EM stress driven by current account, reserves, debt, and risk aversion

Handicapping EM financial crises is not easy but we have come a long way over the last decade at being able to identify the key vulnerabilities for EM. The recent IMF External Sector Report: Global Imbalances and the COVID-19 Crisis issued this month provides a useful guide on the factors which should be given the most focus. 

The IMF's modeling on EM external stress probabilities shows the sensitivities for some key variables. For example, global risk aversion, foreign currency debt, foreign currency reserves, and the current account are, as expected, key variables. Nonetheless, the combination of foreign currency debt and global risk aversion on two which should be given the most attention. A pandemic shock will lead to higher risk aversion and adverse capital flows. High foreign currency debt will make the EM financial sector vulnerable. 

The preconditions before a global crisis will have a big impact on the EM stress. The trifecta preconditions of reserves, foreign currency debt, and current account deficits have differed through time. For this financial crisis EM economies have been most vulnerable from FX debt positions. This is why dollar swap funding and lowering of US interest rates has been so important. The lowering of global interest rates have reduced the stress of meeting cash financing payments, but it has not changed the ability of countries to meet principal payments

EM stress can often be characterized as sudden stop growth impact (SSGI) events and exchange market pressure events (EMPE). Investors have to realize that the signals for each of these events are different, so one set of factors does not fit all situations. When looking back over research on EM stress and crisis, there are approximately 80 different variables that have been used  to measure or identify EM stress events. 

Fragility still exists even with the improved performance in EM stress. This fragility will slow future capital flows and make EM countries vulnerable to a secondary shock. While EM opportunities may seem abundant, the risks are also significantly higher than more simple developed market equity and bond plays.