How US rate rise scuppered emerging markets

The wave of unrest that has spread through currency markets was triggered by the collapse of the overvalued Mexican peso last month. But Mexico is not alone as a source of instability: Spain, Italy and Hong Kong have been sending out distress sign als, and the dollar itself is now involved.

The latest bout of uncertainty began almost a year ago when the US authorities raised interest rates for the first time in four years to try to slow the pace of economic recovery and delay the return of inflation.

In a world where almost all economies, all bond and share markets and increasingly all currencies are inter-dependent and inter-tradeable, the prospect of US interest rates rising, when other leading economies were only in the early stages of economic recovery, destabilised fixed-interest bond prices in all the main markets.

US Treasury bond yields rose nearly 2 per cent last year and falling bond prices rapidly spread to European bond markets and, in turn, undermined share prices. It also focused attention on economies such as Spain, Italy, Belgium and Sweden, which have been running substantial budget deficits and/or have large outstanding national debt totals in relation to the size of their economies.

Investors now demand yields of 3-4 per cent more on Italian, Spanish and Swedish bonds compared with German bonds of similar maturities. A year ago the premium required was only about 2 per cent.

Cautious investors switched from bonds into cash and from soft currencies into the traditional hard currencies - the mark, Swiss franc and yen. Shares in the emerging markets, where fast economic growth and the prospect of rising exports to the developedmarkets combined to offer attractive returns in 1993, began to come under pressure in 1994.

Shares in Brazil and Chile, South Korea and Taiwan ended the year higher than they started. But many emerging markets fell heavily. The Mexican crisis, which came to a head with the collapse of the peso and a slump in the Mexican stock market last month,highlighted the risks, and money that rushed into emerging markets in 1993 trickled out in 1994, then became a flood, creating a "flight to quality".

In the second half of last year much of the money went to the US, and helped to stabilise the dollar, which had fallen more than 10 per cent against the mark and yen in the first six months.

But the Mexican crisis and President Bill Clinton's commitment to help his neighbour with credit of up to $30bn to prop up the peso have made the dollar suspect again.

Traders openly fear that the US will delay or reduce the next rise in interest rates to reduce the flow of money out of Mexico to the US, and the currency flows are being diverted to less sentimental countries.

Pressure on the dollar has put further burdens on countries that traditionally try to peg their currencies to the dollar, including Hong Kong and Saudi Arabia.