Research Briefing

Emerging markets

Emerging markets
March 12, 2013
Authors Maria Laura Lanzeni +49 69 910-31723 maria-laura.lanzeni@db.com Christian Weistroffer +49 69 910-31881 christian.weistroffer@db.com Editor Ralf Hoffmann Deutsche Bank AG DB Research Frankfurt am Main Germany E-mail: marketing.dbr@db.com Fax: +49 69 910-31877 www.dbresearch.com DB Research Management Ralf Hoffmann | Bernhard Speyer

Who is vulnerable to overheating?

In an environment of ultra-loose monetary policy in the developed markets and much-improved economic fundamentals in emerging markets (EMs), the attractiveness of the latter for investors has significantly increased. Correspondingly, capital inflows to EMs have surged sharply. This phenomenon 1 and its policy implications were recently analysed by our colleagues. In this note, we focus on the risk side of recent developments. We would like to investigate whether countries are experiencing too much of a good thing and could become vulnerable to overheating. While the threat of full-blown crises in EMs has receded markedly, a hard landing following overheating could still be damaging, not only for the country in question but given the considerable weight that emerging economies now have in global GDP growth potentially beyond its frontiers. Our empirical approach employs a narrow definition of overheating related to the financial cycle and thus leaves out other aspects frequently associated with overheating such as ouput growing above potential, large current-account deficits, etc.

Emerging markets have come a long way

It is a well documented fact that emerging markets are in much better economic shape structurally, which is to a large extent attributable to better economic policies and the reduction of external and internal imbalances. Most emerging countries survived the severe economic and financial turmoil of 2008-09 without experiencing a balance-of-payments, currency or systemic banking crisis, although some EMs (especially in Eastern Europe) had to resort to the IMF and the EU for financial aid.

The risks of plenty

Despite the improvements in EM economic fundamentals, the recurrence of boom-and-bust cycles will in all likelihood stay with us. If anything can be learned from the recent financial crisis, it is that the potential for a backlash following a prolonged period of economic buoyancy and perceived moderation of risk should not be underestimated. Hence, it is worth investigating which emerging markets could be more prone to overheating.

Deutsche Bank (2013a, 2013b).

Emerging markets: Who is vulnerable to overheating?

The banking sector nexus

Risk of overheating
1

In the broader sense of the term, overheating refers to a situation in which the economy grows above potential, which eventually triggers overinvestment. Such periods of excessive growth are typically associated with strong capital inflows, an appreciating real exchange rate, rapid credit expansion and galloping inflation. They are often followed by a period of uncontrolled economic contraction a hard landing in which asset prices collapse and delinquency rates rise.

Accepting the hypothesis that boom-and-bust episodes will recur, we set out to identify economic indicators (and critical levels thereof) which have led to a hard landing in the past. One possibility is to look at past sovereign debt crises. Yet, at the current juncture, public finances in most of the large emerging markets are in fairly good shape. Likewise, to the extent that many EMs have built up large foreignexchange reserves and reduced currency mismatches in domestic balance sheets, the risk of a balance-of-payments crisis in most of the major emerging markets is small. That leaves us with banking crises. Empirical work by Reinhart and Rogoff (2009) spanning the past eight centuries shows that banking sector problems are closely linked to the financial cycle. Crises were frequently preceded by a period of overheating and subsequent bust. Reinhart and Rogoff suggest that capital inflows and the real exchange rate serve as a good predictor of banking crisis. Exploring more recent crisis episodes in the industrial countries, Borio and Lowe (2002, 2004) and Borio and Drehmann (2009) also conclude that banking crises can best be predicted by indicators of credit and asset-price growth. Given that rapid credit and asset-price growth has actually been observed in several emerging markets over the past couple of years, we can then use 2 banking crisis episodes as proxy for hard landings. A note of caution is warranted: while we use past crises as a source of information to identify potentially harmful overheating trends, we do not attempt here to predict future banking crises.

