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Economic Vulnerability Varies by Country

If inflows of capital suddenly tighten, certain emerging markets are more at risk than others.

Francisco Torralba, Ph.D., 01/13/2014

This article originally appeared in the December/January 2014 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000. 

Investments in emerging-markets economies have outperformed those in developed countries over the global business cycle that began in 2009. Loose monetary conditions set by the central banks of Japan, the United Kingdom, eurozone, and, most importantly, the United States, depressed yields and prompted developed-market investors to seek higher yields overseas, often in emerging markets. A consensus is forming, however, that tighter monetary conditions are on the horizon. Moreover, cyclical and structural factors are beginning to slow down the economies of some emerging markets. It is only a matter of time before the most skittish of those investors return home.

Most emerging-markets countries are particularly exposed to the risk of an abrupt end to capital inflows, which we have learned from the past 40 years of markets history. As such, analysts tend to lump developing countries together in a way they never would with advanced economies. Headlines this past summer about sinking currencies and money gushing out of emerging-markets funds led one to believe that all emerging-markets economies would wreck in the event of a “sudden stop” of capital. My analysis suggests that that is not the case.

I focused on gauging the vulnerability of 16 emerging-markets economies to a freeze in capital inflows. My scorecard consists of 18 metrics that have been linked to such risk, grouped into four sets. For each set, I generate a score, which I derive from the relative position of each country in the cross sectional distribution. I then average the four scores to produce an overall index of vulnerability. The index can take a maximum value of five, for the highest degree of vulnerability, and a minimum of one, the lowest.

Current Account
The first set of characteristics relates to the external balance.

A large current-account deficit implies lots of borrowing from abroad, which might precipitate a crunch if funding dries up. In addition, I check the basic balance, which adds net foreign direct investment (FDI) to the current account balance. FDI is the stickiest and most reliable form of foreign financing. A country with a negative basic balance cannot cover its financing needs with FDI, depends on flightier forms of foreign inflows, and is more vulnerable to sudden stops. For both the current account and the basic balance, I consider as metrics the average balance over the past three years (through the second quarter of 2013), as percent of GDP, and the change from the average balance in the previous three-year period, for a total of four metrics.

On these measures, Turkey fares worst, with a score of five, due mostly to an eye-popping current account deficit of 7.9% of GDP. Note also the big decline in the current account surplus of Malaysia from three years ago. Hungary can brag about a sterling score, although this metric fails to capture why and how the country has achieved that score (hint: plummeting imports and deleveraging pressure).

Financial Inflows
The second set of metrics looks directly at financial inflows.

Francisco Torralba is an Economist for Morningstar Investment Management.

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