LEHMAN BROTHERS' LATEST 'DAMOCLES' INDEX.

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SINGAPORE, July 30 /Xinhua-PRNewswire-AsiaNet/ -- Lehman Brothers, the global investment bank, issued a third quarterly update to its proprietary Damocles Early Warning System, which helps identify the risk of external financial crises in 17 emerging market economies. The latest Damocles results suggest that external risks in emerging markets are well contained.

For June 2004, the most recent month measured, Damocles assigned ratings ranging from zero (Thailand, Indonesia, Poland, Mexico) to 49 (Argentina) with no country currently breaching the initial 75 threshold, which indicates a 1-in-3 chance of an external financial crisis within the next 12 months. A lower score signals a better position in relation to an external financial crisis.

The simple average Damocles score for Asia's nine emerging markets in the index is 13, better than the average score for the emerging markets in Latin America and Eastern Europe. Large pools of foreign exchange reserves are acting as buffers against sudden capital outflows -- particularly in Asia ex-Japan where foreign exchange reserves have nearly doubled since the end of 2000.

Testing Times Ahead

Yet, there are testing times ahead. Emerging market economies all have at least one area of underlying concern; for some, the terrorist threat looms, while for others, there are domestic political and governance issues. This suggests that Damocles is probably understating the potential for trauma. And, with global interest rates now rising, investors could start focusing more on the vulnerabilities in emerging market economies. The risk also remains that problems migrate from the industrial core to the developing periphery: the developed countries are still beset with large-scale macro imbalances -- varying from the large U.S. fiscal and current account deficits to overheated property markets in several countries -- which could unwind in a malign fashion.

With massive holdings of foreign exchange reserves, emerging Asia is well placed to weather external risks. However, there is the danger that continued heavy foreign exchange intervention, combined with loose domestic policies, could cause other Asian countries to follow down China's path of having very strong external positions with growing domestic problems. "Asia needs to be alert to the domestic challenges that can arise from keeping local currencies artificially weak for a prolonged period," said Rob Subbaraman, Lehman Brothers' senior economist for Asia, and one of Damocles' authors.