By Nirmal Bang

When recession began with the announcement of the bankruptcy of Lehman Brothers, it was said that the world economy would go through another Great Depression of 1930. But no one imagined that three months down the line the topic of discussion would be recovery and its sustainability.

The dramatic recovery that we saw in the financial markets in the last few months highlighted two themes. One that interest rate cuts, quantitative easing and fiscal boosts have proved remarkably effective as activity has stabilized and economies in many countries are moving up and two while the US, parts of Europe, Japan and Russia suffered a great deal in the financial meltdown, other parts of the globe like China, India, Brazil andAustralia, have managed to cope with the crisis in a much better way.

In recent months, talks of downside risks and the need for easing of policy have changed to recovery as well as monetary and fiscal tightening. “The world economy has been given a massive push in the right direction through sizeable, sustained and successful policy stimulus,” says Standard Chartered Bank’s chief economist and group head of global research, Gerard Lyons. The combination of liquidity, low rates and fiscal spending has worked, the economist believes.

“While there are some encouraging signs of recovery in the developed world, the real economic action is taking place elsewhere,” says HSBC Group’s chief economist Stephen King in a recent report. “For both cyclical and structural reasons, the emerging nations are set to dominate the world economic activity in the years ahead,” King says.

King says he expects emerging nations to see an economic growth of 6% next year (up from 5.3% last quarter) while the developed world will expand by only 1.8% (from 1.2% previously). And there are structural arguments favouring the out-performance of emerging economies; low per capita incomes and softened political relations have allowed companies across the world to invest in emerging nations.

Information travels around the world much more quickly, making the management of assets within the emerging world easier than before. In recent years, trade linkages between emerging nations have increased rapidly and banking systems in the emerging world have also come out of the crisis relatively unscathed.

In the short term, emerging nations will benefit from factors like lower US interest rates which typically encourage capital to flow into the emerging world.

However, currency appreciation is a serious challenge to the emerging economies owing to high capital outflows. Brazil, for instance, recently imposed a 2% IOF (Imposto sobre Operacões Financeiras) tax on foreign capital inflows into equity and fixed income, barring Foreign Direct Investments (FDI). This move is designed to slow the appreciation of the Brazilian Real, which has gained over 36% against the US Dollar during the year 2009.

After a short recession, Brazil witnessed heavy portfolio inflows in the second quarter of 2009. The average FDI in Brazil for a period of three months ended August was $1.55 billion, down 56% compared to last year. Against this, the portfolio inflows stood at $5.19 billion for the same period. This was a whooping 159% high on an annual basis.

Even as major economies of the world appear to be stabilizing, there are reasons why emerging economies will have an edge. The world was happy to note that the US economy expanded at an annualized rate of 3.5% in the third quarter.

In the Euro-zone, monthly indicators suggest that the real GDP growth turned positive as well in the third quarter. And even the Japanese economy posted its second consecutive quarter of growth in the third quarter. But, fine prints matter. For the United States, some of the lift in the third quarter reflects the temporary effects of the government stimulus.

According to an economist, though there has been a rise in the real GDP in the third quarter, a self-sustaining recovery has not occurred. Unemployment has shot up to the highest rate and is likely to climb further in the coming months.

In the Euro-zone, since peaking in the first quarter of the year 2008, real GDP has contracted more than 5%, making the current downturn the worst in decades. Apart from exports taking a sizable hit, even the domestic demand weakened.

Now, there are indications that growth turned positive again in the third quarter. However, experts feel that the recovery in the Euro-zone will prove to be slow and a poor growth in consumer spending will restrain the overall GDP growth rate in the Euro area.

Back to emerging economies, Asia, which did not have overly leveraged financial systems, is leading the world out of recession.

Data flow has been improving for some months after being hit hard between October ’08 and March ’09. The South Korean economy rebounded with three successive quarters of growth, that contrasts with Japan, which, despite a similar output and export picture, has been hit quite hard.

