Which Emerging Markets Appear Vulnerable? A Look at Early Warning Indicators

All eyes are now on the eurozone debt crisis. However, we know from past experience that problems in advanced economies can spill over to the rest of the world with dangerous consequences. Emerging markets are not immune. The IMF Director Paulo Nogueira Batista Jr recently expressed concern that capital could flee Brazil if the eurozone debt crisis intensifies, and his concern is not unfounded.

As seen in 2008-09, global risk appetite dried up and prompted large capital outflows out of many emerging markets, particularly in Eastern Europe. As a result, certain economies found themselves teetering on the edge of crisis. Latvia, Hungary and Romania were among those who turned to the IMF for help.

These Eastern European economies showed vulnerabilities before the onset of the global financial crisis, as exhibited by high current account deficits and heavy external debt service obligations. However, it took an external shock to bring these vulnerabilities into the spotlight.

So which EM economies look vulnerable in the event of another sudden stop in capital flows?

Below I look at a cross-section of emerging markets and compare their relative vulnerability to a sharp slowdown in capital inflows. (Note: the set of EMs was chosen largely based on data availability).

There is no defined set of early warning indicators that perfectly predicts which countries are at risk of a crisis, but some have stronger predictive power than others. Jeffrey Frankel and George Saravelos conducted a sweeping literature review to find the most consistent leading indicators of crisis. (See: Reserves and other early warning indicators work in crisis after all)

Measures of international reserves and the real exchange rate stand out as the best tools to assess a country’s vulnerability. Their findings suggest the current account balance is also a good indicator to monitor.

Figure 1: Adequacy of international reserves

Source: IMF, national central banks, author’s calculations

*Stock of external debt as of June 2011, **GDP based on IMF’s latest 2011 forecast

International reserves provide a certain degree of insurance against capital flow volatility. Among the EMs surveyed, Russia and India stand out for their relatively large caches of international reserves, while Turkey ranks near the bottom of the pack, both as a % of external debt and % of GDP, which is a source of vulnerability. Blogger Emre Deliveli, as well as journalist Taylan Bilgic, questioned the adequacy of Turkey’s reserves in a recent column.

The ratio of short-term debt to reserves is a particularly good measure for assessing vulnerability. The lower the ratio, the better. Unfortunately, not all countries provide data on short-term debt, but a few do. For example, India’s ratio is 21%, well below Turkey’s ratio of roughly 86%.

This measure, like the others, needs to be taken with a grain of salt. A country may have a large chunk of debt coming due within the next year, but may have very strong macro fundamentals, making repayment problems highly unlikely. So it’s always necessary to consider the context. In any case, Turkey also looks vulnerable on this measure.

Figure 2: Divergence of Real Effective Exchange Rate from Trend

Source: BIS, author’s calculations

The probability of a currency crisis increases when the real exchange rate is overvalued relative to trend. However, this needs to be taken with a grain of salt as well. For example, many Asian currencies showed no significant appreciation in the late 1990s, yet these economies still descended into crisis.

On this measure, the Brazilian real and Indonesian rupiah currently show the most overvaluation relative to trend. In contrast, Turkey looks to be the least vulnerable on this measure.

Figure 3: Current account balance

Source: IMF WEO Database, September 2011

Large current account deficits also increase the probability of crisis and indicate that a country is borrowing more than it’s saving. All recent financial crises (eg. the Asian Crisis, Argentina in 2000, Brazil in 2002) featured current account deficits, with the exception of Russia in 1997. A current account deficit is not necessarily a bad thing if it is financing activities that are enhancing the country’s productive capacity. However, a deficit can quickly become unsustainable if a country is unable to secure the necessary external financing to fund it.

On this measure, Turkey – and to a lesser degree, Poland – look potentially vulnerable.

Conclusion

A look at early warning indicators suggests that Turkey is vulnerable to a sudden stop in capital flows based on its relatively low level of reserves and high current account deficit. Poland also looks vulnerable – albeit less so than Turkey. However, as I note above, these measures need to be taken with a hefty grain of salt. They’re useful in figuring out where a countries’ vulnerabilities may lie, but further investigation is necessary to understand the context.

