As Arab and Asian states this week threw another multi-billion dollar lifeline to Wall Street, financial markets looked on with a mixture of awe and disbelief at the sheer scale of what is taking place.
Never before has the flow of capital from east to west been so explicit and resounding - nor the apparent might of developing nations so robust. The shift in global financial power would seem profound: last year emerging economies grew four times as fast as their developed world counterparts; and amid one of worst financial crises in recent history, the resilience of emerging markets has been without precedent.
Exports from emerging economies are now almost half of the world’s total, while they consume the bulk of the world's energy and have accounted for four-fifths of the growth in oil demand in the past five years; they also account for three-quarters of global foreign-exchange reserves.
At the same time, despite steadily worsening news from credit markets, investors have continued pouring money into the asset class, spurred on in part by successive Fed rate cuts as well as a belief that fast-growing emerging markets are now relatively immune to a US downturn.
But enthusiasts for the emerging markets fairy tale would do well to tread with caution, as the magnitude of the crisis in developed markets proves, almost by the day, deeper than expected. Moreover, the view that emerging markets have “de-coupled” thanks largely to their own sources of growth has yet to be tested.
The ripples are already starting to be felt – and the downward shift in market expectations for global growth is arguably already underway.
Emerging-market bonds fell this week, sending spreads to their widest in two years, after fresh US data deepened fears of a US recession. The tough credit market conditions also further delayed many new bond sales across emerging markets from Latin America to emerging Europe and Asia, as potential issuers try to wait out the volatility, hoping to find a window of opportunity to price deals.
Emerging market stocks also fell this week to their lowest level in five months, despite a few new listings globally. Although for now foreign money seems likely to continue to pour into emerging equities, if only because valuations still lag so far behind the rest of the world, the situation could well reverse.
But what of the oft-cited fount of hope for the global economy – Asian domestic demand -- and the scope for cash-rich emerging market governments to undertake a phase of pump-priming at home? In reality, domestic demand is still largely subdued outside China, as consumers in many Asian states retain the caution and high savings rates that were the most lasting legacy of the 1997 crisis.
Moreover, in the past decades correlations between Asia and the G3 have, if anything, strengthened, and the potential effects of developed market shocks have become more pronounced, according to an Asian Development Bank study. A 1% fall in US output for two years coupled with a 10% drop in the US dollar against Asian currencies would mean a 2% drop in growth for Asia for two years. Factor in a more severe US downturn and the picture gets steadily worse. Moreover, a US recession that means lower commodity prices could suddenly make the outlook for many emerging economies less rosy.
As to government pump-priming, there are clear reasons for hesitation. On the one hand, vast capital inflows from investors seeking haven from a faltering US economy threaten to inflate asset bubbles, and have already spurred excessive borrowing in much of emerging Europe. On the other, the surge in capital is also putting upward pressure on exchange rates across emerging markets. This is particularly worrisome for current-account debtors, notably Turkey and Hungary, making them even more vulnerable to a quick reversal of capital.
And as central banks in Asia, the Gulf and the CIS persist in holding down their currencies, the build-up of reserves is helping fuel an inflationary spiral that is already gripping many emerging economies, including Russia and China. On top of this, rising commodity, energy and food prices and a falling dollar, to which many emerging market currencies are effectively pegged, are all opening the door to inflation’s sinister return. A slower US economy may ease some of the price pressures due to lower external demand, but expensive food and fuel looks increasingly like a structural phenomenon.
If emerging market governments do try to spend their way out of a global economic downturn, the result may simply store up fresh troubles for further down the road.