Greater financial depth can increase a country’s ratio of local savings to gross domestic product and so improve liquidity for local assets—a potentially significant factor in averting contagion from economic events that impact global portfolio flows. Countries with greater financial depth may also be able to sustain larger public and private debt, have lower dollarization rates, and run lower risks of default on their sovereign debt.
By creating risk profiles based on macro/leverage and financial metrics, adjusting for financial depth, and comparing EM risk scores on a cross-country basis, investors can assess the extent to which countries’ securities prices and currency values reflect the prevailing risk levels of systemic financial crisis.
How the EM Countries Compare
In Europe, the Middle East and Africa, Turkey stands out as the highest-risk country. Notable risks include: a potential asset bubble from a significant rise in real estate prices; increased dollarization; and a relatively small financial system. By contrast, the South African financial system is the strongest in the region—a major positive for the country’s sovereign debt. South Africa benefits from significant financial depth, a banking system that has been deleveraging over the last decade and an absence of signs of any asset bubbles. Israel (high real estate prices) and Saudi Arabia (high private credit growth) both shows signs of overheating, but from a strong base.
In Latin America, Mexico and Brazil have strong and stable financial sectors, while Peru’s declining macro risks and long-term credible monetary policy are reflected in reduced dollarization.
Across Asian countries, China, India, Indonesia and Korea all seem to have stable financial systems. Although private credit levels are rising in China and Korea, we believe this is offset by the greater financial depth of their banking systems. India and Indonesia overall have stable systems, with no signs of overheating.
Emerging markets have come a long way since the 1990s, with many countries now benefiting from independent regulation and more proactive risk management. Although economic conditions can change quickly, for now financial sector risks across EM countries seem largely manageable. But as events in the US and Europe have shown, in an environment of tighter global liquidity conditions, investors need to stay alert for future signs of fragility.
