"Who's Naked?": Ranking The Most Vulnerable Emerging Market Currencies

"When the tide goes out we see who's naked."

Warren Buffett's famous saying has rarely been more applicable than now, when the tide - of cheap dollar funding - is finally receding and most emerging market countries have been caught naked.

As SocGen's Jason Daw writes in a extensive new report, as the dollar tide recedes "the misallocation of capital following a decade of cheap money is starting to be exposed" and coupled with high dollar liabilities, the scale of which has not been tested in a Fed  tightening cycle, the result will be periodic episodes of stress such as the one observed now. At a minimum, higher dollar funding costs will make investors more selective in their choice of risk assets. In a worst case scenario, the world will experience another "Asian Financial Crisis", something which Bank of America recently warned about.

So who is most vulnerable, or as Buffett may say, naked?

To assess the vulnerabilities across emerging markets, the French bank examined external positions, short-term external debt, foreign currency-denominated debt, fiscal and debt positions, reserve adequacy, and foreign bond ownership.

It then compiled a scorecard of gross (i.e. total number of indicators that suggest high vulnerability) and net (the summation of negative, neutral, positive vulnerability factors) vulnerabilities sheds light on which currencies might experience additional stress as the Fed continues to tighten monetary policy or if other factors impair EM sentiment.

While we lay out the various metrics that SocGen used to calculate EM vulnerability below, for those pressed for time here is the answer:

  • High vulnerability: Turkey, South Africa, Malaysia, India, Indonesia.
  • Medium vulnerability: Mexico, Chile, Brazil, Colombia, Czech Republic, Hungary, Poland.
  • Low vulnerability: Korea, China, Thailand, Russia.

Below we lay out the various metrics across which SocGen evaluated each nation, starting with.

External position

Current account deficit currencies underperform those with a surplus in times of stress. A country with a current account deficit requires a steady inflow of foreign capital, which can dry up when sentiment toward emerging markets is depressed. Eight countries have deficits – the largest being in Turkey and South Africa – and the remainder have varying surplus levels. Since July, the dollar rallied 8% against deficit currencies (ex-Turkey) and only 2% against those with a surplus.

Turkey, South Africa, India, and Indonesia have a basic balance deficit. The basic balance – current account plus net foreign direct investment – is another metric to gauge funding vulnerabilities. Foreign direct investment is a more stable source of financing, so adding it back to the current account helps to assess a country’s reliance on short-term capital flows. A similar picture compared to the current account emerges – Turkey and South Africa are the most exposed to a deterioration in investor sentiment. The vulnerability of India and Indonesia is small when factoring in FDI while the remainder of emerging markets have a basic balance surplus.

Short-term capital flows

Turkey and South Africa are the most dependent on short-term capital flows. A country with a basic balance of payments deficit requires short-term capital inflows – net portfolio and crossborder banking flows – to fund their balance of payments. Relying on short-term capital flows can pose problems when EM risk appetite falters or a country experiences a domestic shock. Turkey and South Africa are the most dependent on this fickle source of financing. India and Indonesia require very modest short-term capital inflows, while the rest of emerging markets are a net provider of these funds to the rest of the word.

Short-term external debt

Turkey, Malaysia, Hungary, and the Czech Republic have the least favourable short-term external debt ratios. Short-term external debt represents the amount that the government, households and corporates owe to foreign creditors in the next year. Debt servicing costs and rollover risks can increase sharply when EM sentiment sours or there is a deterioration in country-specific factors. China, Brazil, India, and Russia are at the low end of the spectrum with Turkey, Hungary, Malaysia, and Czech Republic being more vulnerable.

FX-denominated debt

Turkey, Hungary, Poland, and Chile have high levels of FX-denominated debt. Foreign currency-denominated debt can be owed to either foreigners (included in external debt) or local residents. Reliance on foreign currency debt is especially problematic when the borrower (corporate, household or government) does not have a sufficient source of foreign currency earnings. These risks are magnified when there is currency depreciation.

Fiscal debt and deficits

Brazil, India, and South Africa have the highest fiscal vulnerabilities. Most EM countries run a small fiscal deficit with modest levels of debt-to-GDP. The exceptions are Brazil, India and South Africa where the combination of fiscal deficit and the level of debt-to-GDP are high compared to EM peers. Not only does this reduce the fiscal space to mitigate adverse growth shocks, but it can also result in investors demanding a higher risk premium on domestic assets.

Foreign bond ownership

South Africa, Indonesia and the Czech Republic have high foreign ownership of local bonds. Depreciation pressure on currencies can be amplified when foreign investors either reduce their bond holdings or hedge their FX risk. Foreign ownership of local currency bonds has generally trended higher over the past ten to 15 years, though in some markets such as Malaysia and Hungary foreign ownership has declined. India and Brazil have low foreign participation while foreign flows and bond index inclusion should see foreign ownership in China rise sharply over time.

Reserve adequacy

South Africa, Turkey, Chile, and Malaysia have inadequate foreign exchange reserves. According to the IMF, holding sufficient  reserves “reduce the likelihood of balance-of-payments crises, help preserve economic and financial stability against pressures on exchange rates and disorderly market conditions, and create space for policy autonomy.” Most countries have reserves that fall within the recommended range; Thailand and Russia have reserves that far exceed the recommended levels while South Africa, Turkey, Chile and Malaysia’s reserves are inadequate.

Summary: Vulnerability scorecard

A scorecard of gross (i.e. total number of indicators that suggest high vulnerability) and net (the summation of negative,  neutral and positive factors) vulnerability sheds light on which currencies might experience heightened stress from higher dollar funding costs or other factors that impair EM sentiment. For each country, the variable is assigned a value of either 1 (vulnerable), 0 (neutral) or -1 (not vulnerable). The values assigned under this scoring system are shown in the table below

The chart below shows the aggregate results across the seven factors. For the number of gross vulnerabilities, the scorecard can range between 0 (no vulnerabilities) to 7 (vulnerable in every factor). For net vulnerability, the scorecard can range between -7 (not vulnerable in every category) to 7 (vulnerable in every category).

  • High vulnerability: Turkey, South Africa, Malaysia, India, Indonesia.
  • Medium vulnerability: Mexico, Chile, Brazil, Colombia, Czech Republic, Hungary, Poland.
  • Low vulnerability: Korea, China, Thailand, Russia.