Even before the terrorist attack on New York emerging markets were having another bad year, with a crisis in Argentina, a 50% devaluation of the Turkish lira and the dramatic collapse of Asian exports. Once concerned about limiting the investment of "hot money", emerging markets are now looking to boost capital flows into their economies.
Until September 11, many analysts had been able to find crumbs of comfort in emerging market developments this year. Investors had become much more discriminating, which helped prevent the problems of particular countries being transmitted to the whole group of emerging markets - so-called "contagion" - as happened so often in the past.
Several countries - China, India, Russia, Hungary, Ecuador - had continued to grow strongly despite the global economic slowdown. Many dedicated emerging markets investors were even predicting a big recovery next year in the financial asset prices of these countries. Such investors are, of course, congenitally optimistic. There was always much that could go wrong in such upbeat predictions. Now it has.
Any broad upswing in the developing countries hinges critically on a now-questionable recovery in the US economy, the main global locomotive. If the US experiences a prolonged recession, it will badly hurt Latin America and much of Asia. And, if an Argentinian debt default hits investor confidence in Brazil, this will be very bad for emerging markets. It will, however, be a few weeks before it is clear how long recovery in the US economy is likely to be delayed by the terrorist attack.
In line with many other economic forecasters, Lewis Alexander, global head of emerging markets at Salomon Smith Barney in New York, was predicting that the US economy would start to pick up in the fourth quarter of this year. Most analysts were also betting that Argentina could avoid an outright default, and that some kind of voluntary restructuring of the country's debt could be worked out.
At best, US recovery has now been pushed back until early next year. At worst, the world could be facing a prolonged recession. If there is now a flight to quality by investors, as seems likely, this will bring back contagion, as one emerging market after another is affected. The countries most at risk are those with large financing requirements, says Konrad Reuss, managing director for sovereign ratings at Standard & Poor's rating agency in London. He cites Turkey, Lebanon and Argentina as the most vulnerable.
However, some emerging markets analysts remain bullish. Arnab Banerji, chief investment officer at Foreign & Colonial fund managers in London, still sees a moderate rally in the US by the first quarter of next year and "a violent rally in emerging markets" early in 2002. "These equity markets are very cheap. And there is no more capital to flow out. It has all been withdrawn," he says.
His is not a lone voice. Rupert Rucker, product specialist for emerging markets at fund managers West AM, in London, says: "There is a big re-rating coming in these developing country stock markets. They are so depressed. Most of the problems have been discounted." It would only need a relatively modest global economic recovery to produce such a bullish outcome, according to the more upbeat fund managers.
At the macroeconomic level, however, the outlook has certainly darkened. Forecast average growth in the emerging market countries this year had already been revised down sharply this summer by Salomon's Alexander to 2.6% (previously 4.9%). For 2002, the growth predicted was revised to 4.2% (5.6% previously). But this assumed 3% US expansion. "Modest 2% to 3% US growth is fine. That is all that is needed to boost developing country exports," argues Banerji. More importantly, it will encourage some investors to rotate capital out of the US, where only a limited stock market rally can be expected, and into emerging …