries. Our measurement consists of: (1) identifying a ruler which we defined as the difference in average income per capita of low and high income countries at a given year and (2) to position all developing countries along this ruler. We normalize the scale of the ruler to be between 0 and 100, with 0 being the average low income per capita of low income countries and 100 being the average income per capita of high income countries. As an example, in 1980 Cote D ivoire distance in the ruler was 9 percent. This means that in 1980, Cote D Ivoire income per capita stood, in a scale from 0 to 100, at 9 points away of the average income per capita of low income countries and 91 points away from the average income per capita of high income countries. In 2007, Cote D Ivoire distance in the ruler dropped 8.2 percentage points to around 0.4 percent; i.e. 0.4 points from the average income per capita of low income countries and 99.6 points away from the average income per capita of high income countries. Thus, the shift of Cote D Ivoire along the ruler indicates that this particular country in the period between 1980 and 2007 became relatively to the average income per capita of high income countries closer to the average income per capita of low income countries. The mapping of this measurement for developing countries suggests a pattern of convergence and divergence among developing countries as pointed out in a recent study by Conceição and Dervis (2008). As illustrated in Figure 18, the histogram that graphs the frequency of country positions along the reference ruler suggests that between 1980 and 2007, there appears to have been overall a convergence of developing countries toward the bottom low of the ruler as shown by the increase of the frequency of countries with smaller distances vis à vis the average income per capita of low income countries. At the same time, the pattern of divergence is suggested by the howling out in the length 6 to 18

20 24 accompanied by the accumulation of countries around different peaks, one towards zero, another around 6 and 12, and the increase in the number of countries in the length 24 to Convergence in Income per Capita Among Developing Countries 25 Frequency of Countries (92 countries) 1980 (94 countries) 5 0 < Relative Location to Low and High Weighted Average Income Per Capita "Ruler" (Scale from 0 to 100, Low Income Average = 0 and High Income Average = 100) Figure 18. Convergence Income per Capita Among Developing Countries Source: Own computation based on WDI World Bank data. Note: For each year a ruler is defined as the difference between the average income per capita of high and low income countries. The scale of the ruler is normalized to be between 0 and 100, with 0 being the average income per capita of low income countries and 100 being the average income per capita of high income countries. A location of 6 implies that a given country is 6 points away from the average of low income countries and 94 points away from the average of high income countries. The chart is a histogram thus indicates the number of countries in each segment of the ruler. Note that negative values indicate those countries where the income per capita is below the average of low income countries. Between 2000 and 2007, among the countries that observed the largest average increase in income per capita were Timor Leste that grew in that period at around 20 percent on an average yearly basis, followed by Equatorial Guinea (16.2 percent), Azerbaijan (15.2 percent), Armenia(13.0 percent), China (10.0 percent), and Angola (9.6 percent). The dramatic increase in income per capita of these countries compares negatively to the average negative growth rates accumulated by some other developing 19

21 countries in this period. Such is the case of Kiribati, Haiti, Grenada, and Eritrea among others (Figure 20). In fact, Figure 20 also suggests that global stagnation in inequality may in fact being driven by increase in inequality among developing groups and the formation of convergence clubs within this group GNI, Atlas Method GNI, PPP GDP, PPP Figure 19 Inequality between countries : Gini Coefficient (GDP and GNI per capita, in PPP and market exchange rates Atlas method) Source: Own calculations based on Maddison (2009) and WDI Note: Maddison data is in GDP and PPP, WDI data corresponds to GNI PPP and market exchange rates Atlas method). The fastest growing economies share the fact that most of them are or were at some point during this period classified as lower middle income countries by the World Bank. They also share the fact that they all have benefited from an increase in income revenue from trade in that period, and, with exception for China, all of them benefited from commodity related trade revenue, in particularly oil revenue. Equatorial Guinea, for instance, that since 2007 is considered a high income country by the World Bank has moved upward the Bank s income classification twice since 2000; from lower middle income to upper middle income in 2004 and from upper middle income to high income in In fact, in 1996, only 10 years before becoming a high income country, Equatorial Guinea was considered a low income country according to the World Bank. This dramatic relative increase in income per capita in Equatorial Guinea is in great part related with investment in oil and oil revenues that is estimated to have contributed close to 97 percent of growth in 2007 (Figure 21). 20

22 20% Timor Leste 15% 10% Equatorial Guinea Azerbaijan Armenia China Angola 5% 0% 5% Eritrea Grenada Haiti Kiribati Figure 20 Average Annual Real Growth in GNI per capita (PPP) Source: Own computations based on WDI

