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Pursuits of Stability By Avinash Persaud |
Janaury 2002: The crisis in Argentina has diverted attention from a crisis brewing in South Africa and another at the heart of international economic policy.
Since July, the South African rand has fallen a staggering 40% - which is as much as the Argentine currency is expected to fall. Some of those who remember the speed with which financial contagion spread around the world from Thailand on 7 July 1997 to Brazil on 15 January 1999 have wondered why there has not been more contagion this time around. But the keys to contagion are surprise and leverage. Unlike what happened in Russia on August 17 1998, the Argentine default on its dollar denominated debt was not a surprise and the level of overseas investor positions and leverage in emerging markets is so small currently as to be a source of concern itself.
There is clearly heightened concern over the health of the international financial system today and this, along with instability in Zimbabwe and despair over South Africa's prospects for growth, has conspired against the rand.
The importance of the rand's collapse alongside the unraveling of the Argentine currency board is that both South Africa and Argentina were hailed as icons of virtue in macro-economic policy-making less than eighteen months ago. These emerging economies pursued the kind of macro-economic objectives more common to industrial economies; Argentina brought inflation down to a grinding halt, and South Africa kept a check on public-sector finances despite many worthy demands on the public purse. But this virtue has been sorely unrewarded. Macro-economic stability and market liberalisation did not prove to be catalysts of growth or beacons for foreign investment and in the long-run, the absence of growth makes almost any policy unsustainable. This sorry tale will cause other countries to pause in their pursuit of macro-economic stability. While no one would argue against macro-economic stability, it has become palpably clear that while it is a necessary condition of economic growth, it is far from a sufficient condition. Worse still, the example of South Africa and Argentina suggests that the overarching pursuit of macro-economic stability may at times undermine those factors which are critical to growth.
It was hoped that by reducing risk and uncertainty, macro-economic stability would bring a flood of foreign money and a domestic investment boom that would offset the initial drag on growth that would come from the economic adjustment. There are two reasons why this did not occur. After the financial traumas of the Asian crisis and the LTCM debacle and given the increasing reliance on historic and market measures of risk and the attractiveness of technology investments in developed countries in recent years, investors had diminished appetite for emerging markets as an asset class whatever the policies being pursued. According to State Street's custodial data, whereas 27 major emerging markets received a net equity inflow from overseas investors in 1996, just 6 did in 2000. The way the international financial system opens and shuts for emerging markets needs addressing, but it is possible that in another set of circumstances the same policies may have been rewarded with more capital inflows.
But there is also a more systemic problem in that even when macro-economic stability has been achieved, investments in emerging markets still carry substantial risks relating to the enforcement of property rights to political and policy stability and even security. Developments related to the September 11 tragedy have highlighted security risks in the a large number of countries previously considered low-risk, such as India.
Consequently, the moderation of growth from economic adjustment is not fully offset by the moderation in risks. Lower growth coupled with lower but still high risks is unappetising for investors. Some of these risks are more perceived than real, but in financial markets perceptions are sometimes more important than reality.
It is important that we learn the right lessons from the current misery of ordinary Argentines and South Africans; perhaps this episode could even help to define a new approach to international economic policy and international investing. Where a country is on the verge of hyperinflation and default there is no substitute for the restoration of some stability.
But once conditions have reached less precipitous levels, it should be recognised that emerging markets cannot easily remove perceptions of risk overnight and trying to do so through rigid policy frameworks may be counter-productive. The pursuit of stability should be seen as a longer-term and more comprehensive objective (i.e. including the legal and political background). Laying the foundations for growth , on the other hand, should become the main focus of policy once a country is no longer bordering on instability. This requires governments to actively support the three key ingredients of growth in the modern era: knowledge, internal connectivity and external orientation, and stable and transparent property rights. These will be the touchstones of investment value not rigid policy rules such as currency boards and fiscal straight jackets.
While the financial markets are sometimes closed to emerging markets and developing countries, across time and countries investors have shown themselves ready to take the gamble where risks are high, but counterbalanced by the potential for high returns.
The author is a managing director at Ebgland's State Street, a member of the Council of the Overseas Development Institute and a visiting scholar at the International Monetary Fund.