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.