The Weekly Mishmash: September 30

1.   Indonesia: Cyclical Stress from Funding Linkages, but Structural Story Remains Intact

By Devi Tan & Seen Meng Chew, Morgan Stanley

Tan and Chew look at the ways a global growth slowdown could hit Indonesia. They conclude trade linkages are unlikely to be a major conduit given Indonesia’s strong domestic demand orientation. But the economy remains vulnerable to global risk aversion (albeit less so than a few years ago). Despite the possibility for near-term turbulence, they remain bullish on Indonesia’s medium-term growth prospects.

EM Muser: This story applies to other EMs as well, with Brazil and Turkey fitting a similar mold. Like Indonesia, they are big emerging markets with large populations and strong domestic demand. And, like Indonesia, they remain vulnerable to global risk aversion, at least in the near-term.

Turkey, in particular, looks vulnerable to external funding shocks. The ratio of short-term external debt to fx reserves is close to 100%. Indonesia has a high ratio by ASEAN standards at over 30%, according to Tan and Chew.

2.    Unprecedented situation in Hungary’s bond market

By Portfolio.hu (free registration may be required)

“Hungary’s State Debt Management Agency (ÁKK) received only HUF 30.2 billion in bids for a proposed HUF 40 billion debt issue in 12-month zero-coupon treasury bills (D120822) on Thursday. This marks a historic record low bid-to-cover ratio for the 12-month facility since January 2000 (since when data are available) and the lowest volume of total bids since April 2003…”

EMMuser: Not looking good for Hungary. As I’ve detailed in a number of posts, the economy has a host of longer-term structural problems, accompanied by a government in denial, and investors seem to finally be waking up to that fact.

3.    Copper Rout Outpaces Analysts Focused on Shortages: Commodities

By Maria Kolesnikova and Agnieszka Troszkiewicz, Bloomberg

(Hat tip David K.)

“Copper, which reached a record $10,190 on the London Metal Exchange in February, sank to $6,800 on Sept. 26, a 14-month low. The contract traded at $7,067.50 today, taking this year’s decline to 26 percent. The metal is on track for its second- worst year in almost a quarter century, exceeded only by a 54 percent retreat in 2008.”

Blogger Barry Ritholz shows a nice chart that suggests copper’s downturn is one more signal that we’re headed for another global recession.

EM Muser: While the sharp fall in copper prices may signal global recession, it will have a more direct effect on certain EMs, particularly Chile, which is still very much copper country. Chile is the world’s largest copper supplier, producing roughly a third of global supply. (See my earlier post: Chile: Latin America’s Wunderkind)

4.    Poland’s elections: cause for concern

By Jan Cienski, Beyond Brics

“[R]ecent opinion polls are showing steady growth for the right-wing opposition Law and Justice party, threatening to introduce an element of political risk to assessments of the Polish economy and the Polish currency. A new opinion poll has Civic Platform, headed by premier Donald Tusk, with 36 per cent support, with Law and Justice (PiS) just behind at 32 per cent…PiS’s tumultuous two years in power from 2005-2007 were marked by populist economic policies and by bitter fights with Brussels, Berlin and Moscow that left Poland marginalised in the EU.”

EM Muser: Poland’s economy has shown remarkable stability in recent years. It was the only EU economy to avert recession in 2008-09 so one might think the ruling Civic Platform party would be a shoe-in, but it’s not.

This story provides a good reminder of why we should not take political risk for granted. Hungary’s a case in point. Commentators did not expect much of a shift in economic policy when the Fidesz government came to power in 2010, and that was a mistake.

 

EM Currencies: Same Same But Different*

Investors fled out of EM currencies at the height of the global financial crisis and retreated into safe haven currencies, such as the Swiss franc and Japanese yen. The recent market turmoil triggered a similar pattern, as EM currencies continue to be risk-sensitive. But there’s now greater variation. Certain EM currencies have shown considerable resilience and I expect greater differentiation among EM FX going forward.

