Emerging stock markets have had five very good years. But don’t bank on them enjoying a sixth. A combination of tighter credit conditions and rising domestic inflation will make life much tougher for many developing countries in 2008. The two biggest emerging markets—China and India—have more downside potential than upside. One of the few candidates to outperform in the year ahead is South Korea.

Over the past five years, high world liquidity—whether caused by rapid US money supply growth or by a world “savings glut"—produced rapid worldwide growth and a commodity price boom. These enabled debt-ridden countries such as Brazil and Argentina to escape from their trap, while assisting rapidly growing economies such as China and India to finance their extraordinary economic expansion.

This has become too good to last. The US subprime mortgage crisis, while it has not affected emerging market credit directly, has forced international banks to reduce their off-balance-sheet assets and lowered the appetite of both capital markets and banks to absorb new debt. This will reduce the flow of funds to emerging markets, particularly those heavily dependent on foreign debt such as Turkey, Brazil and Indonesia.

China and India have their own problems. In China, the government is increasingly determined to tighten liquidity, which is already resulting in dwindling investor enthusiasm for thinly-traded Chinese stocks. In India, the public sector deficit is expanding, with spending up 28% in the first seven months of the 2007-08 fiscal year. In both countries, inflation is well above official targets. Thus, both markets seem likely to be weak in 2008.

To outperform in 2008, a stock market must be reasonably valued, its domestic economy must have high liquidity, and its growth trend must be positive. One such market is South Korea, which currently trades on a multiple around 14 and also benefits from positive political risk.

The outgoing anti-business government of Roh Moo-hyun has been replaced by the pro-business Grand National Party, and new president Lee Myung-bak has vowed to return the country to its traditional 7% growth. In Korea at least, the upside outweighs the downside.