Growth In The Rearview Mirror

Now Western banks in some regions are drawing down cash balances at their emerging-market subsidiaries, driven by a need to shrink the size of their balance sheets at home. The global liquidity tap has in effect been suddenly turned off, leaving several emerging-market companies high and dry.

The fundamental problem with the growth model of many emerging markets stands exposed. These economies rely too heavily on foreign capital to fund their growth, leaving them vulnerable to global boom-bust cycles. Similar droughts hit developing economies in the late 1980s following the U.S. savings-and-loans banking crisis and then again at the beginning of this decade when the dotcom bubble burst.

The problem is not one of low savings. Savings rates in East Asia were high before the crisis in 1997–98, and many emerging markets even now have a large savings pool. The issue is ineffective credit systems that can't put those savings to good use. The reduced availability of foreign capital in the coming years will hopefully set the stage for a change in the growth model to one that depends more on domestic rather than foreign savings. For now, emerging markets will have to deal with the harsh reality that their blockbuster growth over the past few years was a liquidity mirage.

Average growth of developing countries is likely to revert to the 1980–2002 pace of 3.5 to 4 percent for the foreseeable future. That is not too bad at a time when the United States and much of the developed world, hobbled by the ball and chain of high indebtedness, face an extended period of sub-par growth. This sluggishness in the West should increase the relative appeal of investing in emerging markets, particularly in contrast to the 1980s and '90s, when the U.S. was growing at 3 percent—nearly as fast as the developing world—and looked much less risky.

Emerging markets have then achieved at least some sort of decoupling. Trade links are not as strong with the developed world; developing countries currently trade more among themselves than with the United States. Still, recent events show how crucial foreign capital was in lifting growth in the developing world. The broader implication of the radically changed environment for capital flows, with major Western financial institutions firmly in deleveraging mode, is that the golden era of high economic growth that spanned five years from 2003 to'07 is now over. Growth expectations for emerging markets need to be reset to pre-2003 levels.

Sharma is head of emerging markets at Morgan Stanley Investment Management.

© 2008