Flight to Safety – Where’s That?

The VIX index – which measures the implied volatility of the S&P 500 and is used as a proxy for risk sentiment – rose to its highest level in over two years on August 8 and remains elevated. In reaction to this spike in risk aversion, most EM currencies slipped against the US dollar, as seen in Figure 1 below.

Figure 1: Most EM currencies weakened against the USD in early August when risk aversion spiked

Source: Oanda, author’s calculations

Investors’ gut reaction in times of market stress is to retreat from emerging market currencies. However, there are signs of gradual change. Some – such as the Chilean peso, Czech koruna and Indonesian rupiah – showed considerable resilience in early August, in contrast to their sharp weakening at the height of the global financial crisis. (See Figures 2, 3 and 4 below.) Financial commentator Martin Hutchinson recently went so far as to call the Chilean peso a ‘safe haven’ currency.

Figure 2: Select South American Currencies in Comparison

Source: Oanda, author’s calculations

The Brazilian real and Chilean peso have steadily strengthened against the US dollar since the height of the global financial crisis, albeit to a lesser degree than the Swiss franc, a major safe haven. When the S&P 500 plunged in early August, the Chilean peso held relatively steady, while the Brazilian real weakened, though it so far has not plunged like it did in late 2008-early 2009.

Figure 3: Central European Currencies in Comparison

Source: Oanda, author’s calculations

The Czech koruna, Hungarian forint and Polish zloty are all highly correlated with the euro, which is not surprising given these economies’ strong ties to the eurozone. As a result, these currencies are vulnerable to an intensification of the eurozone crisis.

Meanwhile, high levels of Swiss franc borrowing among Hungarian households’ [See related post: Hungary Mortgage Relief: Another Move to Delay the Pain) and moderate levels of franc borrowing among Polish households are also weighing on these currencies. As the Swiss franc has surged (given its safe haven status), there are concerns that it could slow economic growth and potentially even threaten financial stability. Notably, the Czech Republic – which has scant levels of fx-denominated borrowing and a lower public debt burden relative to the rest of Central Europe – has seen its currency diverge from the other two since mid-2010.

Figure 4: Select Asian Currencies in Comparison

Source: Oanda, author’s calculations

The Indonesian rupiah and Philippine peso showed considerable resilience against the USD, relative to other EM currencies, at the beginning of August. Authorities in both these countries have traditionally not shied away from intervening to smooth out volatility. In fact, Indonesia’s central bank recently said it plans to support the currency by purchasing IDR-denominated government bonds if there’s a large sell-off. As for India, the rupee dipped considerably against the USD in early August. India’s high current account deficit and large public debt burden make the INR more vulnerable to sell-offs in times of market stress.

Structural Change Afoot

Problems in advanced economies look to be more structural than cyclical, suggesting they’re not going to be resolved anytime soon. The US lost its prized triple-A rating from S&P on August 5 – the first downgrade in the country’s history. Meanwhile, the eurozone crisis continues to gather momentum, with Italy and now France coming into the spotlight. The broad political consensus needed to tackle these issues is lacking.

We’re moving toward a more multipolar world where the economic clout of emerging markets will grow ever larger, as Lupin Rahman of PIMCO describes. I also touched on this gradual structural shift in my post: Can Emerging Markets Replace the US as the World’s Consumer of Last Resort?.

The bottom line is that emerging markets are not immune to ripple effects from problems in the US and eurozone given their strong trade and financial ties. Nevertheless, their longer-term prospects are generally brighter than those in the developed world (with certain exceptions) given their lower debt burdens, more favourable demographics and faster economic growth.  (See related posts: The Double Whammy: Debt and Demographics and Emerging Markets: Fiscal Health Check)

As a result, I expect old patterns – where investors automatically flee away from all EM assets in times of trouble – to gradually change. Signs of that shift are already apparent, as noted above.

*See Wikipedia for explanation of title phrase ‘same same but different.’

