Ben Aris in Berlin -

Iconoclast Arthur Schopenhauer said that "small is beautiful," and in the current environment many leaders of the frontier markets in emerging Europe and Eurasia would agree. Small countries tend to be nimble, and the current crisis was so big that fast action was essential to cushion the blow. Looking across the region, it's clear that the small countries on the edge of the map are doing best.

Bishkek, Tashkent, Tbilisi and Tirana are some of the few places in the world that are expecting to put in any sort of economic growth this year. Although no one is in a buccaneering mood, the frontier markets are the only place in the world where it will be possible to make decent returns until at least 2012, according to most economists. All the traditional markets like the US or Euroland are going to be mired in an economic bog for at least the next two years.

Even the fashionable BRIC emerging markets are in some trouble, though China remains the exception. In emerging Europe, the big CIS three of Russia, Ukraine and Kazakhstan that attracted so much attention in 2006 have been the countries that are most displaying the symptoms of a classic emerging-market crisis. "Only the CIS-3 countries - Russia, Ukraine and Kazakhstan - have suffered something akin to a classic emerging market 'sudden stop' in capital flows," says Rory MacFarquhar, an economist with Goldman Sachs. "Their export dependence on commodity prices, as well as their heavy reliance on external credit to finance their corporates and banks, left them doubly exposed to last year's crisis; Kazakhstan has fared better than the other two this year, but in large part because its economy was affected by the global shock a full year earlier than the crisis that struck the other two."

The macro numbers coming out of these markets are horrific. Russia's GDP was down 10% over the first half of this year and Ukraine's by 20%. Both countries have been surprised by the power of the blow they took, and analysts are now saying that it will take until at least 2012 before they recover to even 2008 levels of growth.

However, Liam Halligan, chief economist at Prosperity Capital Management, points out that in 2007 a quarter of the world's GDP growth was coming from emerging markets, half in 2008 and in 2009 all of the world's growth will be generated by emerging markets. What used to be described as "backward" and "basket case" countries, are now the only drivers of global prosperity. Autocrats across the region must be laughing into their sleeves.

Hiding under a bushel

Who is driving this growth? In emerging Europe, it's the countries that caught the least attention that are doing best. For example, Uzbekistan, which remains in the iron grip of President Islam Karimov, is probably going to grow fastest this year, with the World Bank predicting 4.4% growth, though the government's forecast is higher after GDP increased by 8.2% in the first six months of the year. Other one-time basket cases like Belarus are also going to turn in results that most EU leaders would die for - 4.0% is forecast by the authorities in Minsk this year. It seems that when it comes to dealing with global meltdowns, the key factor might not be so much that "small is beautiful," but "backwards is best." In most countries, the government's very failure to implement reforms is what has spared them the most pain. Things like sound monetary policy and pots of investment into infrastructure count for little (although have counted for a lot in cases like Poland, Czech and Turkey, all of which have coped far better with the crisis than anyone would have suspected a year ago).

However, it is easy to reprimand countries for failing to "get it" when it comes to the need for reform. There is a tendency amongst international investors to condescend to the leadership of emerging market leaders who fail to impose recognizable rules or force their banks to report to international standards, which takes no account of the legacy issues that transformation carries with it. The leadership of frontier markets need to understand the need for change before they will do anything about it.

And there is nothing like a big crisis to make a point. Most of the frontier markets are cut off from the rest of the world. Their presidents and prime ministers don't read the Wall Street Journal and aren't exposed to the ins and outs of policy debate. But this crisis has forced them to understand that even the most Stalinist state is a member of a global community. During bne's survey of frontier markets in June and July, businessman and bureaucrat after businessman and bureaucrat told us that their banking system was solid simply because they had not made any progress with integrating into the global capital markets, but were still seeing their economies slow or contract because of the effect it was having on their clients who export goods and services.

Bounce back

What will the leaders of the region learn from this crisis? The answer to this question varies from country to country.

