Weighing Emerging Market Risk: The Supply of Capital

Business Economics, Jan, 2000 by James W. Harris

BUSINESSES CONDUCTING COUNTRY RISK ANALYSIS SHOULD CONSIDER NOT ONLY THE DETERMINANTS OF CAPITAL FLOWS, BUT THEIR SOURCES AS WELL.

Economic professionals specializing in country risk or international portfolio analysis face a daunting challenge when called on to assess the volatility of capital flows and risk pricing associated with the more than thirty emerging market countries. One of the reasons is that most analytic frameworks in use do not adequately consider the determinants of the availability of capital, confining themselves instead to the policy and performance characteristics of the emerging markets themselves. Capital flows are overwhelmingly an industrial-country game, however, and assessing what emerging markets get and can sustain requires a broad toolkit, including no less than an understanding of the global economy. [1]

Filling Out the Incomplete Country Risk Framework

Country risk specialists in the last three years have had to get one issue right if they got any--finance. We have seen governments among the emerging markets come and go almost routinely, sometimes amid profound political unrest, and we have seen foreign exchange and default risk turned on its head as emerging market producers and banking systems tried to weather the storms accompanying financial turbulence. It has been a humbling experience for even seasoned risk professionals, and it is natural to ask whether we use the right analytic tool kit.

Only the market seems to render an unarguable verdict about risk, and it does its work with sudden swiftness. For the rest of us, the right framework is an elusive issue. We have all heard about country risk assessment frameworks that over-predicted or under-predicted financial crises--because they overstate or understate risk. While our models end up suffering from this flaw for a variety of reasons, I suggest the key reason is not that we do not understand the emerging markets themselves. Instead, we assess the likelihood of financial crisis badly because we do not incorporate an adequate understanding of the supply side of the global credit market.

None of us really believe that the emerging markets pull capital out of the industrial economies in some deterministic sense--rendering the net aggregate supply to 32 emerging economies stable and predictable, as encouraging events in some emerging markets are offset by discouraging events in others. On the contrary, the aggregate supply of capital among any given class of assets is highly variable. And the causes of volatility are on the supply side. Neglecting this fact is a good way to mis-specify the risk implied in even the most elaborate country ranking schemes.

Ranking the vulnerability of emerging market economies according to criteria that are drawn solely from the emerging market economies themselves runs clear risks. Different groups of countries, say the Asian ones, are indebted to different national banking systems, different classes of direct investors, and to different types of equity and fixed income portfolios, say those in Japan. [2] Shocks emanating from one national source of capital are bound to be propagated among emerging markets in different order and with different severity than shocks emanating from another national source. This problem is not remedied (and is possibly even obscured) by most aggregated vulnerability rankings we might work with, say those that rank emerging markets by the ratio of short-term liabilities to liquid assets.

Determining what causes a financial crisis is a complex issue even after the fact, but given the array of debts among emerging market borrowers, financial crises of consequence are usually triggered on the supply side. Consider the last two large-scale crises: Mexico during 1994-95 and the crisis that began in East Asia in 1997 and reverberated globally during 1998. The increase in the U.S. Federal Funds rate in 1994 clearly contributed to the Mexico crisis. This isn't to blame the Federal Reserve or to absolve Mexico; it is just to acknowledge, using a crisis with which we are all familiar, that the price and availability of capital is potentially the largest source of shocks to a financially vulnerable emerging market.

In the case of East Asia, Thailand, Korea, and Indonesia were beholden in some critical sense to banks in Japan and the EU, whatever their debts to other creditors. And in the spring of 1997, when the yield curves in Japan and the EU changed substantially as the price of domestic short-term credit rose, the Asian crisis was off and running. [3]

An Industrial-Country Game

Acknowledging that shocks emanate from the supply side, how should we factor supply considerations into our risk analysis?

First, a collection of countries chronically contributes a large amount of capital to global markets--Japan, the EU, Taiwan, Singapore, and a handful of others. This volume of funds is, in principle, available to the emerging markets, and it is, of course, also available to industrial countries. Northern Europe is not a net capital exporter on the scale of Japan. But the shift in Europe's annual net position since 1990 is almost $200 billion (shown by the arrows in Figure 1), not so different from the growth in the emerging market's net position during this period as an importer. It is also highly suggestive of how the change in the net position of one part of the global economy can affect the net position of another.