Further, in the key economies – especially China – most debt is funded with huge amounts of domestic capital rather than overseas ‘hot money’, and domestic deposits at that.
However, if we are wrong, the question becomes which emerging markets would be most susceptible to devaluation, speculative attack and a balance of payments crisis?
What to look for
To answer that, we look at official reserve assets, all the securities, commodities and cash denominated in a foreign currency held by a central bank.
Governments can use these reserves to counter disruptive movements in currency markets. While only temporary, that initial intervention, smoothing consumption and capital flows, can be the crucial factor in the aversion of a full-blown run on a currency.
Reserves – and their perceived adequacy – are critical to the resilience of emerging economies and their financial markets. The Asian financial crisis of the late ’90s highlighted the importance of holding adequate reserves, and since then emerging economies have built up substantial amounts.
But exactly what level of reserves qualifies as adequate is a bit woolly.
There are a few rules of thumb. Perhaps the most common is that the minimum level of reserves should equal at least three months of imports. This measure is suitable for countries whose balances of payments are dominated by trade and especially susceptible to a terms of trade shock.
But it is less useful for those that have opened up financially, such as Mexico or South Korea.
For these, the “Greenspan-Guidotti” rule is often called upon: reserves must fully cover a country’s short-term debt.
It’s perhaps the most widely cited standard regarding EM reserve adequacy. As for countries with large banking sectors and open capital accounts, the 20% reserve to broad money ratio is often employed for capturing the risk of capital flight of residents’ deposits.
Essentially, this means the central bank has backed a fifth of the stock of readily accessible, own-currency money with foreign reserves.
Most emerging nations pass the Greenspan-Guidotti test, although Malaysia and Turkey fail by significant margins. South Africa is starting to breach adequate cover for its broad money supply. China and South Korea have significantly less reserves than considered “adequate” to cover their currencies; however, China has capital controls and this test is less applicable to the more developed economies, such as South Korea, which have more stable capital accounts.
These measures are simple and relevant, but they focus only on particular aspects of vulnerability, and the thresholds are unfortunately arbitrary. To address this, the IMF developed a new approach for evaluating reserve adequacy (ARA), which is similar to the Capital Adequacy Ratio that regulators use to test financial institutions.
Essentially, it weighs different risks that could drain reserves during financial shocks (including the rules of thumb we discussed before).
These risks and their importance are derived from a comprehensive study of past periods of market stress. The reserve adequacy ratio for each country therefore depends on its own mix of liabilities. Through further study, IMF researchers concluded that reserves should cover between 100-150% of this metric to mitigate the risk of crisis in a typical country.
Once this level is reached, the probability of severe economic consequences because of market pressure rapidly tails off.
The chart shows that most EM countries had sufficient reserve adequacy ratios as of 2017, although the picture is not quite as healthy as it was a few years ago.
The IMF also computes an alternative metric that takes into account the extent of capital controls (the green lines). Capital controls have a significant effect, so this should be taken into account. Interestingly, although China has over $3trn (£2.2trn, €2.4trn) of currency reserves, those are only judged as adequate once capital controls are taken into account.
Of the major emerging markets, only Turkey, South Africa and Pakistan fail this advanced test.
While we think the probability of an EM currency crisis is very low, these nations would be most vulnerable. As debt continues to accumulate in emerging markets, and as the Federal Reserve’s policy normalisation reduces the amount of dollars sloshing round the globe, we will be watching closely to see if the deterioration in developing nation reserves continues.