China: Credit versus trend

Credit to the private sector to GDP, % 140 130 120 110 100 90 80 70 60 50 95 97 99 01 03 05 07 09 11

Overheating: How to measure it

We start by looking at (i) credit-to-GDP ratios, (ii) CPI-deflated equity prices and (iii) the real effective exchange rate for a set of 36 emerging markets. The selection of indicators follows from the result of an empirical exercise in which we narrowed down the list of potential indicators to the ones with the best predictive power. Please note that the initial and final selection of indicators is based on the early-warning literature of banking crises and does not yield a comprehensive list of overheating indicators. For instance, consumer price 3 inflation and current account imbalances are not included. Our empirical strategy is based on earlier work that we did in the context of a risk monitoring exercise. We employ a signalling approach, where both the dependent and the explanatory variables can assume only discrete values (zero or one). Combining the method developed by Kaminsky & Reinhart (1999) as well as later work by Borio and Lowe (2002, 2004), the idea is to extract signals which are able to hint at future stress in the banking sector, i.e. up to three years ahead.

Actual data
Sources: IFS, DB Reseaarch

HP-Filter

China: Credit gap

Credit to the private sector to GDP/HP-Filter-1 20% 15% 10% 5% 0% -5% -10% -15% 95 97 99 01 03 05 07 09 11

Credit gap Percentile threshold (70%)

Sources: IFS, DB Reseaarch
3

Our identification scheme encompasses systemic crises, borderline events and smaller episodes of systemic relevance. This deviates from the more commonly followed approach in the literature to consider full-blown systemic crises only. Here, we closely follow Borio and Lowe (2002, 2004) who narrow down the list of potential indicators to the credit gap, investment gap, real GDP gap, real equity price and real exchange rate gap as well as monetary aggregates. Although the property price gap yields good results for the industrial countries (see Borio and Drehman, 2009), we had to drop this indicator due to data constraints for the emerging markets. While the credit gap, real equity price gap and REER gap do add to the predictive power of our model, other indicators tested did not significantly improve the models statistical properties. For a detailed description of the methodology used in this paper, see Weistroffer and Valls (2008). Research Briefing

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Emerging markets: Who is vulnerable to overheating?

China: REER versus trend
Index 130 120 110 100 90 80 70 60 50 95 97 99 REER 01 03 05 07 09 11 13

Long-term trend

Sources: Global Insight, DB Research

Our model is calibrated using a three-year forecast horizon, which has proved statistically superior among the different horizons tested. If a warning signal is observed today, it will be interpreted as an alert which will stay valid for the following three years. The model thus captures excess growth in the indicators that in the past have been followed by problems in the banking sector. First, we calculate each indicators percentage deviations from its long-term trend. Longterm trends are extracted using a recursively calculated Hodrick-Prescott filter, which ensures that the trend does not sneak into the future. For example, Chart 2 on the previous page compares the Chinese credit to-GDP-ratio to its underlying long-term trend (which in most cases means the past 20 years, with monthly observations). The difference between those two measures (credit gap) is shown in Chart 3. It is calculated as the percentage deviation of the indicators actual value from its underlying trend. In the case of China, the credit gap shows signs of overheating for the period between 2009 and 2010 and declines afterwards. For the purpose of our empirical exercise, a signal will be issued if the credit gap exceeds a certain threshold, which is depicted by the red line in Chart 3. Thresholds, in turn, are determined in a grid-search procedure, where we optimise the balance between missing a crisis and producing too many false 4 alarms, i.e. balancing so-called type-I and type-II errors. In the example above, the red line reflects the 70% percentile of the credit-to-GDP measure for China. Thresholds are generally applied as a fixed percentile across countries, which yield different absolute values for each country. Table 1 on page 6 shows the current alert level for each country and indicator. Cell colours are based on the number of signals during the past three years: a yellow flag indicates that the indicator has signalled more than 40% but less than 70% of times during the past three years, and the amber flag shows that an indicator has signalled 70% or more during that time. To give a sense of the current degree of over- or undershooting, Table 2 shows each indicators percentage deviation from its long-term trend at present. Table 2 thus takes a forward-looking perspective, as a signal today might be alerting on problems up to three years down the road. The red-marked figures in Table 2 flag that an indicator exceeds its country-specific threshold, as described above for China in Chart 3. Note that we do not make estimates about equilibrium levels of the variables; we just compare actual performance with the trend. If, for example, a country is experiencing financial deepening starting from a low credit-to-GDP level, this 5 may not necessarily be worrisome . However, a rapidly rising credit ratio still needs to be monitored. The same applies for the REER and stock market variables.

