Emergency in emerging markets?

Just a few months ago, it seemed that emerging markets could do no wrong.

China, India and other Asia Pacific economies kept their high-growth stories and their reputations for reasonably sound macroeconomic management intact, while the US and Europe lost credibility and hundreds of billions of dollars dealing with the fallout of palpable regulatory failures. The Middle East, meanwhile, was cushioned from the full impact of the global crisis by buoyant oil prices and reserves of capital that ran, if anything, deeper than their oil wells. The baton of global economic leadership seemed to be passing inexorably eastwards, as the G20 became the new venue for international economic management, and the US lost its unilateral status as the sole economic, as well as political and military, superpower.

Now, though, the risk/reward calculations that were swinging ever more in favor of the world’s developing economies and away from the once-bluechip markets of the West have evidently been thrown into disarray once again, as the ripples from Dubai’s potential semi-sovereign debt defaults spread ever wider. As Dubai announced that it would seek a standstill agreement on up to $60 billion of debt owed by Dubai World, its major investment consortium, global markets reeled, with heavy selling in the US, Europe and Asia. Banks in particular sought to reassure unconvinced investors, still wary of billions of dollars of undeclared liabilities still extant in the financial system, that they were only minimally exposed to the potential debt default. Nakheel, Dubai World’s property arm, saw its sukuk bond prices collapse.

However, Dubai may turn out to be a storm in a teacup compared to a potentially greater emerging markets hazard. In any case, the other Gulf emirates do not appear to have been infected by the instability in their oil-poor neighbor, and have the funds to prop up its failing institutions as investors of last resort. The larger and potentially far more serious macroeconomic emerging markets risk, as detailed at length by Dr. Jim Walker later in this issue, is China.

China’s strong performance throughout 2008-09, sustaining its growth and apparently avoiding major destabilizing changes to its industrial base, has been driven by government-led stimulus initiatives, as almost all commentators acknowledge. The stimulus measures have been easing the pain of an export sector threatened by a permanent secular collapse of demand from the West – demand that hitherto has powered the prosperity of China and most of the other growth economies of Asia. Now, evidence is accumulating that the stimulus packages, rather than supporting a transition away from export dependence on the West to a broader model that includes intra-Asian trade, but above all focuses on unleashing domestic demand, has simply been used to build up excess capacity to target the same old buyers.

A recent European Chamber of Commerce in China report identified at least six major industrial sectors where capacity utilization in China was running at under 85%, and in some cases below 70%. Yet more new capacity is coming onstream soon as a result of the stimulus initatives, with no demand to match. This could induce more stresses in the global trading system, but it also skews China still further towards an unsustainable export-dependent model. China’s leaders, meanwhile, appear content to let its pump-priming capital flow to state-connected enterprises, rather than making the welfare and other domestic reforms needed to support PRC consumers.

Japan and Korea, the other East Asian economies, have also pursued development models that push resources and priorities towards corporations rather than individuals. The long-term result can be seen in Japan’s stagnant economy and shrinking population. In China, the consequences could be far more serious. The growth economy once touted as ready to pull the world out of recession might overbalance and crumble in a fashion that would make Dubai’s current collapse, also exacerbated by an unaccountable government, look like a child’s sandcastle in comparison.