Morningstar Advisor - December 2013/January 2014 - (Page 40)

Spotlight Economic Vulnerability Varies by Country By Francisco Torralba If inflows of capital suddenly tighten, certain emerging markets are more at risk than others. Investments in emerging-markets economies have outperformed those in developed countries over the global business cycle that began in 2009. Loose monetary conditions set by the central banks of Japan, the United Kingdom, eurozone, and, most importantly, the United States, depressed yields and prompted developed-market investors to seek higher yields overseas, often in emerging markets. A consensus is forming, however, that tighter monetary conditions are on the horizon. Moreover, cyclical and structural factors are beginning to slow down the economies of some emerging markets. It is only a matter of time before the most skittish of those investors return home. Most emerging-markets countries are particularly exposed to the risk of an abrupt end to capital inflows, which we have learned from the past 40 years of markets history. As such, analysts tend to lump developing countries together in a way they never would with advanced economies. Headlines this past summer about sinking currencies and money gushing out of emerging-markets funds led one to believe that all emerging-markets economies would wreck in the event of a "sudden stop" of capital. My analysis suggests that that is not the case. I focused on gauging the vulnerability of 16 emerging-markets economies to a freeze in 40 Morningstar Advisor December/January 2014 capital inflows. My scorecard consists of 18 metrics that have been linked to such risk, grouped into four sets. For each set, I generate a score, which I derive from the relative position of each country in the cross sectional distribution. I then average the four scores to produce an overall index of vulnerability. The index can take a maximum value of five, for the highest degree of vulnerability, and a minimum of one, the lowest. On these measures, Turkey fares worst, with a score of five, due mostly to an eye-popping current account deficit of 7.9% of GDP. Note also the big decline in the current account surplus of Malaysia from three years ago. Hungary can brag about a sterling score, although this metric fails to capture why and how the country has achieved that score (hint: plummeting imports and deleveraging pressure). Current Account Financial Inflows The first set of characteristics relates to the external balance. The second set of metrics looks directly at financial inflows. A large current-account deficit implies lots of borrowing from abroad, which might precipitate a crunch if funding dries up. In addition, I check the basic balance, which adds net foreign direct investment (FDI) to the current account balance. FDI is the stickiest and most reliable form of foreign financing. A country with a negative basic balance cannot cover its financing needs with FDI, depends on flightier forms of foreign inflows, and is more vulnerable to sudden stops. For both the current account and the basic balance, I consider as metrics the average balance over the past three years (through the second quarter of 2013), as percent of GDP, and the change from the average balance in the previous three-year period, for a total of four metrics. Portfolio inflows, aka "hot money," tend to go directly into stocks, bonds and bills, bank deposits, and loans. Getting out of a portfolio investment tends to be faster and cheaper than unwinding an FDI investment. Therefore, reversals of hot money flows tend to be more sudden and more disruptive than those of FDI. As a metric, I consider portfolio gross inflows as percent of GDP over the past three years, and their change from the previous three years. A second metric is gross FDI inflows as a percent of gross portfolio and FDI inflows, as well as its change. (In the case of the second metric, a higher number implies a lower degree of vulnerability.) Here, Mexico and Turkey share the dubious honor of being the most exposed. For both,

Table of Contents for the Digital Edition of Morningstar Advisor - December 2013/January 2014

Morningstar Advisor - December 2013/January 2014
Contents
Contributors
Letter From the Editor
What’s Your Purpose?
Working for Gen Y
How to Allocate College Savings
Mobius Looks to a New Frontier
Investments á la Carte
Investment Briefs
How to Manage Bonds for Today and Tomorrow
Cloud Is the New Engine of Growth
Knowing Where to Look
Economic Vulnerability Varies by Country
Factor Investing in Emerging Markets
Following the Rules
Exploring Indexing’s Next Frontiers
Frequent Fliers
Family Blind Spots
Optimal Portfolios for the Long Run
Finding Value in a Pricey Sector
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
The Emerging-Markets Roller Coaster

Morningstar Advisor - December 2013/January 2014