Money: The economic miracle of South-east Asia was a horror story in the making

Are you sitting comfortably? Then I'll begin. Or at least I will if you make certain you have the light turned on, all creaky doors closed and have made certain nothing may happen to cause you undue alarm. Because I am about to recount a horror story.

Quite why I have not written before about South-east Asia escapes me. I had been watching the gyrations of both currency and equity markets with increasing alarm. Too many people, particularly in the UK, have been caught out by believing the economic miracle of the Far East would continue indefinitely for us to ignore what has been happening recently.

The British problem of underweighting the US and overweighting the Far Fast has resulted in massive global underperformance for many managers. Popular wisdom has it that markets which have fallen as far as those of the Far East are now cheap enough to buy and certainly too cheap to sell. Popular wisdom is not always right.

Let us begin at the beginning. South-east Asia has always shown tremendous potential. Large populations enjoying a strong work ethic seemed ripe for development. Develop they did, and most successfully. But prosperity led to profligacy.

It is the most natural reaction in the world to spend when you are doing well. When that spender is a country, or even a region, then you must rely on the market to deliver the necessary correction.

Unfortunately this was all taking place at a time when South-east Asia enjoyed semi-fixed exchange rates. What was once a measure for Hong Kong became general practice for the region. There was tacit acceptance that the South-east Asian currencies were in effect a proxy for the US dollar.

This is not an entirely fanciful notion. The strength of these economies in the past has relied on the performance of the US economy in no small measure. While this has become less important as domestic momentum developed, there seemed every reason in the past to believe that what was good for the American bear suited the Asian tiger just fine.

What is wrong with artificial constraints, however arrived at, is that sooner or later cracks appear. In this case it was interest rate differentials. Pegging one currency to another is fine - if you cannot arbitrage between the two. And if you can borrow in dollars at half the local cost of money, why not?

Well, from a relatively benign scenario, helped by capital inflows, rising reserves and strong economic growth, the situation soon deteriorated across the region. Foreign borrowing led to a deterioration in the current account position. Artificially high exchange rates resulted in strong import growth and a slowing on the export side as these currencies were dragged up by the dollar. High wages and declining productivity were beginning to make South-east Asia look like Western Europe a decade or so back.

But the killer was the level of spending - private, corporate and governmental - financed through borrowed money. There was just too much credit around. Speculative developments suddenly started to look unsound. If the collateral for the loan cannot service the debt and the value of security is in question, collateral damage will occur.

The implications are not comforting. At the very least GDP growth will slow as the position unwinds. Poor performing loans that represent highly leveraged commercial enterprises must inevitably devalue the residual equity. No wonder investors are nervous.

The present situation has focused attention on two unsatisfactory aspects of this whole sorry affair. First, the efficacy of central bank supervision and general regulation and standards is called into question. Lax accounting rules have allowed opaque capital structures to be introduced, so often the true extent of corporate liabilities is obscured by guarantees to subsidiaries or concealed responsibilities for loans.

Secondly, the absence of a significant risk premium in this particular marketplace has now been recognised and will inevitably result in a backlash by investors whose fingers have been badly burned. This in turn will delay the return to the real prosperity of which the region is undoubtedly capable.

Brian Tora is chairman of the Greig Middleton investment strategy committee and may be contacted on 0171-655 4000.