23 Figure 21 Equatorial Guinea GDP per capita, GNI per capita, oil revenues, and oil sector contribution to growth Source: Own computations based on the Central Bank of central African states. The dramatic growth in income per capita seen in some countries in recent years has not always been accompanied by increases in jobs. For example, the strong GDP growth in China in the last decade appears to have generated a surprisingly small number of jobs in that country; according to Prasad s (2009) study on Asian growth, employment growth in China amounted to an anemic 1 percent per year between 2000 and Comparisons of within country inequality are difficult due to scarcity of data, and differences in methodologies to collect data and compute measures of inequality. Still, there is indication that inequality in the dispersion of income has increased in several fast growing developing countries (including China; see, for example, Ravallion and Chen (2007)) as well as developed countries (including the US; see, for example, Piketty and Saez (2003 and 2006)). 22

24 In contrast with the dynamics of cross country income inequality, inequality in human development indicators across countries has decreased (Figure 22). According to Conceição and Dervis (2008): The convergence in human development outcomes suggests that relying only on income to assess the dispersion in living standards across countries may be incomplete, and underestimate some of the developmental gains achieved by many developing countries over the last few years. Yet, one should be careful when interpreting some of the human development data. As described in Angus Deaton (2003; 2006), health indicators as well as some other development indicators have different types of axiomatic constructions and may not have universal unambiguous interpretation as income indicators. This implies that different choice of indicators may yield different and sometimes contradictory results. As an example, Deaton (2006) uses the evolution infant mortality rates in Sweden and Mali. While Mali s infant mortality dropped from 224 per thousand to 124 per thousand in the period from 1970 to 2000, Sweden s infant mortality fell from 11 to 3.2 per thousand in the same period. Comparing these rates yield a pattern of divergence as the rate of infant mortality between Mali and Sweden moved from 20.4 in 1970 to 38.7 in However, if we were to consider the number of children saved out of the 1,000 (by subtracting the infant deaths), we would conclude that there have been in fact a convergence as the ratio of survival rates between Mali and Sweden moved from 0.78 to Rapid growth in developing countries went along very sharp reductions in poverty rates over the last two decades. Table 5 shows that the extreme poverty rate dropped from 42% in 1990 to 25% in 2005, and is expected to decrease further to 15% in Some studies suggest, however, that economic growth has been having a diminishing impact on poverty reduction. According to Conceição and Dervis (2008), in a typical lower middle income country, it now takes much more rapid economic growth to achieve the same rate of poverty reduction than it did two decades ago. Nonetheless, the gain related to poverty rate reduction suggests that the Millennium Development Goal (MDG) target related to this indicator is likely to be met globally. Regionally, with exception of Africa, all regions are expected to meet the MDG goal as well. 23

25 Table 5. People Living in Extreme Poverty (below $1.25 in 2005 PPPs) Source: IMF and World Bank Global Monitoring Report 2009, p. 49. The global progress in reducing poverty was largely due to improvements in income for the poor across Asia, but especially in East Asia. In particular, China, despite the increase in within country inequality, appears to have made dramatic progress in reducing poverty rates. According to official statistics, the ratio of people living under 1.25 dollars a day in China has decreased from 84 percent in 1981 to 15 percent in 2005 and thus closer to other emerging countries levels such as Brazil (Figure 23). The reduction in poverty in China contrasts with the evidence that growth in that country has not been accompanied by high rates of job creation and thus by an increase in wage generated income. According to a World Bank economist and based on the Chinese National Bureau of Statistics, urban job growth in the Chinese capital-intensive economy has averaged around 3.8 percent a year since 2000, which implies that China have generated fewer jobs than other countries in Asia, e.g. South Korea or Japan, did at similar stages of development. 24

26 Figure 22 World Gini of HDI Source: Own computations based on UNDP (2009) Brazil China Figure 23 Poverty ratios of China and Brazil ($1.25 dollars a day, PPP) Source: Own computations based on WDI (2009). Overall, there has been a very rapid growth in developing countries in the first few years of the 21 st century, along with respectable growth in the developed world, pushing global growth rates close to the highest ever. 25

27 However, the nature of global growth appears to have been based on a process that led to the accumulation of macroeconomic and financial imbalances: income and wealth expansion driven by rapid consumption growth and increased indebtedness in the US and a few other rich countries, and by investment imbalances and export growth, and the provision of savings to finance indebtness in the rich world, by rapidly growing developing countries, including China. Many countries benefited from this dynamics, some directly, others indirectly as a result of the increase in commodity prices. Still, some countries and segments of the population within many countries did not benefit from this expansion of income: convergence went along with divergence in income across and within countries. Beyond income, developmental gains have occurred, with the convergence of human development indicators, showing improvements in living standards across indicators related to health and education, as well a sharp reduction in global poverty rates, with dramatic progress in China and much of Asia, but Africa being left behind. However, the imbalances in this growth model appear to have led into a sharp crisis. We next analyze the nature of the crisis and prospects for recovery. Part II Into the Crisis The financial and economic crisis adds to the food and fuel crisis shock that affected negatively many countries from 2005 to the middle of The crisis is unique, in particular, giving its systemic impact in both developed as well as developing countries. But it also shares some features that have been observed in earlier economic crisis. For some early descriptions and interpretations of the crisis see, for example, Krugman (2009) [The Return of Depression Economics and the Crisis of 2008] and Shiller (2008) [The Subprime Solution. How Today s Global Financial Crisis Happened and What to do About it]. Reinhart and Rogoff (2008) examine historical economic crisis and determine that at least up to January 2008, the current crisis had presented both quantitative and qualitative parallels to 18 earlier post war banking crises in industrialized countries they have selected for comparison. Since the crisis is still unfolding, it is too early to make definitive assessments on the causes, mechanisms, and consequences of the crisis, and to identify its idiosyncratic as well as some possible elements that are common with other crises. Many observers consider that the current financial and economic crisis resulted from an interaction between growing financial imbalances (that is, increasing fragility in private sector balance sheets, with excessive risk taking and overleveraging by individuals and financial institutions; see, for example, Borio 26

28 and Drehmann 2009) 2 and the global macroeconomic imbalances between the use and origins of global savings documented above (see, for example, Caballero, Farhi, and Gourinchas 2008, Caballero and Krishnamurthy 2009, and Dunway 2009) 3. Also contributing to the current crisis were failures in financial regulation and flawed incentives, new financial products and actors, and deep interconnections in the modern global financial systems (Blanchard, Caruana, and Moghadam 2009, Truman 2009). Some ascribe the causes of the crisis exclusively to regulatory factors, and see no relationship between the crisis and global imbalances (Dooley, Michael P., David Folkerts Landau Peter M. Garber BRETTON WOODS II STILL DEFINES THE INTERNATIONAL MONETARY SYSTEM. NBER Working Paper 14731). There has been an on going debate to explain the emergence and the persistency (at least up until the crisis) in macroeconomic imbalances in the global economy. One view was given by Ben Bernanke (2005) who first proposed the concept of Global Savings Glut. According to this view, the imbalances emerged not because there was a decrease in national savings in the US (mostly by the household sector, but also by the government) but rather due to developments exogenous to the US, with the emergence of excess of savings, due to a range of factors, emanating primarily from Asia and commodity rich countries. While the debate on global imbalances continues (for a summary see, for example, Little 2008), as well as on the causes and mechanism of the crisis, it is still possible to provide an interpretative narrative describing how global imbalances had implications for the build up of financial imbalances, and how the sub prime crisis in the US triggered the financing and economic crisis. Net positive savings accumulated in current account surplus countries such as China, where investment growth rates were below savings growth rates, were being channeled into investments in current account deficit countries like the US. These excess savings increased market liquidity and push real interest rates to historical low levels (Figure 24). Low global interest rates and ample global liquidity was accompanied by a rapid expansion in credit and increases in asset prices, including property prices, especially housing prices in the US. The increase in asset prices in turn fueled much of the US and the world s consumption and growth, leading to a dangerous spiral in asset price and wealth inflation, credit, consumption, savings imbalances, and growth. In the US, for instance, where American households were drawing on asset appreciation to consume well beyond their means, wealth to income ratio reached almost 10 in 2007, about two times the long term average between 1960 and 2003 (Figure 25). 2 Borio, Claudio and Mathias Drehmann Assessing the risk of banking crises revisited. BIS Quarterly Review (March): Caballero, Ricardo J. and Arvind Krishnamurthy Global Imbalances and Financial Fragility. NBER Working Paper No Dunaway, Steven Global Imbalances and the Financial Crisis. Council Special Report No. 44. March. New York: Council on Foreign Relations. 27

