Tue, Oct 28, 2008 page9

• The financial crisis is likely to test most developing economies

  • By Gerard Lyons
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  The current attention is on how and whether emerging economies will avoid contagion from the present financial crisis. By the time of next year’s IMF meetings in Turkey, the focus is likely to be on preparing for recovery in 2010. But between now and then, the economic outlook for emerging economies is highly uncertain, with slowdown inevitable and recession possible in the most open economies. After the boom of recent years, the world economy will slow, dampening world trade and taking the heat out of commodity markets.

  Whilst the immediate downside risks to emerging market growth need to be taken seriously, this should not be at the expense of taking a positive view of the longer-term outlook. All the positive factors that have led to strong growth across Asia and other regions in recent years remain in place to deliver stronger future growth.

  One way to view the present situation is that emerging economies are not de-coupled from events in the West, but that they are better insulated than in the past. We have already seen contagion through exports slowing sharply, as equity markets have tumbled and, now, as investment plans and consumer confidence suffers. The deeper the US recession the greater the contagion, but the fall-out will not be as great as it would have been in the past.

  Insulation is likely to be seen in many ways. The shortage of liquidity in the West is in sharp contrast to the ample liquidity seen across many emerging regions, particularly Asia and the Middle East, where savings are high. In fact, one legacy of previous financial crises, most notably in Asia in 1997 to 1998, is that around the world many countries have ensured they would be able to cope with a future crisis.

  Currency reserves are high and there is much room for policy maneuver. Thus, it is important to put the present cyclical downturn in context. Yes, it may be a sharp downturn, as we have already seen with equities and exports slowing and with commodity prices easing. But it should not divert attention from the longer-term upward trend.

  Three features need stressing. First, it is important to appreciate fully the scale and the pace of change on the ground in China. In the West, people understand China is growing strongly, but perhaps it is not fully appreciated just how dramatic this change is. It is evident in terms of China’s impact on commodity markets and on emerging market trade. Intra-Asian trade and trade between Asia and other regions such as Latin America, the Middle East and Africa has grown sharply, often with China at the center. Meanwhile within China, the private sector has been let loose, triggering pent-up spending, although this is still too heavily geared toward investment.

  Second, and equally important, financial markets appear to still underestimate the catch-up potential of a wide array of emerging economies, such as India, Indonesia and Brazil, among others. Huge populations are just one part of the story; So too is the way these economies are leveraging off their domestic resources and at the same time trying to move up the value curve. The West may want to become knowledge-based economies, but so do many countries across the emerging world.

  But third, one should not underestimate the potential volatility of many emerging markets. The trend may be up, but we should anticipate increased volatility along that upward trend. The business cycle has not been abandoned, despite the emergence of India and China. It is this third aspect that warrants particular attention at this time of economic and financial crisis in the West. Many emerging countries do not have the independent policy institutions, or indeed the policy tools that are taken for granted in the West. There has been, and continues to be, significant progress, but this does not lessen the challenges as we have seen increased volatility across financial markets and in capital flows.

  All financial crises are different, but they often share common characteristics, where the outcome descends on the combination among fundamentals, the policy response, and confidence. China, in particular, has ample scope to use fiscal policy as its stock absorber, with the government preparing to spend its surplus if the economy’s investment-fueled growth stalls. India may not have the fiscal ammunition at China’s disposal but its corporate sector, for instance, has enjoyed healthy profit margins and has not placed itself at risk through excessive leverage. Indeed, most Asian economies have resilience from their lack of leverage, with low corporate debt, high household savings and generally low financial leverage. And with inflation worries being replaced by fears over growth, there is also the ability for monetary policy to be more stimulatory. Those defenses are likely to be tested now.

  Gerard Lyons is chief economist and group head of global research at Standard Chartered Bank
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