May 28th, 2015 | By Nick Sargen
In the wake of the 2008 Financial Crisis, investors have been on the lookout for the next crisis situation. For the past two years, market participants have been primarily concerned about how emerging economies would fare in a global environment where commodity prices are soft and U.S. interest rates and the dollar are rising. The reason: Emerging economies were the principal beneficiaries of strong commodity prices during the past decade and attracted record foreign capital inflows when the developed economies experienced severe recessions in 2008-09. In the meantime, however, growth rates in the emerging economies have slowed considerably, as commodity prices have softened, and their currencies have come under pressure.
Two years ago, when talk of Fed tapering caused U.S bond yields to spike, market participants focused on the "fragile five" – consisting of Brazil, Turkey, India, South Africa, and Indonesia – on grounds they needed to finance large external imbalances. While the taper tantrum proved to be short-lived, the ensuing plunge in oil prices and the resurgence in the dollar since mid-2014 have contributed to an exodus of capital from emerging economies and declines in foreign exchange reserves of many countries. According to a recent Financial Times report entitled "The Great Unraveling" (April 2, 2015), the 15 largest emerging economies experienced their biggest absolute capital outflow since the 2008 crisis in the second half of 2014, while their foreign exchange reserves suffered their first annual decline since records began in 1995.
This begs the question, "Which countries are most vulnerable to a debt crisis?"
According to economists at the IMF and Capital Economics, a private research firm, debt problems tend to emerge following a rapid expansion of debt, rather than when debt passes a specific threshold. The IMF study finds that an increase in the private debt sector ratio of more than 3 percentage points per year on a sustained basis can serve as an early warning signal of financial stress. Along these lines, the economists at Capital Economics observe that "since 1990 no emerging market that has seen its private sector debt ratio increase by more than 30%-pts in the space of a decade has subsequently avoided a banking crisis." Using this criterion, their study identifies five emerging economies as being vulnerable – China, Turkey, Korea, Brazil, and Russia.
Economists at the BIS have been at the forefront in developing a framework for measuring booms and busts in financial systems. Their research suggests that credit aggregates, as a proxy for leverage, and property prices, as a measure of available collateral, play a particularly important role. In the 2013/2014 Annual Report, the BIS identified Asia as a region that was at risk, while also flagging countries such as China, Turkey, and Brazil. The report notes that since the end of 2009, credit to the private sector has expanded by an average of 10% per year and that there are indications of problems ahead: "In China, this growth was mainly driven by non-banks, whereas banks financed the expansion in Turkey. At present, there are signs that some of these booms are stalling. For example, property price growth in Brazil has weakened, which is typical of the later stages of the financial cycle. Rising defaults in the property sector in China also point in this direction."
While the various studies utilize different methodologies, it is striking how similar the countries on their watch lists are. In this regard, our own assessment is that Brazil, Russia, Turkey, and Venezuela bear close watching, because they have large external deficits (except Russia), relatively high inflation, currency pressures, and financial systems that are vulnerable, as well as a host of political issues.
We are also paying considerable attention to China, because conditions in its property market are deteriorating and the banking system has considerable exposure to that sector as well as to municipalities. That said, we also recognize the Chinese authorities have the latitude to ease monetary policy further, and they can also direct banks to roll over existing obligations to institutions that would otherwise be insolvent. These factors mitigate the risk of a "hard landing" for the Chinese economy, but they do not preclude a further slowdown in the country's long-term growth rate.
For the most part, we believe the concerns expressed above are already priced into emerging markets, as their equity markets have underperformed the U.S. and other developed markets consistently in the past four years, and their currencies have sold off considerably against the U.S. dollar since mid-2014. The past few weeks have seen a small reversal in these trends, as oil prices have firmed while the dollar has eased. But these moves may prove to be temporary if commodity prices remain soft.
The main risk that is not priced into markets is the potential for a crisis in a single country to spread to other countries in that region or around the world such as occurred in the 1980s in Latin America and in the late 1990s in Asia. In our view, a repeat of these occurrences is fairly low today for several reasons. First, current account and budgetary imbalances today are considerably smaller than those run by Latin American countries in the 1980s, and inflation rates are also substantially lower today such that currencies are not significantly mispriced. Second, in the wake of the 1997-98 crisis, Asian countries compiled massive holdings of foreign exchange reserves to protect themselves against capital flight. Also, most countries in the region strengthened their banking systems after they experienced massive loan losses. Third, the debt buildup in emerging economies in recent years mainly has been domestic debt in the private sector, rather than foreign-currency denominated debt of sovereigns, which also leaves them less exposed to capital flight. Finally, we believe the Federal Reserve will proceed very cautiously in tightening monetary policy.
Of the countries we are monitoring closely, two stand out as having potential to create spill-over problems: Namely, China's economy could impact the rest of Asia as well as other emerging economies, while Brazil's economy could influence others in Latin America. In this regard, China is on more solid footing than Brazil, as it has the scope to ease monetary policy further and to influence bank lending directly. Brazil, by comparison, increasingly finds itself in a box, where the authorities may have to keep interest rates high to combat inflation and to attract foreign capital, which adds to risks in the banking system, while political problems make it difficult for the government to embark on much needed economic reforms.
Our take, therefore, is that while we cannot entirely rule out the risk of a regional crisis, we do not foresee a repeat of the experience of the 1980s or 1990s.
 Global Financial Stability Report, IMF, September 2011.
 See 2013/2014 Annual Report, BIS, Chapter 4.