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May 17, 2023

Institutions are deteriorating in emerging markets – especially China

Our guest blogger says the quality of economic institutions has markedly eroded.
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In-house blogger
Guest blogger
Ahmet Akarli
Senior Research Fellow
London School of Economics
Former senior economist and managing director
Goldman Sachs
All opinions expressed in this content are those of the contributor(s) and do not reflect the views of Macrobond Financial AB.
All written and electronic communication from Macrobond Financial AB is for information or marketing purposes and does not qualify as substantive research.

Emerging market economies (EMEs) are risking their ability to sustain the favourable income growth of the past two decades and convergence with developed economies. In particular, China’s intensifying institutional weaknesses pose significant headwinds for the global economy and EMEs at large. 

EMEs carried out extensive neo-liberal institutional reforms through the 1980s and 1990s. These reforms strengthened legal and regulatory structures, consolidated monetary and fiscal anchors, deregulated local markets, and facilitated further integration of the EMEs into the broader global economic and financial system. 

The reforms were initially painful. They often came in the aftermath of a severe financial crisis and were typically reinforced by strict conditions imposed by the International Monetary Fund (IMF). 

However, the reforms helped unleash new economic potential. They created a more stable domestic macroeconomic and financial environment, facilitated greater economic openness, and, as such, facilitated rapid economic expansion and income convergence. 

Median EME real per capita income levels roughly doubled, reaching 30 percent of the US level in late 2010s – up from 20 percent in the early 2000s. This convergence meant that EMEs assumed an unprecedented importance in the global economy, raising their share of global GDP to 50 percent from 35 percent during the same period.

Amid the good times of rapid income growth, a degree of complacency set in; institutional reform processes stalled. The global financial crisis (GFC) reinforced further inertia, as EME policy makers turned their attention to dampening the adverse financial effects of the crisis on domestic economies. 

But the more significant inflection point came with the pandemic. Under the huge economic and political pressures generated by Covid-19, nations struggled with their fiscal and monetary anchors. More fundamental market reforms were diluted, especially in economies with populist and/or authoritarian leanings.

The following chart is a visualisation of this accelerating erosion, using the Heritage Foundation’s Economic Freedom Indices (EFIs). While institutional quality is a concept that’s hard to measure and even harder to link formally to long-term economic growth, proxies such as the EFIs are often best-suited to identifying broad dispersion patterns over time. 

(The EFIs, which have been loosely associated with long-term economic growth, are global in scope and go back to the 1990s; with the availability of 2023 estimates, post-Covid trends can be pinned down more clearly.)

The institutional erosion in China, the Philippines, Thailand, Russia, South Africa, Turkey, Chile and Mexico is particularly striking. This reflects a deterioration in underlying fiscal balances, trade freedoms, property rights and judicial effectiveness. Argentina and Brazil show less erosion, but their scores are persistently low versus their Latin American peers. 

EFIs still remain relatively elevated in many EMEs, suggesting that their overall institutional setup broadly remains growth-supportive. However, the direction of travel is worrisome. If unchecked, this trend would eventually undermine the EMEs’ capacity to generate endogenously driven income growth. 

The magnitude and the speed of the deterioration observed in China, the world’s second largest economy, is particularly concerning. China’s EFI levels are hovering near historic lows, and the extent of the decline since 2020 is unprecedented for any EME. Breaking down China’s EFI score into its component parts shows a broad-based erosion, as our second visualisation shows: 

Proxy sub-indices pertaining to business and financial freedoms, investment conditions, fiscal health, and – crucially – property rights and judicial effectiveness are all in decline. 

This underscores the depth of the structural constraints facing the Chinese economy and the growth challenges it is likely to face in the coming decades. Given its systemic importance for the global economy, China’s deepening institutional weaknesses will also have important repercussions – implying weaker growth for the rest of the world, with other EMEs no exception. 

The broad institutional erosion across emerging markets underscores the pressing need to introduce a new generation of productivity-enhancing structural reforms. The alternative is a world where EMEs will struggle to emulate the strong income growth and convergence of the recent past. 

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