The Emerging Markets Party.

2007 is increasingly regarded as the year in which the credit crunch commenced, and it also marked the start of a fundamental shift in the balance of the global economy in favor of emerging markets.

For the last 15-20 years, developed economies have enjoyed a period of rising wealth, improving living standards and relative stability. Economic corrections have been comparatively mild and short-lived. This period was underwritten by three factors – low inflation, rapid growth in global trade and a remarkable growth in the availability of cheap debt (disguised as financial innovation).

The sub-prime problems have radically and abruptly reduced the supply of debt. As the oxygen of cheap and abundant debt is withdrawn, a key pillar of support for the economy and equity market disappears. Investors are now looking to the emerging markets of Asia, Eastern Europe and the Middle East for returns.

Emerging markets are being driven by substantial short-term capital flows fleeing developed markets and the U.S. dollar. The Indian and Chinese stock markets are like trompe-l’oeils - paintings designed to deceive the eye. They may provide a dangerous illusion of a modern economy for foreign investors.

Share prices are proned to being influenced by insiders and their associates. In the case of China, most traded shares are in government enterprises that continue to be controlled by the State. Some Chinese shares aren’t even really shares as they don’t convey full ownership rights equally to all shareholders.

The Indian and Chinese markets have been driven by a number of initial public offerings generously priced to provide investors (themselves privileged insiders) with large gains. A few shares contribute disproportionately to market performance. A handful of stocks drove the rise in India’s Sensex Index in late 2007 reflecting the lack of liquidity in many stocks. In China, restrictions on foreign investments by domestic investors and the lack of investment alternatives has contributed to the sharp increase in the price of Chinese stocks. Borrowings by corporations and individual investors have been channeled into the stock market creating dangerous levels of leveraged exposure to share prices.

De-coupling assumes that emerging markets will not be significantly affected by a U.S. slowdown. Exports account are significant for most emerging market economies. Russian and Brazilian growth depends on commodity demand and high commodity prices. A slowdown in the U.S. and Europe will affect growth.

The belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested- tet's a whole lot of crab in my books..! The Indian, Chinese and Russian economies may be capable of becoming self sustaining growth engines but only in the longer term. Their ability to take over from the U.S. as the driver of the global economy in the short run is questionable – after all the Euro zone and Japan have never successfully fulfilled this role.

India and China face infrastructure constraints that will constrain growth. Inflation (higher energy and commodity costs and rising domestic costs) and rising local currency interest rates may slow growth. Both the Indian rupee and Chinese Yuan has appreciated against the U.S.dollar. Currency appreciation attracts capital flows but reduces local currency earnings and the competitive position of exporters.

It's a vicious cycle. Corporate earnings growth in developed countries assumes an increased contribution from sales to rapidly growing emerging markets. Commodity prices and the fortunes of commodity producers are underpinned by the emerging market growth story. A U.S. slowdown will lead to a slowdown in emerging markets which will lead to slowdown in the U.S. - "so, round and round it goes".

Some emerging markets are also dependent upon foreign capital inflows. For example, India is running a trade deficit of around 10% of GDP and a budget deficit of around 3%....Ermm, I am sure you can think of some Asean country very similar to this! This must be financed. To date, this has been financed, in part, by foreign capital – both portfolio investments and foreign direct investment. Changes in global financing conditions may adversely affect India and its growth prospects.

The additional risks of emerging market investments are also not being properly priced in. Enforceability of property rights, good corporate governance, equal access to timely, accurate financial information- like the overly deflated inflation data, deceptive subsidy schemes, corruption and political risks are all being ignored.

The sheer complexity of the global economy and the supporting financial system makes it impossible to know how this will play out. The dynamics of the interplay between global financial markets and the world’s economies may be in the process of fundamental change. Getting on the right side of these changes will shape investment success or failure in the coming years.

Investors need to be prepared for these changes and have the capital to take advantage of these opportunities. Thomas Edison once remarked: "There’s value in disaster. All our mistakes are burned up. Thank God, we can start anew." That wisdom may be more applicable than ever in 2008.