Economics: Emerging markets carry their risks

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The Independent Online
AND SO to Davos, where the clear air and high altitude are meant to provide a perspective on our turbulent world. Even from the world economic forum, with its throng of keen ministers selling the advantages of their countries, the golden scenario for 1990s growth is looking a little tarnished.

The big problem, of course, is Russia, generally the subject of much Western gloom. There are some brave contrarians who maintain that the ejection of Yegor Gaidar and Boris Fyodorov from the government may actually accelerate reforms.

The argument is that the government had delivered nothing, because it was so deadlocked between reformers and conservatives. At least now, it will be able to make slow progress. And if Russia collapses into Weimar-style hyperinflation, the conservatives will get the blame. Reform would then be resurrected.

But there is also a risk that there will be virtually no progress towards a market economy, that the reformers are fatally compromised, and that the next failure causes the Russian people to turn to the populist and dangerous Vladimir Zhirinovsky.

On this view, Weimar degenerates into the the Third Reich - with nuclear weapons.

I have a lot of sympathy with Professor Jeff Sachs's view that the West has brought much of this upon itself by failing adequately to support reform, but that does not help us now. An increase in support as the reformers are on the way out would send entirely the wrong signals.

So it is increasingly likely that one assumption of the last few years - that Russia would gradually develop into a peaceable, democratic neighbour - may have to be revised. If so, the economic consequences for Europe will be profound. The sharp defence savings being made by all western European countries (although least by Britain) will have to be thrown into reverse, particularly since the Asia-leaning President Bill Clinton and a Democrat-controlled Congress will be reluctant to raise the US commitment to Europe's defence. Indeed, the need for an anti-Russian corral may be a new impulsion towards European union.

A Russian relapse may also strengthen the Western commitment to the integration of eastern Europe into the world market economy. If you cannot have a stable and peaceable neighbour, the next best alternative is to have strong and stable buffers in between.

So the failure of the reformers in Russia does not necessarily imperil the eastern European leg of the world's emerging markets - the middle-income developing countries of east Asia, Latin America and eastern Europe. This is another great Davos talking point.

The stupendous performance of most of the non-developed- country stock markets since the beginning of last year - Thailand up 60 per cent, Taiwan up 75 per cent, Hong Kong up 106 per cent and so on, is simply too good to last.

Some of these gains bear the hallmarks of classic speculative bubbles. Some will burst. Malaysia is already down sharply this year.

More may follow when the developed world begins to pull out of recession in earnest, and short- term interest rates start rising in both the US and Europe. So far, the emerging markets have benefited from the hunt after any respectable yield. Only a little of the flood of savings into bonds and Western equities has had to spill into Third World stocks to have a dramatic effect on their price.

Leaving aside this temporary over-enthusiasm, I nevertheless suspect that the underlying capital flows from the developed to the more politically stable middle-income countries are here to stay. There are simply too many factors pulling money that way for the flow to go into reverse.

As Sushil Wadhwani and Mushtaq Shah argue in an interesting paper, ('Emerging Giants, Globalisation and Equities.' Goldman Sachs, London), the collapse of communism, the process of world trade liberalisation and the acceptance of market-based incentives are all likely to boost developing country growth rates. India is shedding its Nehruvian socialism, and even South Africa's ANC is ridding itself of its residual Marxist baggage.

Many of the developing countries do not merely have low wage costs: they have also substantially improved their education. The average number of years of schooling in the Third World has more than doubled from 2.4 years in 1960 to 5.3 years in 1986.

Nor are Third World exports any longer raw commodities: the share of manufactures in developing countries' exports to the industrial world has leapt from 15 per cent to more than half in the last decade. This new competition in labour-intensive manufactures is probably one of the reasons why the low-skilled have failed to participate in the growth of earnings in the US and the UK.

High growth rates in many of the developing countries should not, though, come at the expense of the developed world as a whole. Competition will keep inflation in check, which should allow governments to pursue higher growth. Moreover, the markets for goods from industrial countries will increase rapidly. Growth is rarely a zero-sum gain. So long as governments redistribute some of the gains to the disadvantaged there need be no losers.

The industrial world will also benefit if many of the developing countries become a more reliable repository for its savings. As industrial country populations age, with fewer people of working age to support more elderly, it makes sense to build up claims on younger countries that need capital. If this scenario is right, the world begins to look rather as it did in the three decades before the First World War, a period characterised by a sharp growth in new economies, such as the US, falling prices and a surging interest in overseas investment.

The second chart shows the average net flow of savings between selective economies between 1880 and 1913. (If the current account is in surplus, it is matched by an outflow of savings, if it is in deficit there is an inflow). The size of these flows was gigantic: 4.5 per cent of national income today would represent nearly pounds 30bn a year.

We will certainly not see sustained net flows of that size again. A feature of the late Victorian-Edwardian age that we do not share was the commitment to the fixed exchange rates of the gold standard. Business people believed that there was no currency or macro-economic risk in overseas investment, an age of innocence that we are unlikely to regain except possibly within Europe if we adopt a single currency.

But the opportunities in many developing countries are likely to be too large for big investment institutions to ignore, although they would be well advised to remember the history of past capital flows to the Third World, particularly those that led to the debt crisis of 1982.

If the total capital inflows do not result in a corresponding build-up of useful investment that can earn foreign exchange (either by exporting or by substituting for imports), they will merely end in tears as the country is ultimately unable to provide a return to the foreign investor.

Equity investment and even foreign direct investment rather than bank lending do not remove this risk: instead of defaulting on loans, the country may simply apply foreign exchange controls, allow its currency to fall, or suffer a collapse in its stock market.

The impact on the developing country may not be quite as serious as a prolonged debt work-out, but the overseas investor is unlikely to be much happier.

This brave new world of emerging markets is full of excitement and opportunities. But it also has its dangers.

(Graphs omitted)