Role of Markets and Governments in managing the growth in Emerging/Developing Economies

Sun, Jun 19, 2011

Biz Arena, In Focus


Through this paper, I aim to bring into perspective the role of markets and governments in initiating, promoting and sustaining growth in these emerging economies. The close coordination of the various forces which shape an emerging economy requires better understanding to appreciate the dynamicity and core growth equations behind the success story of emerging economies. Through this study, we may be able to better understand their deep interplay as well as the intrinsic challenges they face.

The 2nd part in this 3 part series covers the role of Markets as growth drivers in Emerging economies while the final part of the series next issue will deal with the counter-balancing forces.

Role of Markets as a Growth Engine

Price Discovery – Economists have traditionally believed that there exists an invisible hand in a free market based economy, which bring a state of equilibrium in market and this in-turn result in price discovery. Advocates of the free market form of economy argue that price discovery is a natural process that ensures fair, accurate, and responsive pricing. The essential philosophy of price discovery is that firms maximize their profit and consumers maximize their benefits. The preconditions for price discovery to happen are the presence of a large number of buyers and sellers, absence of any buyer/seller having absolute power to influence the market and absence of any form of information asymmetry among the parties involved. This concept of price discovery is the most intrinsic feature of a free market based economy. The mechanism of price discovery ensures that there is an unbiased way to determine the intrinsic value of any good in the market. Through the presence of a large number of buyers and sellers, the continuous exchange of goods enables all parties involved to obtain the best value with minimal inaccuracies. This technically ensures that skewed pricing schemes or incorrect valuation is not followed and every product has a constantly varying price affected by its quality and the nature of its demand. This dynamicity brings out the competitive forces in the market and ensures that innovation is always at the forefront of any industry policy.

Foreign Investment Opportunities – A major attraction of following free market policies is its ability to attract foreign investors into funding growth and development projects in the country. Foreign investors and angel investors generally look for high growth opportunities to invest their money in as seen by the increasing FII and FDI inflows into India (see Chart 1). With the maturity of developed markets and flat growth seen in such economies, these developed countries divert large sums of money into such emerging investment locations offering higher growth rates. The only caveat is the added risk introduced into their investment profile. For this reason, such investment vehicles generally prefer politically stable and economically progressive countries which have transparent policies and lower regulations on investments. Such foreign investments are crucial for augmenting the government spending on key sectors like education, healthcare, infrastructure, natural resources. India recently made news when FII inflows crossed the magical figure of Rs. 1 Lakh Crore which reinforced the confidence of foreign funds on the robustness of the Indian markets and its capability to sustain high growth with balanced policy (see Chart 2).

Chart 1

Chart 1

Chart 1

Data Source: Department of Industrial Policy & Promotion, Govt. of India
* Data for FY10 is for the first 11 months – Apr. 2009-Feb. 2010

Chart 2

Chart 2

Chart 2

Data shows the Total FII Inflows of 2010 which went beyond Rs. 1 Lakh Crore

However, a word of caution must be added to this rosy picture. The basic premise of foreign investment into emerging economies is to capitalize on the high growth rates offered. Hence, this funding is primarily profit seeking in its nature. An over dependence on these inflows would leave a country in a sensitive position where a slight destability may lead to huge outflows of investment. The onus is firmly on these emerging countries to establish and maintain a stable environment conducive for investment and presenting a balanced picture of sustainable growth. There are many instances of economies encountering pricing bubbles and speculative trading on the back of erratic foreign investments. So not only is it essential that investment is attracted, but regulations must also be made to limit these inflows to ensure sustainable growth. The inflationary tendencies of the economy as well as the speculative valuation of stocks on the back of FII and FDI inflows are well documented and hence need extra caution to be exercised.

Growth in GDP – Gross Domestic Product or GDP is a primary measure of the vitality of an economy as it conveys the dollar value of all the goods and services produced by that country over a specified period of time. As can be clearly seen, a robust and dynamic market can spur growth in the investment in private industries which in turn helps fund their growth plans. The highly capital intensive nature of heavy industries and core sectors requires heavy investments and this is where markets come into the picture. Through the stock markets as well as foreign investment vehicles, industries gain the capital required to pursue high growth strategies and scale up their businesses. This in turn results in increased production of goods and services and hence a robust GDP growth. As seen in Chart 3, the promising growth of emerging economies such as India and China is set to outstrip Western countries and sustain at much higher rates as per independent estimates.

Chart 3

Chart 3

Chart 3

Data shows the projections of the Real GDP growth of the major economies of today based on growth rates and figures taken historically.

Rise of the Consumer – The market structure promotes transparency of pricing, infusion of cash for growth initiatives and provides competitively priced technologically superior products in the hands of the consumers. In addition to this, the growth impetus provided by market economies results in huge employment opportunities resulting in increased per capita income. This increased income thus boosts consumer spending and helps in developing high growth markets internally. The presence of large number of competitive firms in every sphere helps shift the power into the hands of the consumer and empowers him to make informed decisions. Consumer spending accounts for nearly 60% of the total GDP of United States of America and international trends show the importance of a strong local consumer demand to ensure robust growth patterns.

As we have seen above, there are numerous benefits of an open economy which triggers and sustains high  growth in an economy. However, an area of concern is the formation of asset and valuation bubbles due to large inflows of investments. Since emerging economies are currently riding high on consumer sentiments, FIIs and FDIs are reaching unprecedented levels. This is primarily backed by strong short term profit making interests. An uncontrolled free market structure can result in valuation bubbles which are basically high valuations built on weak fundamentals. Preventive measures for such scenarios require a strong presence of regulatory authorities and balancing policy shifts to ensure that growth is balanced and sustainable.

Part 3 concludes next issue with the counter balancing forces of government policy needed to stabilize and drive emerging economies into a progressive future.

Nabarun Sengupta

Master in Business Administration(2010-2012)

IIT Kanpur

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