Recently, the most oft-asked question from investors has been “Is this like 1997?”, referring to the Asian crisis, which broadened out to other emerging markets in the following two years. This is more of an empirical question. We remember 1997 well—having conducted in-depth analysis in June of that year of financial vulnerability in various Asian markets. The analysis was based on the seminal research of Graciela Kaminsky and the now-famous Carmen Reinhart, among others. Looking back, the basics of financial vulnerability have not changed much. Using similar variables to analyse vulnerability (there is no hindsight bias) we have found that:
l Of the nine markets analysed, six (or two-thirds) are demonstrating heightened financial vulnerability—close to what we saw in mid-1997. Back in 2005-06, almost none were. To be sure, the absolute of concern/vulnerability were slightly higher in mid-1997 for almost all markets covered. While many markets appear at risk today, they are not yet at the severe levels of 1997.
l Elevated financial vulnerability is often, but not always associated with currency and/or banking crises. Singapore (surprisingly), India and Malaysia score poorly on our measure of financial vulnerability. China, Hong Kong and Indonesia are also concerning. Korea and Taiwan look less vulnerable, while Thailand is in the middle. Our financial vulnerability analysis is driven by 10 factors. Excessive real credit growth, the gap between credit growth and economic growth, rising loan-deposit ratios and elevated money multipliers—all signs of credit booms and financial liberalisation. Deteriorating current accounts, “over-valued” currencies, rising foreign debt, especially shorter duration debt reflect international illiquidity. Weakening economic growth and falling financial stock prices are canaries in the coalmine.
l There is considerable alpha in assessing financial vulnerability in countries. In eight of the nine markets, investing during periods of heightened financial vulnerability has historically produced returns well below those in calmer, less stressed times. (Hong Kong is an exception.) Indeed, returns have almost always been negative or negligible in periods of elevated financial vulnerability. Macro-risk assessment appears to matter to equity investors.
l An improving US current account deficit is closely associated with rising emerging market financial vulnerability. An improving US current account deficit signals declining global liquidity—a problem especially for dollar-short entities, i.e. those with external deficits and/or US debt. As a risk case, we are concerned that the improving US current account balance could improve further, if the past relationship with the inflation-adjusted trade-weighted dollar is a guide. (Note: