by Raghuram Rajan

Many commentators are looking for an increase in domestic demand in emerging markets to compensate for the slowdown in the US. Indeed, domestic consumption is picking up in several countries including China, while governments in Asia and the Middle East are turning to neglected public investment. Yet years of strong growth and cutbacks in public investment, which have restored economic health to emerging markets, have also eaten up excess capacity. Any increase in domestic demand, if it is not to result in bottlenecks and even higher inflation, will have to be accompanied by a shift in production from an external focus to an internal focus. This means that emerging market currencies will have to appreciate, and the weight of output will shift from traded goods such as T-shirts and electronics to non-traded goods such as real estate and health services over the next few years.

A shift from an outward focus to an inward focus will have to be accompanied by much more institutional discipline. With fewer constraints on underlying inflation, emerging market central banks will have to be more careful in targeting low inflation, especially as exchange pegs become less viable. Labour markets will have to be more flexible, while product markets will have to be deregulated far more if profitable productive growth is sought in the non-traded goods sector. With more expenditure flowing to assets such as housing, the financial sector will have to be careful not to precipitate booms and busts, and this will mean more reform as well as better supervision. Finally, governments will have to meet the greater demand for public investment without eroding fiscal discipline, maintaining greater caution as the cushion of large foreign exchange reserves diminishes and increases their vulnerability.

The remainder of this column can be read here. Debate from our panel of economists appears below.

August 20, 2008 9:08am in Emerging economies, Globalisation | Comment