Malaysia: Overheating indicators

% 25 20 15 10 5 0 -5 -10 -15 -20 -25 95 97 99 01 03 05 07 09 11 13 Credit gap (left) REER gap (left) Stock price gap (right)
Sources: IFS, national sources, DB Research

80 60 40 20 0 -20 -40 -60 -80

Thailand: Overheating indicators

% 30 20 10 0 -10 -20 -30 -40 95 97 99 01 03 05 07 09 11 13 Credit gap (left) REER gap (left) Stock price gap (right)
Sources: IFS, national sources, DB Research

100 50 0 -50 -100 -150

What countries show overheating pressures?

Two-thirds of the countries in our sample show signs of excess growth to varying degrees in at least one of the indicators during the past three years (Table 1). Five countries, Peru, China, Malaysia, the Philippines and Thailand, show alert levels (either yellow or amber) for two of the indicators, warranting a more in-depth look at possible overheating risks in these countries.

At the optimised threshold levels, credit gap, REER gap and equity price gap capture 88%, 93% and 86% of the in-sample crisis episodes, respectively. Noise-to-signal ratios are relatively high at levels of 0.6, 0.8 and 0.8, respectively. However, looking at joint signals reduces overall noise levels substantially. Greater financial depth may even help to cushion the effects of capital outflows. See e.g. IMF (2011). Research Briefing

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Emerging markets: Who is vulnerable to overheating?

Brazil: REER vs trend
Index 250 200 150 100 50 0 95 97 99 Brazil 01 03 05 07 09 11 13

In the case of Peru and China, alert signals for credit growth are concentrated at the beginning of our 3-year period, namely in 2010, but recent developments 6 show more moderate credit-to-GDP growth (as mentioned above for China) . In China, the strongest and most persistent signal is for the REER it has flagged since early 2008. Whatever ones opinion about the fair value of the 7 renminbi , our findings show a fairly strong real appreciation in recent years (Chart 4). The overheating signals for Malaysia, the Philippines and Thailand seem at first sight to be in line with recent macroeconomic developments. The three countries were among the strongest growth performers in Asia (and in the whole EM universe) in 2012, with real GDP increasing by 5.6%, 6.6% and 6%, respectively although in the case of Thailand there were large basis effects from the devastating floods of 2011. For Malaysia (Chart 5), the areas to watch in terms of possible stability risks are the sizeable REER appreciation (6% in 2012 and a cumulative 16% since 2010) and significant credit growth in excess of GDP growth (i.e. a 6 pp increase in the credit-to-GDP ratio in 2012 and 12 pp since 2010). In the case of the Philippines, our model indicates frothiness in stock markets over the past three years, including recent months. Indeed, in 2012, the Philippine stock exchange index rose by a whopping 30% (CPI-deflated). Growth in credit-to-GDP was very robust in 2011 but has since slowed down. Thailand (Chart 6) is the country with the strongest signals, both over the past 3 years and at present. The current stock market gap (vs the long-term trend) is no less than 66%. The real effective exchange rate is almost 10% above trend and credit-to-GDP about 8%. As said above, some of these values may be contaminated by basis effects due to the strong economic rebound in 2012 from the year-earlier floods. Still, the persistence of the signals indicates that overheating pressures may be accumulating. With respect to Latin America, we observe amber signals for a real-exchangerate overvaluation in Peru and Brazil for the 3-year period (Table 1). In Peru, the REER signal has been very persistent, including the latest observations. By contrast, for Brazil (Chart 7) the overvaluation signal lasted until early 2012 and weakened thereafter (pace currency wars). Still, given that signals were issued within the 3-year period relevant from a financial cycle point of view, close monitoring is warranted. For Peru, the REER signal comes on top of a signal for excess credit growth, as mentioned on page 3. In Central and Eastern Europe there are no signals for any country with respect to overheating in credit, which is not surprising given that many countries in the region already experienced a boom-and-bust cycle in recent years, so that current levels of financial deepening are a far cry from exuberance. That is particularly the case in the Baltics, Ukraine, Kazakhstan and Hungary (see Chart 8). Russia, another country which was hard hit by the 2008-09 crisis, is back to its pre-crisis growth trend in the credit-to-GDP ratio. Yet another group of CEE countries, Poland, the Czech Republic and Turkey, seem to have avoided the credit bust altogether, keeping up a fairly steady financial deepening process for several years now (see Chart 9). The Middle East and Africa region exhibits some strong signals for real exchange rate overvaluation over the past 3 years (vs trend). The case of Egypt
6

Long-term trend

Sources: Global Insight, DB Research

CEE: Financial deepening (I)

Credit to the private sector-to-GDP, % 140 120 100 80 60 40 20 0 03 04 05 06 07 08 09 10 11 12 Latvia Hungary
Sources: IFS, DB Research

Ukraine Kazakhstan

CEE: Financial deepening (II)

Credit to private sector-to-GDP, % 70 60 50 40 30 20 10 0 03 04 05 06 07 08 09 10 11 12 Poland Turkey
Sources: IFS, DB Research

Czech Republic Russia

A more accurate assessment of the true credit gap in China should in the future take into account the so-called total social financing which includes bank loans and non-bank financial instruments, since the share of non-bank lending in total financing has increased substantially over the past couple of years. For example, our colleagues think the RMB is overvalued but point to caveats in this estimation given data issues. See Deutsche Bank (2013a). Research Briefing

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Emerging markets: Who is vulnerable to overheating?

appears counterintuitive given the currencys weakness of recent months. The explanation probably lies in the extreme depreciation of the Egyptian pound in the early 2000s, which led to a weak long-term currency trend in our model. In Nigeria, there are strong and persistent signs of overvaluation, including the latest data: our current REER measure yields a 30% gap with respect to the long-term trend. Similarly, the equity market gap is very wide, at 21%. Credit growth, on the other hand, remains subdued, possibly related to Nigerias past banking problems. This may mitigate overheating pressures emanating from the other two indicators, at least for now.

Conclusion
Relying on the banking crisis literature and our own previous work we have tried to provide a framework for detecting possible vulnerabilities in emerging markets emanating from excessive credit-to-GDP growth, real currency appreciation and/or real stock market gains. For the emerging markets overall there is little reason for immediate concern, going by the frequency and distribution of alert signals. Of the individual regions, Asia seems to be the one to watch for a possible build-up of overheating pressures. Evidence from other indicators not included in the model such as housing prices seems at least not to contradict our findings. Maria Laura Lanzeni (+49 69 910-31745, maria-laura.lanzeni@db.com) Christian Weistroffer (+49 69 910-31881, christian.weistroffer@db.com) ___________________________________________________

References
Borio, Claudio and Mathias Drehmann (2009). Assessing the risk of banking crisis revisited. BIS Quarterly Review. March pp. 29-46. Borio, Claudio and Philip Lowe (2002). Assessing the risk of banking crises, BIS Quarterly Review, December, pp. 43-54. Borio, Claudio and Philip Lowe (2004). Securing sustainable price stability: should credit come back from the wilderness? BIS Working Paper, No.157, July. Deutsche Bank (2013a). Ranking policy weapons for currency wars in: Emerging Markets Monthly, pp. 24-30, Deutsche Bank. Global Markets Research. 7 February 2013. Deutsche Bank (2013b). Emerging markets capital flows what has changed? in: Global Economic Perspectives. Deutsche Bank. Global Markets Research. 13 February 2013. IMF (2011). Staff Discussion Note Financial Deepening and International Monetary Stability, 2011. Kaminsky, Graciela L. and Carmen M. Reinhart (1999). The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. American Economic Review, Vol. 89, No. 3, June, pp. 473-500. Reinhart, Carmen M. and Kenneth Rogoff (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton University Press, 2009. Weistroffer, Christian and Veronica Valls (2008). Monitoring banking sector risks: An applied approach. Research Notes 29. Deutsche Bank Research.

