Hamish McRae: The new powers are punishing the old

Market madness or something more sinister? Yesterday brought some modest calm back to the financial markets after a few days of near panic, with share prices around the world and the US dollar weakening dramatically. That is welcome. Panic does no one any good, though its twin sibling, euphoria, can be pretty destructive too.

There is a great temptation, whenever the markets indulge in one of their sudden lurches, to roll one's eyes, note that we have seen this all before, and sigh at their naivety and their greed. Of course there are lots of tensions in the world economy at this stage of the economic cycle.

As far as shares are concerned, it would be pretty odd, after an almost uninterrupted recovery from the bursting of the internet bubble, were there not to be some setbacks. It would be pretty odd, too, given the size of the US current account deficit at close to 7 per cent of GDP, were there not to be some weakness of the dollar. The odd thing, you could reasonably argue, is that it all took so long for these wider concerns to be reflected in the markets. Did they not know that the oil price was soaring and world interest rates rising? What do these people do all day?

Sooner or later share markets were bound to have a mid-cycle "correction" - a nice word, that, to describe a share crash, for it suggests that falling prices are the correct and proper reaction to an earlier mistake. Sooner or later, too, the dollar was also bound to correct, a necessary precondition for the corresponding correction of the US current account deficit.

There is a lot of common sense in this "business as usual" approach. Once in a generation there comes the perfect storm, the wild euphoria followed by deep despair. We had that in the early 1970s and again at the turn of the millennium. In between there are market ructions but, in the broad scheme of things, they don't matter that much. The present fluctuations fall into that category and are just the sort of healthy reminder that markets need periodically to keep them sweet.

But there is one gaping hole in this comfortable and comforting analysis. It presumes that it is the developed world that calls the shots. These are our markets, the dollar is a developed country's currency, the key players are the finance ministers and central bankers of the rich world. All previous market cycles have been shaped, for better or worse, by the interaction between the economies of developed countries and their policy-makers.

But while this interaction remains hugely important, it is no longer the sole determinant of world markets or the world economy - maybe not even the most important. Half the world's incremental economic growth last year came not from the present developed countries but from the newly developing ones: from China, India, Russia and Brazil.

The great surge not only in the oil price but also in commodity prices has been driven principally by demand from China. Two thirds of the world's savings come from Asia and to lesser extent, the Middle East. Had Japan and China not been prepared to lend the US the money to cover its current account deficit, that "correction" of the dollar would have started much earlier. Indeed, the deficit would not have been allowed to grow to its present extent because it would not have been possible to finance it.

We naturally focus on our own financial markets, but share price falls in some of the so-called "emerging" stock markets has been more marked than those nearer home. But then the boom in, for example, Indian share prices over the past three years has far outstripped anything in the West. The total market capitalisation is smaller, to be sure, but the movements are larger. The tail is starting to wag the dog.

We don't yet know much about what has happened in the past few weeks. There have been stories that the amplitude of the fluctuations has been increased by computer trades. They have become amazingly complicated, but the sort of thing that happens is that when markets move beyond a certain point, some mathematical wizard will have calculated that they are likely to move more. So the computer instructs itself to sell more stuff, thereby increasing the extent of the fall.

I suspect there is something in this, but if so, it is not really very new. There have been plenty of sudden movements in the past and programme trading has been responsible for lots of bumps before now. What is new is the change in the source of global funds: the stock of global financial assets is still controlled overwhelmingly by the established developed world, but the flow of new savings is coming from the newly developing countries.

There has been much comment in the papers in the past few weeks about a change in investors' appetite for risk. Apparently a declining desire to hold risky assets is behind the falls. But to say that is unhelpful because it fails to explain why there should be such a shift of sentiment. There is no rational reason why the perspective of Western institutions and their clients should suddenly have shifted. Maybe the suggestion that there might be a slightly higher interest rate peak in the US? That probably is right, but surely this would not of itself be enough to move markets to the extent that they have moved.

What I think may be happening is a shift of sentiment not so much in the developed world but in the newly developing countries. The people behind that wall of savings in Asia and also the Middle East are wondering whether it is such a good idea to put so many of their savings bets in one basket, albeit as enormous a basket as the US economy. If this is right, this will be the first market correction - let's keep calling it that - that is being driven by the new savers of Asia.

This might seem odd because the stock of wealth in the "old" developed world is much larger than the stock in the "new" one. But market movements are set by flows, not stocks, and all it needs is some shift in the flow of savings for markets to react quite violently. You could almost say that the new economic powers are punishing the old ones.

If this is right, what has been happening in the past couple of weeks is part of a bigger shift of power. We can see the extraordinary growth of the Chinese economy and the way in which Chinese money is scouring the world for control over raw materials, particularly energy. We see how Indian business is entering the global marketplace. But the idea that share prices in what we think of as our domestic markets should be determined by investment choices made by people on the other side of the planet is a bit scary. But scary or not, we had better get used to it. This shift in power has a way to run.