By Mohamed El-Erian * A year ago, only a few people expected that the crisis brewing in Asia would not only economically destabilise that region but would spread with ferocity to Russia and threaten Latin America. Even fewer believed that industrial countries would also be affected, resulting in a slowdown of economic growth. Oil prices were not expected to collapse to nominal levels not seen since the mid-1980s and to inflation-adjusted levels below those prevailing in 1973 -- before the first oil shock. Finally, very few predicted sharp losses for Western financial institutions, with a major hedge fund, Long-Term Capital Management, having to be rescued. All this happened in 1998 because of the emerging market crisis. Indeed, it is a year to remember. Like a severe earthquake, it shook almost all countries and markets in the world. For some economies with weak foundations, the result was a collapse in the financial system (e.g., Russia); for others, it was significant cracks and splinters, risking of further damage (e.g., Latin America); and for a third group, it was only a light tremor (e.g., Egypt). But for all, there is a need to assess the broader implications of the 1998 emerging market earthquake, deal with a series of 1999 aftershocks and guard against the risk of damage from future upheavals. The origin of the 1998 emerging market crisis was poor economic conditions. This was most evident in certain Asian economies and in Russia. But these poor economic conditions do not explain the ferocity of the crisis. It is the interaction with "poor market technicals" which accounts for the massive scale of the earthquake. When investors are highly leveraged (that is, have borrowed heavily to buy), a sharp fall in the price of a security can cause a rush for liquidity. This results in an indiscriminate disposal of other securities. Thus, investors sell regardless of the underlying values, because they are forced to get liquidity. Indeed, this was the dominant theme in the international financial system after the August default by Russia on its domestic debt. With many sellers of existing debt and very few buyers, there has been only limited appetite in the market for new emerging market debt issuance. As a result, countries having to borrow to finance their deficits are finding market access very difficult, if not impossible. Instead, they are having to tighten their belts domestically. Some are in a position to do so in an orderly fashion. Others will find it more difficult. It is for this reason that the world economy as a whole is facing two alternatives for 1999: either slower economic growth or slower economic growth and a renewed phase of financial disruption. Recognising this, industrial countries have been rapidly lowering their interest rates. This will continue in 1999 in the United States. There is now the recognition that domestic policy actions alone will not suffice. There is also a need for stronger international policy actions. Accordingly, there will be further efforts in 1999 to strengthen the international financial architecture. Meanwhile, the lower global demand will mean that, in the absence of a very cold winter or supply disruptions, international oil prices will languish. These factors are "day one" issues for the more vulnerable emerging economies such as Brazil and Venezuela. At the other extreme, they also serve to accentuate the attractiveness of countries which have not been significantly disrupted by the emerging market earthquake. These countries -- such as Egypt, Hungary and Poland -- have earned "low correlation" characteristics which protect them from global instability: high international reserves, low short-term debt, solid fiscal positions, little exposure to the main areas of systemic risks and already covered international funding needs. The rapid decline of emerging east Asia from "miracle countries" to "crisis countries" is also serving as an important reminder that the country differentiation of today cannot be taken for granted tomorrow. Thus, as noted earlier, all countries are having to draw lessons from the 1998 earthquake, guard against negative aftershocks and reduce exposure to disruptions from future earthquakes. The common denominator here has two elements: first, increasing domestic and regional savings so that these can serve reliably as shock absorbers in the context of fluid international conditions; second, taking advantage of the opportunities offered by the international capital markets while minimising the risk by maintaining solid domestic economic conditions and sound supervision and regulation of the domestic financial system. Progress on these fundamental domestic policy issues will ensure that countries are well equipped to continue growing in the context of a fluid international environment. Meanwhile, progress on international policy issues aimed at enhancing both crisis prevention and crisis management will help minimise the more disruptive and unpredictable nature of the international financial system. As we enter the new year, we all need to keep a careful eye on both sets of issues. Hopefully, with progress on both, in a year's time we will be looking back at 1999 for all its positive developments rather than remembering 1998 for all the disruptions and chaos. *The writer is managing director of Citigroup and chairman of the London-based Arab Bankers Association.
