Economic Domino Theory

How Does Capital Flight Affect Me?

Anyone who has invested in the stock market - and that's a whopping 43% of American households - can tell you that the American economy is not an island unto itself. Even those who had invested only in blue chip American stocks found themselves on a roller coaster ride in 1998. The Dow gained more than 1,400 points in the first seven months of the year then lost 1,800 points in just 6 weeks, due in large part to global financial instability. As corporate earnings reports began to trickle in, investors saw that American companies counted on exports to continue the steady earnings growth that had underpinned rising stock prices. Net exports from the U.S dropped 3.4% in the first quarter, and another 7.7% in the second quarter. As prospects for selling outside the U.S. became shaky, so, too, did earnings projections for the coming months; as earnings growth becomes flat, stock prices decline.

Of course, many investors were not invested solely in blue chip stocks. Financial experts preach that if you are willing to accept higher risk, you can receive higher earnings. That's why investing in emerging markets is so attractive - the risk of default on loans or devalued stock is greater, but then so are the returns. Lots of mutual funds specialize in emerging markets, and their investors expect to see price fluctuations that might turn the stomach of even the most seasoned roller coaster fanatic. These are the folks who were watching the July 1997 currency crisis in Thailand with more than passing interest because they knew their investments were at stake. How does it work, though?

When they buy a mutual fund that invests in an emerging economy, such as Russia, the fund invests that money in the Russian government through bonds, or in new businesses in Russia by either buying the firm's stock or buying corporate bonds. As long as the government or business is solvent, it collects revenues and pays back its debts. When its economy sours, however, a government can restructure the debt or devalue the currency, and a business can simply go bankrupt and default on the loans.

It doesn't happen quite that quickly, of course. It takes time for the economic turmoil to bubble up into a default. When the local currency is devalued, it makes it more expensive for the business to buy supplies to make its products, which means that they must raise prices to sell the products profitably. Because the products are more expensive, consumers buy fewer of them, which sends sales and corporate profits plummeting. Investors try to sell the stock, but no one wants to buy it so they have to sell at a loss. Borrowers with dollar-denominated loans suddenly realize it will take more rubles to pay off the loans. If the borrower is a government, it may unilaterally decide to restructure the debt (i.e., extend the repayment period or reduce the amount to be repaid). These are the reasons that emerging market investments are considered so risky, and why they can mean big payoffs or big losses for investors.