The elephant and the dragon

Sometimes the repayment costs become too great. Individuals and companies can declare bankruptcy and either liquidate their assets to repay their lenders or restructure their affairs. Countries, though, cannot declare bankruptcy. They just stop paying their lenders, and default on their debts. Such national, or sovereign, defaults are quite common. For example, a case today in front of the law courts in New York concerns a default by Argentina in 2001. The financial institutions that lent to Argentina before the country defaulted want their money back.

When the Fed decided to reverse its easy money policy, the impact around the world was bound to be important. As the prospective return on dollar investments rises, investors consider buying financial securities in US dollars. To buy dollars, they sell currencies that appear relatively risky or offer low returns.

India imports more than it exports and runs a large deficit on its account with the rest of the world. This current spending deficit means that each year India has to import capital from overseas to balance its foreign accounts. The Indian capital requirement for the next 12 months is estimated at $250 billion, only a little less than the country holds in foreign reserves in its central bank. In good times, this situation would not cause serious alarm, but two current factors make India's situation worse: the nervousness of the world's financial markets, which hate uncertainty, and, within India, the inefficiency of the government and falling economic growth. With a relatively young and dynamic labor force and with the advantage of the English language, much has been expected of India, the "I" in BRICS. But badly needed economic reform has not happened, and the Indian government has failed to break its bad habits of political infighting and corruption.

Will India's crisis affect other emerging countries, like China? Changes in the external value of a traded currency are a good indicator of confidence in a country. We can see that since June, when the Fed started to signal its policy change, a crisis of confidence has affected most emerging markets. Since June 30 the Thai baht has fallen 5.5 percent and the Malaysian ringgit 7.5 percent, against a fall in the Indian rupee of more than 15 percent. Over the same time the Chinese yuan is down less than 2 percent.

Like India, China's economic growth rate has fallen. As in India, questions are being asked about China's real appetite for economic reform as well as the off-balance sheet debt Chinese local governments have incurred and how this debt, when it goes bad, will affect China's banks. But in other ways China's position is very different to India's. China runs a big surplus on its trading with the rest of the world, its foreign exchange reserves are very large, its foreign debt is low, and its currency is still only partly convertible into other major currencies. China's strong economic record since 1980 has given it credit with the markets. At a time of crisis the markets sell India, but give China the benefit of the doubt.

China should be happy, indeed proud, that, at a time of rising tension in the financial markets, its currency still trades near its highs against the world's strongest currencies, such as the Swiss franc and the Norwegian kroner. But given China's strong external financial position and the recent history of a strong yuan, the fact that the Chinese currency has not fallen at all since June is a warning of potential trouble ahead. As the yield on US Treasury bonds continues to rise, investors will go on selling securities in countries where they feel less comfortable and confident. India heads the list of these countries because, with large current account and budget deficits, inflation around 7 percent, and falling growth, it has failed to inspire the confidence of international investors.

At present, China's strong external position and partly closed currency enable it to weather comfortably the storms emanating from US monetary tightening. Before long, though, the markets will begin to wonder about future Chinese growth and to look for the fundamental economic reforms that can bring this about.

The author is a visiting professor at Guanghua School of Management, Peking University. The views do not necessarily reflect those of China Daily.