2006 was a boom year for emerging markets: The iShares MSCI Emerging Markets Index ( EEM), a proxy for emerging markets worldwide, grew by 22%. Regional markets in Southeast Asia fared better still. The FTSE ASEAN Index, which tracks equities in Indonesia, Malaysia, Philippines, Singapore and Thailand, surged 31% last year, while the Shanghai stock exchange soared by over 125%.

But routine questions over whether this kind of growth is sustainable have taken on more serious tones amid a new round of political instability in Thailand specifically and weakness in emerging markets generally.

Doubts over the sustainability of last year's boom raise the question of whether 2007 is the next 1997, when Thailand's currency devaluation sparked the so-called Asian contagion: bouts of panic-selling in Asian markets that spilled over into other emerging markets and, eventually, developing ones as well.

"What's often forgotten, I think, is that the way we correlate risk in Asia is very high," says Sean Darby, head of Asian strategy at Nomura Holdings in Hong Kong. "We're almost certainly due for a correction this year."

Castor Pang, an equity buy-side strategist at the Hong Kong investment firm Sun Hung Kai, says the effect of Thailand's instability could once again become contagious, at least regionally.

"The situation in Thailand is probably likely to affect the economies nearby, like Malaysia and Indonesia," he says. "Whether the Dow and the Nasdaq can continue an uptrend for the whole year is the major factor which could affect whether Thailand, Singapore and Malaysia keep going up, because of the liquidity impact" if foreign investment pulls out in the region in favor of the relative safety of U.S. indices.

Bulls point out that the key difference between today and 10 years ago is that Asia's "tiger cubs," such as Thailand and Malaysia, are now running big national current account surpluses, meaning there's still plenty of cash for these countries to buy back both local stocks and currencies if things go awry. But the U.S., which ran similar current account surpluses until early 2001, is testament to how quickly funds can run dry in times of political turmoil.

Charles Puntratanamongkol, a prominent Thai entrepreneur and heir to the largest plastics empire in Southeast Asia, is concerned about exactly this. "There's a genuinely strong and credible belief here that the bombs here in Bangkok are politically rather than terrorist motivated," he says. "If that's the case, then I'm worried, because there's no recognizable solution and there's no telling how long this could go on for."

On New Year's Eve, eight bombs went off in central Bangkok, killing three and wounding dozens more. No one has yet claimed responsibility, raising concerns that the explosions were organized by disgruntled supporters of former Prime Minister Thaksin Shinawatre, who has condemned the bombings from Beijing, where he is living in exile. Another theory is that the attacks were planned by Thailand's current military government, which has accused Shinawatre supporters of masterminding the attacks.

The bombings and recent moves by the new government to impose restrictions of withdrawals of foreign investment shocked investors in Thailand, whose main bourse, the SET, has fallen 17% in the past month and is down nearly 70% in the past 12 months.

But heightened political risk is not the only threat to the region. Currency traders fear that if the dollar continues to weaken, the Federal Reserve will take action to shore up the greenback, via rate hikes and/or aggressively buying Treasury and agency securities, resulting in dramatic outflows of capital from the region. Such a scenario could prompt a vicious cycle in the Asian economies, because if asset prices nose-dive, liquidity would also dry up, compounding the effects.

On top of this, inflated asset prices after several years of big gains can lead to swift and painful corrections. For example, China Life Insurance ( LFC) ADRs soared nearly 250% last year but fell more than 8% Tuesday as investors became cautious following the enormous first-day gains of the company's dual listing on the Shanghai stock exchange.

"My personal view is that people's appetite for risk is higher than it was in 1997," says Cliff Quisenberry, who manages $803.42 million for Eaton Vance's emerging markets fund in New York, Parametric Portfolio Associates, which returned 37.18% in 2006. "On the other hand, you get enough of these drips and drabs and people get antsy about emerging markets in general."

Falling commodity prices -- notably crude -- are another big risk to emerging markets such as Russia and Latin America, where local economies have been able to pay down national debt on the back of the 2002-2006 surge in the price of oil. Many investors, especially in Asia, believe it is crude's fall -- not Chavez's comments about nationalizing Venezuela's economy -- that has pulled down emerging markets of late.

On Wednesday, crude futures plunged 3.8% to a 19-month low of $53.53 per barrel in Nymex trading. Partially in reaction, the iShares MSCI Emerging Markets ETF dipped 0.2% to $108.30 after trading as low as $106.54 intraday; the EEM is down nearly 6% since Jan. 3.

Where's the Kobe?

Turning back to Asia, Nomura's Darby sees equities in Indonesia, Malaysia and China as overvalued right now and headed for a fall in 2007. Still, he remains bullish on Asia for the long term because consumption is set to grow and a falling oil price will benefit most countries in the region, all of which are oil importers apart from Malaysia.

But despite strong economic growth in Asia, actual productivity remains lower than pre-1998 levels, says Michael Spencer, chief Asia economist for Deutsche Bank in Hong Kong.

Lack of productivity and unsustainable growth were the key reasons for the Asian market crash in 1997; in a vicious investment cycle, aggressive foreign investment was pushing up asset prices, which in turn was attracting more foreign capital. The only problem was that these assets were producing so little.

"But that doesn't change the fact that it's the fastest-growing area of the world," says Spencer.

That certainly seems to be the view of the big U.S. companies right now, which are showing little concern for the region's vulnerabilities, as evinced by the following, each announced last week:

  • Following up on a 2006 promise to make "significant and growing investments in China," Google (GOOG) is pairing up with China Mobile (CHL), providing exclusive search content to the mobile provider.
  • Milwaukee-based Brady (BRC), which manufactures labels, signs and other security products, is investing in expansions in manufacturing plants in Thailand, Malaysia and India.
  • A division of General Electric (GE) bought 1.39 billion shares in Thailand's Bank of Ayudhya PCL. The conglomerate paid 22.3 billion baht, or $624.5 million, for the 25.4% stake in Thailand's sixth-largest bank.

Additionally, tech giant Cisco ( CSCO) has said it wants 20% of its senior managers working in Bangalore by 2010 at an ambitious architectural project dubbed the "Globalization Center." The company is also investing $50 million in a strategic partnership with China Communication Services and has so far invested $70 million in 30 different China-based start-ups.

"People are investing on the basis that growth in every country in Asia is self-sustaining, which is just not true," says Spencer. "China will slow down this year," he adds, citing a consensus view that there will be a 100-basis-point decline in growth. "In 2007, a lot of questions will be asked about growth dynamics in emerging markets."

Just 10 days into the new year, a lot of those questions are already being asked.
At the time of publication, Daniel M. Harrison held no positions in stocks mentioned.

Harrison is a business journalist specialising in European and emerging markets, in particular Asia. He has an MBA from BI, Norway and a blog at www.theglobalperspective.biz. He lives in New York.

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