Stephen King: Chinese and Indians have the strength to withstand shocks

Developed world inflation has risen but the emerging markets shrug their shoulders
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The Independent Online

I'm writing this piece sitting on a plane on the way back from Singapore, following a trip that also took in Beijing, Shanghai and Hong Kong. I've just been reading Jeremy Warner's comments in last Thursday's Independent concerning both the Big Brother household and the strengths and weaknesses of emerging markets. In his view "the excitement that currently surrounds the emerging markets of China and India, though fully justified in some respects, is in danger of becoming overblown". He suggests that the "probable impact of a global slowdown in the developing world [would be] a great deal worse than it will be for us".

I know exactly what he means. Time and again, when the developed world has a bit of an economic hiccup, the developing (or emerging) world goes into freefall. At the end of 1994, after a series of interest rate increases from the Federal Reserve, Mexico found itself unable to attract the hot money inflows which had kept it going through the low interest rate era of the early 1990s. The peso collapsed, interest rates soared, and the economy headed straight into recession. In 1997, after Alan Greenspan had warned of irrational exuberance and the Federal Reserve, once again, had started to raise interest rates, the Thai baht tumbled, triggering a wave of emerging market failures which spread from Asia through to Russia, Brazil and Argentina.

For the developed world, emerging markets acted rather usefully as a global safety valve against inflationary excess. Far better for the emerging economies to collapse, driving global commodity prices down and the dollar up, than for the US or Europe to head into recession. After all, lower commodity prices and a higher dollar meant lower imported inflation into the US, and that, for America, was a good thing, notwithstanding the crises taking place elsewhere.

Admittedly, this is, perhaps, an overly cynical view. It's not so much that US policymakers went out of their way to engineer an emerging markets crisis, but rather that the consequences of the crises that followed US interest rate increases - or, in some cases, the fear of US rate increases - were often rather good news for the United States. I'd argue, for example, that the late 1990s economic boom in the US was only possible because of the deflationary effects that stemmed from the Asian crisis: the US was able to grow strongly without encountering the usual inflationary upsurge.

I wonder, though, whether things are changing. There are, for example, two good, long-term, structural reasons behind the recent success of emerging markets, China and India included. Using the broadest of canvases, I'd cite first of all the change in political relationships following both Deng Xiaoping's rapprochement with the West and, in addition, the collapse of the Soviet Union (which forced a reappraisal of India's relationship with the developed world). Secondly, I'd emphasise the information technology revolution. Put these two together and you have a recipe for heightened flows of capital into emerging markets.

Beyond these structural themes, though, there's a new mental toughness displayed by emerging market policymakers that was never there in the 1990s. US politicians may complain about ever-rising current account surpluses in emerging markets (the main culprits are the Middle East, China and Russia), but these surpluses are the source of ever-rising foreign exchange reserves. It's as if policymakers in emerging markets look back at the dark days of the 1990s when deficits were large and economies were entirely dependent on hot money flows and say, with a Churchillian quaver, "Never again." These surpluses and reserves have already proved their worth: after two years of US interest rate increases, emerging markets have continued to flourish, an obvious dislocation from earlier, more traumatic, experiences. Only the very brave currency speculator is likely to take on a well-performing emerging market these days.

Emerging market policymakers have also taken a leaf out of the anti-inflationary books of Western central banks. If anything, emerging market inflationary performance has, in recent years, been superior to that of the US, UK and other merchants of price stability. While emerging market inflation rates are still higher than those in the developed world, there's been no increase in emerging market inflation in recent years. Sadly, the US and the UK cannot offer such an impressive performance. Good inflation performance has allowed many emerging markets to issue debt in their own currencies rather than in dollars, thereby reducing their vulnerability to sudden and unexpected currency moves.

Put another way, shocks that previously would have all too often tripped up the typical emerging market have proved to be mostly irrelevant. US interest rates have gone up, but emerging markets don't care. Developed world inflation has risen, but emerging market policymakers have shrugged their shoulders and said, "So what?"

China has been saying "So what?" for longer than most. It's not difficult to see why. At the time of the 1997 Asian crisis, supposedly wise pundits argued that China would face an economic meltdown unless it devalued the renminbi in order to restore levels of competitiveness lost following the collapse of other Asian currencies. There was no devaluation, and there was no meltdown. After the 2000 stock market crash and 2001 US recession, China was again supposedly in big trouble. Once again though, China's economic resilience shone through.

Many Western commentators feel uncomfortable with these conclusions. China, they say, is undemocratic, has scant regard for property rights, and cheats by deliberately manipulating its exchange rate to gain a competitive advantage which, in turn, destroys jobs in the US and Europe. China, they add, also misallocates capital, wasting its money on trophy projects. (Shanghai's magnetic levitation train springs to mind. I wonder, though, what China's critics would make of the structure formerly known as the Millennium Dome.)

Some of this may be true. When it comes to economic growth, though, I'm not sure how much of it is relevant. After all, Japan failed to allocate capital appropriately for decade after decade, yet Japanese living standards today are far higher than they were in the 1950s. The same is true of Germany, France and South Korea, all of whom grew quickly in the 1950s or 1960s yet paid scant regard to the requirements of "efficient markets". Countries grow quickly for all sorts of reasons (in China's case, the removal of political shackles preventing contact with the rest of the world has doubtless been an instrumental factor). Free market models of efficient capital allocation with bountiful rewards for shareholders - and I accept this is a heretical comment - may only work in special cases, notably when a developing economy catches up economically with its developed neighbours, as Japan discovered in the 1990s.

If economies really are emerging, we'd better get used to the idea that, over time, their economic muscle will increase. Yes, there may be the occasional slip-up on the way. I agree with Hamish McRae, also writing in Thursday's Independent, that India, for example, is showing signs of overheating which may, in time, require a corrective dose of monetary tightening to engineer an economic slowdown. Ultimately, though, emerging markets deserve to emerge. Gordon Brown is absolutely right to talk about reforms to international institutions that will take the Chinese and Indians seriously. While he's at it, perhaps he should also encourage the Big Brother housemates to do the same.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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