Chile: Latin America’s Wunderkind

Chile’s finance minister, Felipe Larraín, swung through London this week with a contingent of business people in tow to celebrate ‘Chile Day’ on June 27. The event was aimed at promoting the country as an investment destination. Given Chile’s strong institutions and envy-inducing macroeconomic performance, they certainly have a lot to celebrate. Mr. Larraín stopped by the London School of Economics for a public airing of his marketing pitch and managed to impress your resident blogger.

Why is Chile the economic envy of the region?

Highest sovereign credit rating in Latin America

• Fitch upgraded Chile’s rating to A+ in February 2011, citing the country’s ‘structural strengths’ and ‘very strong institutional framework.’

• Moody’s upgraded Chile’s rating to Aa3, the fourth highest investment grade, in June 2010, around the same time that it cut Greece’s rating to junk.

• Ratings agencies are notoriously behind the curve, but Moody’s move came as a positive surprise in the wake of Chile’s ‘financial resilience’ to the devastating February 2010 earthquake.

First South American member of the OECD

• Chile became the 31^st member of the OECD’s club of advanced economies in January 2010.

• In welcoming Chile, the organisation noted Chile’s  ‘prudent tax policies’ that gave it the leeway for stimulus measures to weather the global financial crisis as well as the country’s ‘groundbreaking’ pension reforms in the early 1980s.

Solid public finances

• The country has one of the lowest public debt levels in the world at less than 10% of GDP at the end of 2010. This is a sharp contrast from the lofty levels in most advanced economies.

• Chile needed $8.4bn in financing for reconstruction efforts after the earthquake. Officials showed an admirable political willingness to raise taxes – something the far-more-indebted US has shown no stomach for – as well as issue debt, rather than tap its sovereign wealth fund.

• The government issued a global peso bond for the first time in history in July 2010: US$520Mn in 10-years at a yield of 5.5%.

• Chile has a fiscal rule to help maintain fiscal discipline by insulating public spending from short-term copper price fluctuations and the business cycle. See this recent IMF paper on the rule.

Strong institutions

• Chile has the strongest institutional quality in Latin America and ranked 28^th out of the 139 countries surveyed globally in this category, according to the latest Global Competitiveness Index, due to transparent policymaking and low levels of corruption.

Balanced growth

• For a small open economy, Chile has surprisingly strong domestic demand. The ratio of consumption (private + government) to GDP in 2010 was 70%, which is in line with that in many advanced economies as well as with bigger emerging markets, such as Turkey.

• Consumption showed considerable resilience during the global financial crisis. As seen in the graph below, consumption is the only GDP component that has positively contributed to growth every year in the 2007-10 period.

Source: Banco Central de Chile

• Export-led economies, such as the Czech Republic and Hungary, where export-to-GDP ratios exceed 70% of GDP, are more vulnerable to downturns in world trade and contracted more sharply than Chile during the global financial crisis.

No impending danger of overheating or a sudden stop in capital flows

• Gross capital inflows are strong, at 16% of GDP in Q1 2011, but are driven by FDI, making the economy less vulnerable to a sudden stop in capital inflows. FDI is generally considered less prone to reversal than foreign inflows into equities and debt securities.

• Bank lending to the private sector – at around 10% y/y – is growing at a measured pace, much slower than in many other countries in the region (eg. Brazil, Colombia, Peru).

BUT….

Fate is largely tied to China

• Those who think a hard landing is on the way in China should be wary about Chile.

• Asked what an abrupt China slowdown would mean for Chile, Mr. Larrain artfully dodged the question and simply said he doesn’t expect such a scenario.

• China bought about a quarter of Chile’s exports in 2010 and Asia as whole accounts for about half of exports, a higher percentage than in Argentina or Brazil.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011

Chile is still copper country

• The country’s exports are not very diversified and copper continues to dominate, leaving the economy vulnerable to any downturn in global demand for the metal.

Source: Lecture by Felipe Larraín at LSE on June 29, 2011