“But we stress that Asia cannot boom if the West is not booming,” says Standard Chartered Bank’s Gerard Lyons. “The trouble in Asia is still its export dependency,” Lyons adds. And he is not the only one who shows Asia the mirror.

Credit Agricole economist Cynthia Kalasopatan says: “A complete recovery can only take place in Asia when the US economy fully exits the crisis and job markets return to normal.” While annual export figures should start to improve, for many countries export levels will still be below those seen before last year’s crisis. The pressure remains on Asian economies to drive domestic demand. In China, this is happening, suggests Lyons.

The strength of Asia’s economies has helped nations here to weather the global financial crisis and today the region is leading the world to economic recovery, says Dominique Strauss-Kahn, Managing Director of the International Monetary Fund. “We expect Asia’s GDP growth to pick up to 5¾ % next year, compared to only 3% for the global economy,” he added in a recent annual lecture at the Monetary Authority of Singapore.

In addition to policy measures, strong fundamentals in Asian countries have also made them more resistant to the global downturn, believes Kalasopatan. Asian countries learnt their lessons the hard way during the Asian financial crisis in 1997 and have implemented strong measures such as the clean up of public and external accounts and the restructuring of the banking sector to consolidate their economies. “The banking sector now stands in good shape,” says Kalasopatan.

In a recent memorial lecture, Former Governor of Reserve Bank of India (RBI) Dr YV Reddy said: “Asia’s economies are dominated by banking systems, which are concentrated on traditional retail banking. It does not have a dominant derivatives market that in a way caused the crisis.”

While the world has been, for some time, looking at China as the new engine of growth among emerging markets, there is praise for India as well. “The emerging-market country that probably weathered the global crisis with the best natural resilience is India,” says Credit Agricole’s Jean-Louis Martine.

“Unlike China, India's economy continued on its growth path without a massive stimulus plan,” Jean adds. But even in India, the industrial production in the first half of 2009 was much weaker than a year ago.

Even as a number of Indian economic indicators like motor vehicle sales, industrial production and the service sector Purchasing Mangers Index (PMI) have improved markedly in recent months, there are few other challenges that are affecting the Indian economy. It is very clear that the recovery has begun, but it is facing a challenge in the form of the country’s 13th drought in the past 60 years.

“Agricultural output contracted in the previous 12 droughts, recording an average fall of 3%,” says HSBC’s Asia economist Robert Prior-Wandesforde. With agriculture now a smaller part of the economy (accounting for 20% of the total output) the GDP effect should be smaller than in the past.

Another issue which worries analysts is that of significant slowdown in non-food credit growth. According to Standard Chartered Bank’s head of research in India Samiran Chakraborty, in the current financial year beginning April, credit growth has averaged 4.3% year-onyear, down from 10.5% during the same period in the last fiscal year.

A sharp reduction in commodity prices (especially oil and base metals), lower credit demand for business expansion, drawdown of inventories, easy availability of non-bank financing and banks’ cautious stance towards retail credit are all contributing to the slowdown in credit growth, says Chakraborty in a recent report. “It is important to stress that credit needs in 2008 were inflated by higher commodity prices, so the correction in 2009 is not surprising,” he adds.

Despite concerns, the economic rebound has managed to attract foreign funds in a big way. According to the latest data available, the Foreign Direct Investment (FDI) during the period from April ’09 to August ’09 stands at $13.8 billion.

Although this figure is slightly lower compared to $14.65 billion in the corresponding period of 2008, the portfolio inflows – Foreign Institutional Investment (FII) - have recovered completely.

Compared to the net outflow of $11.46 billion in 2008, FIIs have pumped in $14.85 billion in equities alone, until 13th Nov ’09. Investor sentiments fuelled by the year-on-year GDP growth rate - from 5.8% in the first quarter to 6.1% in the second quarter - shows that the economy is on recovery track.

And, growth in the industrial production rose from 3.8% year-on-year in the second quarter to 9.1% in the third quarter clearly suggests that the expansion has been a continuous onE.