The most compelling reason not to fret about media chatter asserting elevated risk of an EM funding crisis is that the largest EM equity markets are not at risk of a funding crisis. Russia provides an illustrative example. Yes, its military adventures in neighboring countries (and the Middle East) dissipate financial and human capital, while its meddling in other countries’ elections subject it to sanctions. These dubious activities do not, however, create the risk of a funding crisis. Russia does not need to borrow from abroad to finance its consumption and investments. It sells more in oil and gas to its European neighbors than it buys in goods from the rest of the world. With little external debt, ample FX reserves, and a large current account surplus, the risk of a Russian financial crisis is remote (especially with the price of oil hovering between $60 and $80 a barrel).
Argentina and Turkey, understandably, are much in the news. Yet these countries are nearly irrelevant for EM equity investors. Argentina is no longer classified as an emerging market, and Turkey’s equity market represents less than 1% of all EM stock markets. So, let’s take a look at the countries that do matter for those of us invested in EM equities.
We assess the risk of a funding crisis by examining three key metrics: external debt, FX reserves, and current account balance. External debt may need to be refinanced if foreign investors lose confidence in a country’s credit. FX reserves provide the immediate liquidity to repay the external debt. The current account measures whether the risks of external debt and FX reserves are likely improving or worsening.
China, Korea, Taiwan, India, and Russia, each in its own way presents political or economic risks—that’s what makes them emerging markets. How much of that risk is unknown to the market? How much is fully priced into these nations’ valuations? According to our analysis, none presents any measurable risk of a funding crisis. All have low external-debt-to-GDP ratios and ample FX reserves, and most run current account surpluses. (India runs an immaterial current account deficit.) Together, these large, low-crisis-risk markets compose about 60% of the MSCI Emerging Markets Index.
Brazil, Mexico, and South Africa run current account deficits, but also have low external debt to GDP paired with healthy FX reserves. These three countries, which display modest risk, compose 15% of the MSCI Emerging Markets Index. A few countries, including, notably, Turkey and Indonesia, seem at more material risk with high external debt, low FX reserves, and significant current account deficits. These markets, however, are only a small fraction of the total EM equity market.
Interestingly, the United States fares poorly on the three crisis risk measures we analyze. External debt to GDP is higher than in the worst EM countries, and we run a persistent current account deficit. But with great wealth and the world’s reserve currency, the United States seems in no immediate danger of a funding crisis. Longer-term, as government deficits are heading to over 100% of GDP, complacency seems ill advised.