Swing in the tail of emerging markets will begin to wag the dog

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The Independent Online
Is the crisis of confidence in many East Asian currencies a re- run of the Mexican debt crisis of 15 years ago with potentially serious impact on the world financial system? Or is it just a blip to help remind us that the world's fastest-growing region will inevitably suffer growing pains.

Even in these days of transcontinental vacationing most people will have had little direct experience of the Thai baht or the Malaysian ringgit. So the plunge of the former and the weakness of the latter will not have had much impact on Briton's travel plans.

But the decision of Thailand to call in the International Monetary Fund yesterday will have pushed the plight of the baht onto more people's radar screens. And there was a certain wry humour to be extracted last week from the denunciation of the financier George Soros by Malaysia's acerbic Prime Minister, Mohamed Mahathir.

The latter called currency speculators "rogues, robbers and brigands", singling out a "certain powerful American financier" as a key culprit - he subsequently confirmed that Mr Soros was indeed the chap he had in mind.

If UK history were a precedent, this could be a strong bull signal for both countries. The rebuilding of fiscal disciple in the UK began with the IMF loan in 1976, and while Mr Soros may indeed have made pounds 2bn from speculating against sterling at the time of its ejection from the ERM, that event also led to the sustained economic recovery of the UK, a recovery which in the markets' eyes justifies the pound at an even higher level against the mark than the level which Mr Soros deemed inappropriate. (Incidentally, if sterling is again too high, why is Mr Soros not selling it?)

If that sounds frivolous, remember that fundamental changes in the market perception of a currency not only occur but frequently repeat themselves at surprisingly short intervals.

Mexico has gone through the cycle of being the darling of the markets, then the disaster, then back again to being the darling twice in the last 20 years.

The Mexican experience is really the better model. Because East Asia has, over the last two decades, been the most successful region in the world in terms of economic growth there is a widespread assumption this performance will continue.

The balance of probability is indeed that it will, but that does not preclude the existence of several shocks, perhaps quite severe ones, on the way. Indeed it would be more surprising if there were no shocks, for in historical terms the last few years have seen unusually even growth in this part of the world.

The graphs show what has been happening to economic growth in the main developing regions over the past quarter century - East Asia, Latin America and Central Asia and the Middle East.

East Asia is interesting not only because it has the fastest average performance, just over 7 per cent a year, but also because the volatility of that growth has decreased.

The 1987/96 period shows a much more even performance than the 1971/86. By contrast growth in the other two regions remains as volatile as ever.

Of course it is possible that there has been a step-change in East Asia's economic performance and that the new stability will become the norm. But there is no necessary reason why this should be so, just as there is no necessary reason to suppose that the business cycle is dead in the developed world.

If that is right, the obvious question is whether the knock-on impact of East Asian currency turmoil will be as serious as that of Latin America. The answer to that depends on whether you are thinking about the world financial system or the world economy.

The present bumps in East Asia differ from the shocks in Latin America in two crucial ways.

First, the region's external debt is largely (not entirely) in the form of equity and direct investments, rather than bank loans. Second, the region is the most vibrant part of the global economy, rather than being a bit of backwater.

It is difficult to generalise about East Asian debt because the situation varies vastly from country to country, but it would be hard to see debt defaults, if and when they occur, threatening the world banking system.

The banks have wised up to that. Instead the difficulties will be reflected in falls in equity markets or a decline in returns from investments in plant and local subsidiaries. It is a problem for equity investors and companies, rather than for banks.

That is disagreeable for investors; but it is not a threat to the world's banks. That does, however, lead to a real concern, which is the medium- term damage to international growth.

The great motor of growth over the next two decades will be what, for want of a better expression, are called the emerging markets. North America is not going to grow very quickly; nor is Europe; nor is Japan. The age profile of these regions (with the partial exception of North America) simply will not generate rapid growth.

In world terms, the bulk of the growth will come from elsewhere, so that around the year 2004 the combined output of the developing countries will exceed that of the developed - though these labels themselves are becoming less and less meaningful.

To maintain this growth will require continuing investment by the developed countries, of which virtually all will come from the private sector. While in one sense it is healthy to remind investors that things can go down as well as up, there is a danger that these flows of funds will dry up. At the moment there has been very little contagion beyond East Asia; but the risk remains.

For the moment the region, while fast-growing, is probably not big enough to destabilise the rest of the world. But as its growth continues, it will come to matter more and more. The problem (for us, not them) is less the fate of the baht and the ringgit; it is more that as these emerging countries have a larger and larger weight in the world, swings in their real economies will increasingly affect our own. As the tails become heavier, they will begin to wag the dog.

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