The world economy is now recovering, but the pace of that recovery varies greatly across the globe. While the crisis weakened advanced economies and left them vulnerable to shocks—as the crisis in Europe plainly demonstrates—emerging markets are racing ahead. They now face risks from overheating if the recovery continues and slowdown if advanced countries stumble again. Capital flows to emerging markets—which respond both to supply in advanced economies and demand in emerging ones—are likely to be even more volatile in the years ahead. Policy makers must remain cautious and flexible, ready to deploy a wide range of instruments when needed.

The Global Recovery: Strong but Slowing

Over the last year, the world economy rebounded remarkably from an equally remarkable collapse. This is especially evident in world trade, which fell four times more sharply than global GDP in 2008, reflecting the global credit crunch and the collapse in demand for durable goods. Trade is now up 23 percent (y/y) through May, and world GDP is up 5 percent (y/y) in the first quarter of 2010.

However, this pace—which reflects both the return of confidence and the depth of the crisis—cannot continue. Inventory restocking, for example, added 1.5 to 2 percentage points to GDP growth in the OECD in recent quarters but its contribution is expected to dwindle to zero by the end of 2010. And, according to the IMF, world output growth peaked in the fourth quarter of 2009 at 5.4 percent (q/q, annualized) and will slow to 4.6 percent in 2010 and 4.3 percent in 2011.

Additional risks—though incorporated into these forecasts—are difficult to evaluate and could weigh growth down further. The retraction of fiscal stimulus in advanced countries in 2011 is expected to reduce demand there by more than 1 percent, requiring private sector expansion to offset the decline; China’s policy tightening will also slow activity in the world’s fastest-growing large economy. Though the euro has strengthened recently, the crisis in Europe is far from over and represents the largest threat to the global recovery.

Even if the recovery continues unabated, the crisis will leave a lasting legacy in advanced countries that will widen the gap between their growth and that of emerging markets. It will also make the external environment facing emerging markets, including capital inflows, exceptionally vulnerable to shocks in the coming years.

Legacy of Vulnerabilities

Unused capacity remains high in advanced countries. Low capacity utilization—which is 5.6 percentage points below its 1997–2007 average in the United States, for example—is holding down investment. High unemployment—which increased from 5.7 percent at the beginning of 2008 to 8.6 percent in May 2010 in OECD countries and is projected to remain well above pre-crisis levels for an extended period—is also depressing consumer demand. Too much construction has left several countries with a huge unsold housing inventory. With GDP expected to remain permanently below its pre-crisis trend in the advanced countries, incomes will likely be lower in the long run and savings rates higher than before the crisis. In emerging economies, by contrast, GDP has already returned to the pre-crisis trend.

Despite unprecedented government support, banks in advanced countries also remain fragile. They are still deleveraging and hesitant to lend: the IMF expects a credit shortfall of 2 percent of GDP in the United States and the Euro area in 2010. With nearly $5 trillion of debt maturing by 2012, the banks also face pressure to raise additional capital. Banks in Europe, which dominate foreign lending to Latin America and Eastern Europe, are under even greater stress, as slow European growth will make repairing balance sheets particularly difficult and falling sovereign bond prices have eroded assets.

The crisis also left a legacy in the public sectors of advanced countries. Debt surged sharply, primarily because of lost tax revenue. Public debt in advanced countries increased from 73 percent of GDP in 2007 to 90 percent in 2009 and is projected to exceed 100 percent in 2011. Greater government borrowing needs (major advanced economies will roll over $4 trillion in debt in the second half of 2010) could crowd out lending to private sectors in advanced countries and to emerging markets, where public debt has remained steady at approximately 37 percent of GDP.

Policy makers must also reverse the massive liquidity overhang left after the crisis. Since 2007, the money supply of advanced countries (M2) and reserves in emerging markets have grown by nearly $5 trillion combined. Policy interest rates, which remain historically low, must be raised as well. Emerging markets, most notably China, and a few advanced economies, including Canada and Australia, have already begun this process. The United States, the Euro area, and Japan, however, remain committed or obliged to maintaining exceptionally loose monetary policy well into the future.