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Research Briefing

Emerging markets: Who is vulnerable to overheating?

Table 1 Table 2

Jan 2013 Latin America Argentina Brazil Chile Colombia Mexico Peru Venezuela

REER gap*

Credit gap*

Equity price gap*

Jan 2013 Latin America Argentina Brazil Chile Colombia Mexico Peru Venezuela

REER gap*

Credit gap*

Equity price gap*

-14.2% 3.1% 1.8% 6.0% -0.9% 5.7% 32.5%

12.6% 3.5% 3.1% 5.0% 0.2% -1.1% 4.9%

11.2% -12.6% -5.3% -3.3% 5.6% -6.5% 103.3%

Central and Eastern Europe Bulgaria Croatia Czech Rep. Estonia Hungary Kazakhstan Latvia Lithuania Poland Romania Russia Turkey Ukraine Middle East and Africa Egypt Israel Nigeria South Africa Asia China Hong Kong India Indonesia Korea Malaysia Pakistan Philippines Singapore Taiwan Thailand Vietnam
* Alert level based on the number of signals during the past 3 years: >40% (yellow), >70% (amber) Source: DB Research calculations

Central and Eastern Europe Bulgaria Croatia Czech Rep. Estonia Hungary Kazakhstan Latvia Lithuania Poland Romania Russia Turkey Ukraine Middle East and Africa Egypt Israel Nigeria South Africa Asia China Hong Kong India Indonesia Korea Malaysia Pakistan Philippines Singapore Taiwan Thailand Vietnam 12.3% -4.3% -3.1% 3.3% 8.7% 19.0% 10.2% -7.2% 5.7% -7.2% 9.5% 2.0% 2.1% -2.6% -2.6% 8.4% -3.4% 5.7% -6.0% 6.8% 9.9% 0.9% 7.6% -12.9% -13.4% -0.6% -6.9% 0.7% -5.3% 3.4% 23.9% 21.0% 0.3% -2.0% 65.7% 16.1% -0.9% 2.1% 30.1% -5.6% 6.8% 0.7% -24.8% -1.9% 3.1% -5.8% 20.9% 20.6% -1.1% 1.4% -8.7% -3.8% -9.1% 3.0% -5.1% -6.5% -6.0% -9.4% 22.7% 3.7% -1.7% -11.4% -7.1% -4.7% -15.9% -24.7% -15.1% -24.5% -16.9% -4.0% -12.3% -1.0% 1.8% -13.0% 79.6% -4.1% 12.1% 21.3% -7.4% -28.5% 21.2% 7.2% 4.6% 9.6% 5.9% 9.9% -68.9%

* Current indicator levels (most recent data available), signals (red) based on country-specific thresholds Source: DB Research calculations

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Research Briefing

Emerging Markets publications

Two years of Arab Spring: Where are we now? Whats next? .............................. January 25, 2013 Current Issues CIS Quarterly Monitor ................................................. January 22, 2013 th CIS Research, 4 Quarter 2012 What drives FDI to Russian regions? ..................... November 28, 2012 Research Briefing GCC financial markets: Long-term prospects for finance in the Gulf region ..................................................... November 14, 2012 Current Issues Foreign investment in farmland: No low-hanging fruit ................................................ November 13, 2012 Current Issues Brazil: Fair economic prospects .................................. October 26, 2012 Research Briefing
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New Asian frontier markets: Bangladesh, Cambodia, Lao PDR, Myanmar ............. October 18, 2012 Research Briefing Microfinance in evolution: An industry between crisis and advancement........ September 13, 2012 Current Issues Western Balkans: Bumps on the road to EU accession .............................August 24, 2012 Current Issues

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