The world economy is under threat. In spite of better news from some quarters, Europe is in a clear recession that started in the second half of 2011, and the US economy will undergo a fiscal adjustment in excess of 3 per cent of output at the end of this year. China – along with much of the developing world – is in a deceleration phase.

The fear of another crisis is still here and the question is whether anyone can help to alleviate its impact. In this context, emerging markets could have a new and important role to play. Their relative importance in the world economy has increased dramatically. Currently, they represent 50 per cent of global gross domestic product (in purchasing power parity terms) up from only 30 per cent 20 years ago.
These countries now have more room for manoeuvre in the face of a deterioration in economic conditions. Most have adopted sound macroeconomic policies, controlling inflationary pressures and consolidating improved fiscal positions – in contrast to their more developed peers.

Chile, for example, runs fiscal policy according to a structural rule whereby spending is determined by anticipated revenue, which depends on an independent committee’s estimates of the long-term copper price and potential output growth. Fiscal policy is countercyclical, resulting in a surplus in the good times and a deficit in the bad times. The rule has allowed Chile to accumulate more than $20bn (about 9 per cent of GDP) in sovereign wealth funds, most of which can be used in case of significant shocks.

Given their greater room for manoeuvre, the challenge now for emerging economies is to draw up well-structured contingency plans to counteract the pressures coming from the developed world. Most have room for a more expansionary fiscal policy during 2012 and are acting accordingly, as the examples of China, India, Mexico, and Chile demonstrate.

Yet, if things worsen in the global economy, countries should be ready to react quickly. Public investment is a case in point. There are opportunities to expedite investments and to bring forward new projects that have passed the appraisals. It is also possible to have in the toolbox a set of incentives for private investments that may bring more private projects forward.

However, a well-designed contingency plan should go beyond fiscal policy. At its heart, it should include measures promoting flexibility and work incentives in labour markets in order to combat unemployment’s pernicious social effects. Emergency public programmes to employ people directly may be needed, but these programmes also create long-term dependency of workers on low- paying, low-productivity jobs. Temporary incentive schemes for private-sector employment are generally a better option.

Careful monitoring of domestic financial markets is also key to limiting the fallout of a crisis stemming from the developed world. It should be a priority to identify systemic risks and make ready a battery of prudential instruments to provide liquidity to the banking system quickly. These include the timely use of repurchase agreements (“repos”) by the central bank and the auctioning of foreign exchange deposits by the treasury.

It is also essential that countries establish a financial stability council that brings together the main economic decision-makers (including at least the finance minister, central bank president and the heads of banking and security regulation) to monitor financial risks and co-ordinate policy responses.

Authorities must be keenly aware that there is no reasonable response from fiscal policy that may fully counteract a credit crunch, as the recent experience of 2009 shows.

These elements are at the core of the contingency plan we have been designing in Chile during the past few months. At recent meetings with my emerging market colleagues, especially from Latin America, we have discussed the design of contingency programmes that will enable us to respond effectively should the international outlook deteriorate further. In this way, emerging markets can not only help themselves but also help cushion the rest of the global economy. In other words, we now have a clear opportunity to be part of the solution instead of being part of the problem.

By Felipe Larraín, Finance minister of Chile