The Global Financial Crisis and Middle-Income Countries

A more volatile global economic landscape has left individual economies more vulnerable to external shocks.
A more volatile global economic landscape has left individual economies more vulnerable to external shocks.

By Donghyun Park, Shu Tian, Gemma Estrada, Yothin Jinjarak

To withstand external shocks and sustain growth, middle-income countries need to get the basics right on manufacturing, currency management, and education.

Co-written by Joshua Aizenman

Many economies are still reeling from the global financial crisis. Now, at least, there is some emerging clarity about how the crisis changed the global economy, and what countries should do to protect themselves from future shocks.

It is too early to tell whether the global crisis will permanently lower global growth. But clearly, the global economic landscape has changed substantially since the crisis. An important question is whether vulnerability and adjustment to shocks has also changed fundamentally.

This is key for developing Asia, which is deeply integrated with the world economy but generally lacks the policies and institutions to cope with shocks.

Recent research on the relationship between volatility and GDP growth suggests that country-level growth since the crisis is more dependent on external factors, including global growth, oil prices, and financial volatility. Econometric analysis indicates that the effect of global GDP growth on national GDP growth jumped by 85% since the crisis. One possible reason for this is that the global financial crisis deprived the world economy of its traditional anchor and source of stability – the United States.

  Developing Asia is deeply integrated with world economy, but vulnerable to external shocks

This has made the global landscape more volatile, leaving individual economies more vulnerable to external shocks. Moreover, despite the slowdown of global trade since the crisis, there is evidence that growth spillovers from trade partners are significant determinants of a country’s growth.

The evidence suggests that a recession at a major trading partner now has bigger repercussions. The spillover effect of a downturn was zero before the crisis, but turned positive post-crisis. One explanation for this is the reduction of monetary and fiscal policy flexibility caused by the global financial crisis, which has left countries with fewer tools to mitigate external shocks.

For middle-income countries, including most of developing Asia, several factors help countries adjust to shocks. Specifically, economic growth is buoyed if a country prioritizes advanced education, has a greater share of manufacturing output in GDP, and stable exchange rates (Figure 1).

This finding confirms the key role of human capital and a skilled workforce in sustaining rapid growth in middle-income countries. At low income, an abundant pool of unskilled workers can power economic growth, as the People’s Republic of China’s experience shows. But as an economy shifts to middle income, knowledge and skills come to the fore.

The study finds that a strong manufacturing sector is crucial for growth, especially in middle-income countries. This belies the notion that information and communications technology (ICT) makes it possible for countries with an excellent ICT sector, like India, to bypass manufacturing and leapfrog from agriculture directly to services.

Lower political polarization, greater exchange rate flexibility, and higher educational attainment also mitigate volatility. Political instability increases uncertainty for both firms and households. This can, in turn, lead to more volatile behavior, which translates into growth that is more volatile. For example, firms might change their investment plans abruptly in response to new political developments in a highly charged political environment.

Another key ingredient of economic stability is the availability of skilled workers. They can adapt more smoothly than unskilled workers can to new technologies and other jarring changes. Among all ingredients of economic growth, education was the most positively related to the level of growth, and an important factor as well in the volatility of a country’s growth trajectory. Adaptable and versatile workers not only help an economy to grow faster but also absorb shocks, resulting in less volatile growth.

  Human capital, skilled workforce key to sustaining growth in middle-income countries

Flexible exchange rates can also act as a shock absorber, helping an economy to adjust by weakening the currency and boosting exports. Stable exchange rates, on the other hand, foster faster growth overall. This dichotomy makes exchange rate management more of an art than a science, as a balance is required between shock-mitigating flexibility and growth-promoting stability.

This is certainly the experience of most middle-income countries that made a relatively quick transition to high income, such as the Republic of Korea. As well as maintaining competitive but flexible exchange rates, those countries invested heavily in education and developed vibrant export-oriented manufacturing sectors.

In an uncertain global economic environment, the message—especially for middle-income countries in the developing world—is clear: To withstand external shocks and sustain growth, they need to get the basics right on manufacturing, currency management, and above all on education.

This blog was first published by The Brookings Institution.