The Storm Clouds Spread

Many developing countries were fortunate to enter this crisis in relatively strong shape. They had large holdings of international reserves, limited leverage and relatively low indebtedness. Policy flexibility was also considerable, as reflected in the ability to prudently use monetary and fiscal policy in a countercyclical manner. And internal consumption was picking up momentum.

The robust initial conditions have served to partially insulate the developing world from the effects of the global financial crisis that most observers rightly classify as the worst since the 1930s. Contrary to what would be expected on the basis of the experience of the past 30 years, there has been no dramatic collapse in growth and consumption; widespread defaults have not materialized; and many governments retain their core policy credibility.

Developing-country governments should, in general, feel good, given the ongoing turns in policy reactions in the U.S. and other industrial countries. Yet there is no room for relaxation and complacency.

The short-term outlook remains treacherous, as a good chunk of the strong capital position of these markets is now being eroded by the crisis. Accordingly, governments should not relax their cautious stance, lest they fall victim to the vagaries of what still is an unpredictable and fast-moving global crisis. In today's world, you certainly do not want to come anywhere near running out of cash at a time when virtually no one is lending.

What's more, the favorable initial conditions will provide little comfort for emerging-market equity investors. The long-term story in these markets may still look good, but investors are sitting on large losses now. Why? In major global dislocations like the one we are experiencing, fundamental drivers of value get totally overwhelmed by "technicals." Foreign investors, facing large losses at home, all scramble to repatriate their funds at the same time. The emerging-market equity door is simply not big enough to accommodate them all without a large and disorderly decline in prices.

Provided they are sufficiently liquid and that their portfolios are not overly concentrated, investors should think twice before joining this stampede. As a rule, long-term value investors should not become distressed sellers on account of technical factors alone. They should be guided primarily by their views on fundamentals, which will once again assert themselves over time. Moreover, help is on the way. Emerging markets will be aided, albeit neither immediately nor smoothly, by the aggressive policy decisions now being taken in industrial countries.

El-Erian, co-CEO of bond specialist PIMCO, is author of “When Markets Collide: Investment Strategies for an Era of Global Economic Change.”

© 2008