The effects of this legacy—rising public debt, fragile banks, and spare capacity—are most clearly manifested in the European debt crisis. That crisis, however, has an even deeper cause—the loss of competitiveness in the European periphery associated with euro adoption. Fixing that problem will require many years of deflationary adjustment in the troubled economies; European policy rates and the euro will have to stay low in support. The outcome of this adjustment is highly uncertain: Europe could send large shocks through the global economy. Developing countries, which depend on Europe for bank finance and over 20 percent of their export market, could be especially hurt.

Capital Flows After the Great Recession

The differentiated nature of the recovery—and the vulnerability of the global economy to new shocks—may well translate into further volatility in capital flows to developing countries. These flows have been recovering modestly in the aggregate since 2009, but several countries, including Brazil, Peru, Indonesia, and Korea, are already experiencing unwanted surges. Given the unsteady recovery in advanced economies, policy makers in emerging markets should be prepared to act if capital flows surge or falter.

A surge in flows, however, could pose greater policy challenges to many countries.

After falling sharply in 2008 and 2009, capital flows rebounded in 2010, returning roughly to 2005–2006 levels in dollar terms. Relative to GDP, however, flows are significantly lower—below 4 percent, compared to well over 6 percent in 2005–2007—with the recovery most buoyant in Asia and weakest in Eastern Europe, where the fall was also sharpest. This muted recovery reflects the weakness of investment in advanced countries, deleveraging by banks, increased borrowing by governments in advanced countries, relatively liquid conditions in emerging markets, and perceptions of high risks (emerging market bond spreads, measured by the EMBI, remain about 100 basis points above their pre-crisis level).

By 2011, under the baseline scenario of a continued global recovery, these impediments will likely recede, but will not disappear. The likelihood that the fundamentals that drive capital flows to emerging markets—relatively slow growth and low interest rates in advanced countries, rapid growth and higher interest rates in emerging markets, and reduced risk aversion—will continue suggest that the flows could well surge. Surges will put upward pressure on exchange rates or force unwanted reserve accumulation, which, if left unsterilized,1 will add to inflationary pressures and could trigger asset bubbles. Furthermore, given the vulnerabilities that will persist in advanced countries, a new shock (for example, higher policy rates, a recession, or a European banking crisis) could transform the feast of capital flows to famine, with serious destabilizing effects for receiving countries as seen many times.

Policy: Caution and Flexibility

The resilience of emerging markets during the crisis despite the collapse in capital flows in 2009 illustrates yet again the importance of sound macroeconomic management—containing fiscal deficits and driving down debt/GDP ratios, building adequate foreign currency reserves, targeting moderate inflation, and allowing exchange rates to float. In the years ahead, however, policy approaches should be even more cautious and maintain even wider margins to respond to changing circumstances.

Policy makers must remain cautious and flexible, ready to deploy a wide range of instruments when needed.

Given their sound fundamentals and ample reserves, most emerging markets, with the possible exception of several Eastern European countries, have the capacity to manage a moderate slowdown in capital flows and exports, such as the one that could be caused by a potential faltering of the global recovery in 2011.

A surge in flows, however, could pose greater policy challenges to many countries. Accumulating further reserve and sterilizing inflows, allowing exchange rates to appreciate as appropriate, facilitating capital outflows (foreign investment by residents), and retrenching government expenditures are some of the available policy responses. Each has limits, however. Various forms of capital controls, such as higher reserve requirements on foreign currency deposits or taxes on inflows, could then be justified in some instances.

Uri Dadush is a senior associate in and the director of Carnegie's International Economics Program. Bennett Stancil is a junior fellow in Carnegie's International Economics Program. This note is based on a presentation to a Conference on Capital Flows organized by the Central Bank of Peru, the G24, and the Reinventing Bretton Woods Committee in Cusco, Peru, on July 18, 2010.

1. Sterilization is a process by which central banks offset the impact of foreign reserve adjustments on the domestic money supply.