Europe is in a desperate search for growth. With unemployment high, consumers scared, firms unable to find credit, and governments and banks retrenching, domestic demand is stagnant or falling across Europe. Other advanced countries, beginning with the United States, are in recovery, but it is a slow and hesitant one. In this dismal picture, developing economies remain the one bright spot, as they have been for a long time. Whereas exports of advanced economies to other advanced economies grew at 3.1 percent a year over the last decade, those of advanced economies to the developing economies grew at 9.6 percent over the same period. As a result, the share of total G-7 exports going to developing economies has increased from 24 percent of total exports to 35 percent of exports over the period.

This raises a pressing question: can the emerging markets provide the locomotive that pulls Europe out of its slump? The answer is no. Emerging markets can help, but they are still too small and vulnerable to do the job on their own.

Uri Dadush
Dadush was a senior associate at the Carnegie Endowment for International Peace. He focuses on trends in the global economy and is currently tracking developments in the eurozone crisis.
More >

It is undoubtedly true that the developing countries are on a high long-term growth path. Their growth is driven by fundamental forces which are unlikely to change soon: technological catch-up, a young and rapidly growing labor force, high rates of savings and investment. Moreover, developing countries have relatively small state sectors and they have become more market oriented and open to trade and investment. They have also reduced government debt levels, built up foreign currency reserves, and greatly improved their macroeconomic management.

But the share of European GDP that is exported to developing countries is still too small for them to provide a sufficient pull:   for example, Italy’s merchandise exports to developing countries account for just 7.4 percent of its GDP.    

What is more, the locomotive has a tendency to overheat. Overheating in developing countries can take many forms, all worrisome: large scale currency appreciation, housing and asset price bubbles, out-of-control credit expansion, inflation, unsustainable current account deficits, and so on. For example, a recent World Bank report identifies some 20 developing countries—including India, Russia, and Turkey— which have inflation higher than 6 percent. Moreover, overly rapid credit expansion in economies such as Brazil and Turkey places their financial stability at risk. Large current account deficits loom in several developing countries, including, for example, South Africa, Cambodia, Sri Lanka, and Jordan.

Overheating is often a risk in the presence of rapid growth, but it can become fatal in economies where financial markets are small and underdeveloped. The problem is aggravated by inflows of money caused by the massive monetary expansion and near-zero policy interest rates in advanced countries. The overheating can create a domino effect. If global investors lose confidence in one emerging market, they immediately start questioning others.    

There is another reason why the locomotive effect of emerging markets is less than it seems. Everyone understands that developing economies can be a source of growth because their middle class is growing so rapidly while their counterparts in advanced countries are struggling. But few people appreciate that this is only a very partial story, since developing economies tend to export as much as they import (in fact, they still run a current account surplus as a group) and so they cannot, by definition, be net providers of demand to the rest of the world on a sustained basis.

It turns out that the main effect of developing countries on growth in advanced countries is not through the aggregate demand channel but through the spur they provide to efficiency: namely the reorientation of economic activity in advanced countries towards high-value added goods and services, which are intensive in knowledge, marketing know-how, and capital, and which are in high demand in emerging markets. By the same token, however, labor-intensive, traditional sectors in advanced countries will tend to decline as sourcing them is cheaper in developing countries. 

The implication is that it is right to bet on the emerging markets in the long run, but foolish to believe they can, on their own, compensate for a failure of domestic demand to recover in advanced countries. And anyway, so long as advanced countries are in trouble and their monetary policies remain so expansionary, emerging markets are themselves at risk of overheating and sudden stops.

Not all countries or firms will win from the dynamism of the developing countries. Those that that are most flexible and respond to the new demand by providing innovative and fairly priced products will see the big gains. 

This article originally appeared in L’Espresso.