08/18/1998 15:38:29 EMERGING MARKETS-When downturn becomes a spiral

By Mike Dolan LONDON, Aug 18 (Reuters) - Emerging markets pay investors big returns to guard against the perceived risk of devaluation or debt default. But when both happen, things can get out of control. A downward spiral of confidence among foreign investors, local companies, banks and citizens is almost impossible to shore up in the short term, analysts said. The chances are the currency slide overshoots massively, leading to inflation and the risk of social and political upheaval. That's the story of Indonesia in 1998 -- and it's hard not to see Russia in the same boat, analysts said. Russia won't admit to either of the "d" words, but most analysts would agree the former superpower effectively devalued its currency and defaulted on its debt on Monday. "The worry is that what appears at first to be a purely financial crisis begins to be perceived as a wider political problem," said David Lubin, emerging markets adviser at HSBC Markets in London. "It's going to take a long, long time to regain any sort of investor confidence." In the absence of foreign capital, which will be loth to return to Russia now for months and perhaps years, fiscal policy will have to be tightened even more radically than previously demanded, analysts said. If a sharp economic downturn is to be averted, interest rates will have to be slashed to offset the effect of the fiscal squeeze. A sudden loosening of monetary policy would undermine the currency further and risks a sharp acceleration of inflation, they added. The scramble for hard currency by banks and corporates with dollar liabilities and by citizens fearful of the familiar ravages of inflation could send the currency into tailspin. Rising inflation would eventually erode the real incomes of ordinary Russians for the second time this decade and the potential political implications of the ensuing social unrest risks undermining confidence in the currency even further. It becomes a seemingly endless spiral. But whether devaluation is the cause or the effect of economic crises in developing countries has become a moot point over the past 12 months of global emerging market turmoil, analysts said. They said forced devaluation certainly exaggerates the problems but is rarely the root cause. Peter Von Maydell, currency economist at Credit Suisse First Boston, said the Russian devaluation and the more generalised currency instability in developing countries was chiefly due to the collapse of global commodity prices over the past year. The subsequent impact on countries' terms of trade has meant peoples' real incomes get hit one way or the other, he said. "For Russia, this is a pure oil and metals story -- these are 70 percent of their exports and 40 percent of their budget receipts," said Von Maydell. "There's not much they could have done over the past year to offset those commodity price falls. "In a 'normal' country, a terms of trade collapse like we've just seen in Russia would see the fiscal deficit widen as a shock absorber. But Russia isn't allowed to do that by the IMF and will probably have a monetary expansion instead." Russia's problems servicing its short-term debt, meantime, compound the problem by increasing the demand for dollars and exacerbating liquidity problems in the banking system. This adds to the urgency for lower interest rates. In turn, rising inflation expectations contribute to a "dollarisation" of the economy once again, analysts said. "People will never trust the rouble again," said Paul MacNamara, economist at Bank Julius Baer. "People can take a 20 percent devaluation. What they can't take is having a stack of roubles which they can't change at any price." Ultimately in Indonesia, President Suharto's 30-year rule was ended in May as riots against rising food prices reached a crescendo. However, the history lessons are not all as bleak and Mexico's recovery after its "Tequila" crisis at the end of 1994 shows there can eventually be a more peaceful route out of such a spiral. Von Maydell said authorities need to make policy goals and targets as transparent as possible as quickly as possible. "Mexico did a brilliant job three years ago when it adopted a quasi-inflation target, and they recouped their credibility within 12 months," he said. "Transparency and a visible policy anchor are the quickest way to reduce volatility and uncertainty." ((London newsroom +44171 542 6762, fax: +583 7239, uk.emergingmarkets.newsreuters.com))