29 Figure 24 World and US Real Interest Rates (in %) Source: Caballero et al, 2008, An Equilibrium Model of Global Imbalances and Low Interest Rates, AER, 98:1, pp.359, Figure 1, (b) Wealth to Income Ratio Figure 25 US Wealth to Income Ratio Source: Own computation based on data from the Survey of Consumer Finances 28

30 The Trigger Sub prime Crisis 4 By mid 2006, house prices in the US had already peaked reaching levels not seen in at least a generation. A growing debate took place on whether a housing bubble was being developed or not. For example, Karl Case and Robert Shiller were among the first researchers to argue that a bubble was taking form in the US housing market. In Case and Shiller (2005), they provide empirical evidence on prices being excessively high and out of line with fundamentals that historically explained real estate valuations. Using US statelevel data on home prices and household incomes since 1985, they find that the ratio of house prices to per capita personal income increased steadily since the end of the 90s on most US large cities. To the extent that prices kept growing and since house prices increases act like a capital gain for households, increasing their total wealth, households didn t need to save much out of their labor income. During the boom years however, many analysts argued that the rise in house prices posed no risk to the mortgage industry or to the economy at large. The explanation was that, even if there was indeed a housing bubble, central bankers had the monetary tools to prevent a bubble from affecting the rest of the economy. Some even argued that the Federal Reserve should not try to target asset prices, like real estate prices, and instead just clean up once the bubble burst (Mishkin, 2001). Of course, the opposite view in favor of a more active engagement of central banks and other authorities in managing asset price bubbles was also being aired, namely after the dot com bubble (see, for instance, Borio, Claudio and Philip Lowe Asset prices, financial and monetary stability: exploring the nexus. BIS Working Papers. No 114). The debate continues now with both views being re assessed (for a recent discussion, including an extensive review of the perspectives that suggested that it would be appropriate for monetary authorities to lean against a bubble, and that it might be important to actually do so, see, for example, White, William R Should Monetary Policy Lean or Clean? Federal Reserve Bank of Dallas Globalization and Monetary Policy Institute Working Paper No. 34 August. However signals that a housing bubble not only existed, but that it had reached unprecedented proportions were not hard to find. For example, a look at housing price to rent ratios (analogous to the price earnings ratio used to value stocks) was already pointing to housing prices much higher than what fundamentals would imply (Figure 26). In early 2007 in the US, excess housing inventory and the inability of demand to absorb that inventory started to depressed house prices. The ability of sub prime borrowers to pay for their mortgages decreased thus increasing the risk and associated cost of lending to this group. As the price of mortgages went up, sub prime borrowers saw themselves unable to pay for their loans and were then forced to leave or try to sell their houses. At the same time, as the cost of mortgages were going up, less people were able to afford mortgages to buy new houses. The result of more people having to sell their houses in contrast to less people being able to buy houses accelerated the drop in house prices. 4 For a detailed account of the crisis, see, for example, the BIS 79 th Annual Report (June 2009). 29

31 Price rent ratio Jan 1987 Jan 1988 Jan 1989 Jan 1990 Jan 1991 Jan 1992 Jan 1993 Jan 1994 Jan 1995 Jan 1996 Jan 1997 Jan 1998 Jan 1999 Jan 2000 Jan 2001 Jan 2002 Jan 2003 Jan 2004 Jan 2005 Jan 2006 Jan 2007 Jan 2008 Jan 2009 Figure 26 The US House Price to Rent Ratio Source: Case/Shiller US Home Price Indices, Bureau of Labor Statistics; Note: The Price to Rent ratio is the Case/Shiller Home Prices Composite 10 index divided by the Owners Equivalent Rent (OER) from the BLS. As house prices declined, the risk of sub prime mortgages increased even further and so did interest rates, which precipitated an even larger number of people being forced to sell their houses. The consequence was a continued decline in house prices. On the macro front, the construction sector and all other services related to the housing sector were also being hit as demand for new houses slowdown. This, in turn, would contribute for the weakening of the economy. Sub prime lending was being re packaged into complex securities and traded by financial institutions, mostly in the developed markets. These new securities were so complex that it was incredibly difficult to know where the risk actually resided or how to price it. The traditional banking model, in which a bank takes deposits and issue loans to firms and households and hold them until maturity, was no longer a good description of the financial sector. Markus Brunnermeier (2009), in a detailed description of the credit crisis, establishes that (the traditional banking model) was replaced by the originate and distribute model, in which loans are pooled, tranched, and then resold via securitization. He argues that this new model facilitated large capital inflows from saving countries, mainly Asian ones, and led to a decline in lending standards. 30

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