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Economic Forecasts

Why Emerging Markets Must Use Caution

Countries with rapidly growing economies need to act soon to keep prices under control.

Emerging markets that weathered the recession face a new test: Inflation. In part, the dilemma reflects the growth of the middle classes in these countries. That’s boosting domestic demand, a welcome trend both for the developing economies themselves and for U.S. exporters. But it also suggests that, having loosened fiscal and monetary policy to stave off disaster, the governments and central banks of such countries must tighten both.

“The risk is that central banks don’t get ahead of inflation. Then you get a bubble,” says Michel Leonard, senior vice president and chief economist for Alliant Insurance, a Blackstone Group company. Bubbles inevitably burst. At the least, that dries up fresh investment. If capital can move freely in and out of the country, however, investors may seek safer havens for their cash abroad. Instead of slumping, the economy crashes. While all this is goes on, the cost of living for workers outpaces pay increases, prompting food shortages and civil unrest.

Foreign investment also plays a role. The average exposure to emerging markets of institutional investors remains low, about 10%-17%. Subpar growth in the U.S. and Europe is driving them to increase their exposure to riskier countries that offer higher potential returns. As foreign investment in such economies rises, their currencies appreciate. Leonard sees this situation as unsustainable. “I’ve never seen currency appreciating and high inflation,” he says. “It doesn’t happen. That bodes ill for those bondholders.”

Countries that undertook significant economic reforms over the last two decades should stay in fairly good shape. The Central Bank of Brazil and the Reserve Bank of India, for example, are already ratcheting up interest rates to rein in prices.

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By contrast, the Philippines and Malaysia are both prime candidates for trouble. Venezuela is in for even worse pain. Its consumer price index topped 30% even before the 2008 financial crisis. Efforts to rein in inflation by revaluing the bolivar and toughening capital controls merely encouraged the growth of a black market in U.S. dollars. The police crackdown now under way on the black market will make it that much tougher for ordinary Venezuelans to obtain the necessities of life. President Hugo Chávez will use this as reason for ever-greater government intervention in the economy, a cycle he’ll continue as long as Venezuela’s oil revenue allows him to do so.

China is something of a special case. Its strict financial and currency controls will help it avert the worst case scenario of capital flight. It also has strong deflationary forces in play, courtesy of excessive investment in heavy industry and resulting overcapacity. But factories aren’t the only buildings attracting money. Real estate markets in Chinese cities have grown so hot that Beijing fears a meltdown. Central government restrictions on fresh bank lending for construction will help, but its efforts to steer to what for China is a soft landing will be nerve-racking.