In Armenia, the central bank's extremely conservative approach toward the growth of the banking sector annoyed businessmen who believed they were missing out on the pan-regional boom. But the central bank has since been vindicated and many western governments now wish they had been as prudent.

In places like Belarus, the crisis will almost certainly be a boon for reform. The country had already launched an unprecedented (in Minsk, anyway) drive to liberalise the economy when the crisis hit. However, President Alexander Lukashenko remains extremely reluctant to let any outsider tell him how to run his show. However, after Minsk was forced to devalue their ruble at the start of this year and turn to the International Monetary Fund (IMF) for help, he has been forced to listen. The IMF negotiations dragged on for months, but the end result is the Belarusian liberalisation programme has now been melded with an IMF-led austerity programme. Give it a few years and the Belarusians will probably be looking back at September 2008 wistfully as the point when the one-time pariah nation was forced to join the rest of Europe.

The bigger countries are doing less well. Ukraine has become a political basket case. There is no real leadership there at the moment and probably won't be until after the presidential elections set for January. Kazakhstan is faring better thanks to the sensible stewardship of men like National Bank of Kazakhstan Governor Grigori Marchenko, who got it right from the start. But the Kremlin is doing least well, largely because even after spending some $200bn of reserves on a gradual devaluation of the ruble at the start of the year, it still has $400bn in the bank and so can afford to thumb its nose at the likes of the IMF.

Since GDP growth has capsized, going from a peak of 8.5% growth in the first quarter of 2008 to a contraction of 8.5% forecast for this year, the big question is what the changed growth outlook will mean for Russia's internal stability and the government's willingness to implement economic reforms. "In 1998, Russians expected very little from their leaders in Moscow. They were positively surprised when the Putin administration after 2000 started to implement some useful reforms, such as simplifying the tax system and cleaning up regulations," says Katinka Barysch, deputy director of the Centre for European Reform. "Since then, Putin's muscular rhetoric, combined with Alexei Kudrin's sound macro-economic management, have raised expectations. The people that took to the streets in Russian cities in recent weeks and months did not so much protest against government policies as demand government help. The government could react either by getting serious about modernising and diversifying the economy, or it could resort to economic nationalism and populist spending increases. So far, there is more evidence of the latter than the former."

Of course, the irony of this is that the reason why Putin pushed through the reforms that made him so beloved by the Russian people is that Russians were so humiliated by the complete collapse of the economy in 1998 that the leaders vowed "never again." This gave the Kremlin the political backbone to force through the reforms that have so transformed the country over the last decade.

Smaller countries have taken on this lesson much faster. The crisis has also changed the rules of the game. Until last year, governments of these frontier markets had to live on their meagre means, but since the crisis hit, everyone has suddenly become eligible for massive loans from the multilateral lenders. The tonic prescribed by the global financial doctors is huge spending on massive infrastructure projects that all the countries badly need. Suddenly, it doesn't matter if you load up on debt, as long as you get the wheels of commerce turning. The irony of this situation is that if these governments spend wisely - far from a given - then they could leapfrog ahead by years in terms of development and lay the foundations for much faster growth in the future.

Indeed, some emerging Europe fund managers argue the crisis will drive even more investors into their arms. Prosperity Capital Management has earned an average 36% return on assets over the last decade, including the huge losses it incurred during the September 2008 sell-off. "The subprime debacle is a milestone for the world. It will accelerate and accentuate the shift of capital from west to east. Global emerging markets are home to two-thirds of the world's population and some 40% of the total GDP stock, but only account for about 10% of equity capitalisation," says Halligan. "The fact the region is one of the few in the world that is still growing would already be an attractive proposition, but as the demographic situation in the west is getting worse, and will get a lot worse in the next three to five years, fund managers are going to be forced to look for yield... The press can throw as much dirt as they like at Russia and the other frontier markets, but investors have no choice if they are going to get the yields they need to cover the pension payments or meet investors' expectations for returns."

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