Risks concentrated in the usual suspects - Capital Economics
Emerging Markets Economics

Risks concentrated in the usual suspects

Emerging Markets Financial Risk Monitor
Written by William Jackson
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Economic and financial vulnerabilities remain low across much of the emerging world. But banking sector vulnerabilities are high in Turkey and China. And we are now explicitly forecasting a sovereign debt default in Argentina. Sovereign debt risks are also acute in Lebanon and some smaller EMs.

  • Economic and financial vulnerabilities remain low across much of the emerging world. But banking sector vulnerabilities are high in Turkey and China. And we are now explicitly forecasting a sovereign debt default in Argentina. Sovereign debt risks are also acute in Lebanon and some smaller EMs.
  • We split EM crises into three categories: currency crises, banking crises and fiscal crises. The broad trend over the past twenty years has been towards fewer EM crises. This reflects several developments, the most important of which has been a marked improvement in policymaking. However, financial vulnerabilities spiked in a number of EMs in the run-up to the global crisis in 2008, and they built again in 2013-14. Our EM Financial Risk Tracker suggests that vulnerabilities, in aggregate, are relatively muted. (See Chart 1.)
  • We are increasingly concerned about banking vulnerabilities in Turkey. Although the financial sector came through last year’s crisis relatively well, growing government intervention and deposit dollarisation suggest that the fallout from a fresh period of financial stress could be more severe. Elsewhere, the bailout of China’s Baoshang bank highlighted that a banking crisis is a serious medium-term risk.
  • Currency vulnerabilities have diminished over the past year in most countries, although widening current account deficits in Romania and Colombia point to relatively large falls in their currencies. The Argentine peso will also weaken sharply against the dollar, making its existing sovereign vulnerabilities worse. We think that Argentina’s government will need some form of debt restructuring over the next three years – regardless of who wins October’s presidential election.

Chart 1: EM Financial Risk Tracker1 (Diffusion Index)

Sources: Refinitiv, IMF, BIS, Capital Economics. 1) A diffusion index created from the various indicators of financial risk contained in this document.

Methodological note: This Monitor is intended to help clients better identify where economic and financial risks lie within individual EMs. It assesses vulnerability to three types of crisis – banking, currency and fiscal (definitions of each type of crisis can be found here). For each category, we have identified three indicators that provided a reliable early warning signal in the run-up to previous crises. We present the latest values for these indicators for the major EMs that we cover, together with our interpretation of where each country lies within a spectrum of risk for each type of crisis.


Banking Sector Vulnerabilities

  • Banking sector risks in most EMs have eased. The big credit booms seen in a handful of major countries (e.g. Brazil and Russia) have continued to deflate without causing significant stress. Foreign currency lending is generally low, and loan-to-deposit ratios have come down.
  • That said, there are a few points of concern. Turkey’s banks came through last year’s crisis relatively unscathed. But several new developments should ring alarm bells. Deposit dollarisation is rising and the government is taking an increasingly interventionist approach towards directing lending decisions. The next time financial stress hits, the fallout for the banking sector could be much more severe. (See our Emerging Europe Focus, “Turkey’s banks: why the next crisis will be worse”, 13th June.)
  • In China, the bailout of Baoshang Bank in June underlined that a banking crisis is a major medium-term risk. Medium-sized banks, which are more dependent on wholesale funding, appear to be the main point of concern. (See our China Focus, “What might trigger a hard landing?”, 16th May.) Concerns about Andean banking sectors are also emerging. Although residents are now deleveraging, a relatively large share of lending is denominated in foreign currencies.

Chart 2: Banking Sector Vulnerability Indicators of Selected EMs

Sources: Bloomberg, BIS, CEIC, Refinitiv. 1) Change from the minimum over the past decade to latest, as a % of GDP. 2) As a % of GDP.


Currency Vulnerabilities

  • The risk of a repeat of the very large currency falls seen in some EMs last year is low. Current account deficits across much of the emerging world are now much smaller, suggesting that currencies are no longer fundamentally misaligned. More generally, following falls last year, exchange rates don’t look overvalued. We think most EM currencies will depreciate by around 5-10% against the dollar this year.
  • There are a few currencies which are likely to underperform. Very high inflation, as well as continuing risks related to banks and sovereign debt, mean that we expect substantial falls in the Turkish lira and Argentina peso this year. But falls won’t be on the same scale as in 2018. We expect these currencies to depreciate by 15% and 25%, respectively, against the dollar by year-end.
  • In Colombia and Romania, current account deficits have widened in the last few years and, at 4-5% of GDP, now stand among the largest of among major emerging market. They’re not in the same league as Turkey and Argentina were a year ago, but there are risks of substantial currency falls (of 15-20% versus the dollar). This also explains why these two countries are among the few in the emerging world whose central banks are likely to hike interest rates this year, while most others will be loosening policy.

Chart 3: Currency Vulnerability Indicators of Selected EMs

Sources: Bloomberg, BIS, CEIC, Refinitiv. 1) Change from maximum in past three years to latest, as a % of GDP. 2) As a % of GDP.


Sovereign Vulnerabilities

  • Public debt ratios have risen across much of the emerging world in the last few years, but governments have taken steps to repair their balance sheets, and budget balances have improved as a result. This should limit the rise in public debt in the future.
  • One country whose debt ratio is on an unsustainable trajectory is Argentina. The IMF’s view that the debt ratio will fall is based on overly optimistic assumptions. We think that a fall in the real exchange rate and fiscal slippage will push the debt ratio up and trigger some form of debt restructuring within the next three years. (See our Latin America Focus, “Will Argentina default?”, 17th June.) Default risks are also high in some small EMs, such as Lebanon.
  • Elsewhere, problems at state-owned firms have focused attention on public debt in Mexico and South Africa. In both cases, governments are likely to try to muddle through, providing piecemeal bailouts. But this will only kick the can down the road. On a more positive note, the pension reform bill in Brazil passed a major hurdle in congress, providing hope that the government will be able to get its fiscal house in order.

Chart 4: Sovereign Vulnerability Indicators of Selected EMs

Sources: Bloomberg, BIS, CEIC, Refinitiv. 1) Change in general government gross debt, as a % of GDP. 2) As a % of foreign exchange reserves. 3) Change from the minimum over the past five years to latest, as a % of GDP.


Historical Data

Chart 5: Number of Emerging Market Crises by Region

Sources: IMF, Capital Economics

Chart 6: Number of Emerging Market Crises by Crisis Type

Sources: IMF, Capital Economics


Definition of Crises

  • Banking crisis: We use the definition outlined in a 2013 IMF paper “Systemic Banking Crises: A New Database”. This is a broad (and subjective) definition that characterises a banking crisis as an episode in which corporate and financial sectors experience “large” number of defaults and financial institutions and corporations face “great difficulties” repaying contracts on time.
  • Currency crisis: Defined as a depreciation or devaluation in the exchange rate of more than 30% against the US dollar within a year.
  • Sovereign debt crisis: Defined as the failure by a government to meet a principal or interest payment on the scheduled due date (or within the specified grace period).

William Jackson, Chief Emerging Markets Economist, +44 20 7808 4054, william.jackson@capitaleconomics.com
James Swanston, Assistant Economist, +44 20 7808 4991, james.swanston@capitaleconomics.com

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Capital Economics Economist
james.swanston@capitaleconomics.com