- The Washington Times - Thursday, January 29, 2009



As the financial crisis unfolds and deepens, there seems to be an expectation - even a hope - among policy-makers and analysts that, despite globalization, emerging markets have been somehow “decoupled” from the chaos, and will consequently grow sufficiently to prevent what is now a near-global recession from turning into something worse.

This is wishful thinking. The full impact of the current crisis may be delayed somewhat, but barring close attention and action, the effects on emerging markets threaten to be profound and long-lasting.

It is true that emerging markets began the year in reasonably good financial shape. According to a World Bank report published in June, as of the middle of 2007 the foreign exchange reserves at developing countries amounted to $3.2 trillion, just under 25 percent of their combined gross domestic product. The top five countries accounted for 60 percent of the total.

The good news is that those figures undoubtedly swelled during the 12 months ended June 30, 2008; the bad news is that growth in those foreign exchange reserves was almost certainly skewed in favor of oil and commodity-producing countries. For everybody else, the vertiginous increase in food and energy prices was extremely painful.

Needless to say, the steep decline in oil and commodity prices since mid-summer has been a welcome relief. But, on balance, the collapse in equity and debt prices around the world since September has more than offset the benefit of lower food and oil bills.

For much of this decade, private capital inflows - debt and equity - provided the much-needed fuel for growth in emerging markets. Last year, those inflows totaled a record $1 trillion, according to the same World Bank study cited above. The increase marked the fifth straight year of strong gains. The study notes, too, that net bank lending and bond flows have increased from virtually zero in 2002 to 3 percent of developing countries’ GDP in 2007, while net foreign direct and portfolio equity flows have increased from 2.7 percent of GDP to 4.5 percent.

Accompanying the report was a 2008-2009 forecast for private fund flows. At the time, conditions were sufficiently uncertain that the bank’s analysts felt constrained to make two projections.

Under a soft-landing scenario, private fund flows were expected to decline by about 15 percent in 2009 from 2007 levels. Under a hard-landing scenario, private fund inflows were forecast to drop by nearly 50 percent in 2009. Subsequent developments have, however, given new meaning to the phrase “hard landing.” It seems unlikely, for example, that forecasters could have anticipated that by late November stock prices in China, as measured by the Shanghai Composite Index, would have declined by nearly 64 percent as of earlier this month; that equity prices in India would be down by more than 55 percent; or that the Morgan Stanley EAFE world index would be down by nearly 50 percent.

Inevitably, declines of this magnitude have a deleterious effect on investors, whether foreign or domestic. The sight of outright shutdowns at various exchanges - from Russia to Kuwait - at different times during the current crisis only serves to compound the gloom and distrust. The fact that policy-makers in much more mature, market-based economies are scrambling to come up with appropriate answers underscores the extent of the global systemic damage.

Indeed, the simple reality is that, since the crisis began, emerging markets have essentially lost access to capital. At this juncture, it is difficult to predict when, or if, that access will be restored.

In short, the next few years will be a very difficult period for emerging markets. Many governments will likely be tempted to turn their backs on free markets. Not only should this urge be strenuously resisted, but efforts should be re-doubled to integrate local capital markets further into the global financial system. This means the regulatory-reform process needs to continue even as it avoids over-regulation.

At the same time, to the extent possible, regulators in emerging markets need to be pro-active and pre-emptive; they need to know as much or more than market participants do themselves. This will not be an easy task.

With respect to regulation, reports from relevant working committees formed at last month’s Group of 20 meeting in Washington should be a useful source of ideas for policymakers in emerging markets. Those reports are expected to be completed by April.

In the interim, emerging market governments need to do two things: First, make it known in Washington and elsewhere how important the absolute integrity of the credit rating agencies is to their respective countries. Until now, the soundness of sovereign risk analysis at companies like Moody’s and Standard & Poor’s has not been questioned. But in the wake of the AAA-ratings attached to so many mortgage-related products in the United States, questions - and doubts - will now probably be raised.

Second, fiscal stimulus packages will be needed to mitigate the pain of what may be an entire world in recession. Each country will need to tailor its own response. Officials at the International Monetary Fund and the World Bank can provide advice and then help acquire the funding.

Emerging markets need to move quickly in response to this crisis. We have come too far not to continue this journey.

H.E. Shaukat Aziz is the former Prime Minister of Pakistan.

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