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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.

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Deutsche Bank (2013a, 2013b).

the risk of a balance-of-payments crisis in most of the major emerging markets is small. Empirical work by Reinhart and Rogoff (2009) spanning the past eight centuries shows that banking sector problems are closely linked to the financial cycle. investment gap. That leaves us with banking crises. i. to the extent that many EMs have built up large foreignexchange reserves and reduced currency mismatches in domestic balance sheets. DB Reseaarch 3 Our identification scheme encompasses systemic crises. 2004). We employ a signalling approach.e. 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. we closely follow Borio and Lowe (2002. Exploring more recent crisis episodes in the industrial countries. we do not attempt here to predict future banking crises. where both the dependent and the explanatory variables can assume only discrete values (zero or one). China: Credit versus trend Credit to the private sector to GDP. real GDP gap. the idea is to extract signals which are able to hint at future stress in the banking sector. 2009). Borio and Lowe (2002. real equity price gap and REER gap do add to the predictive power of our model. Accepting the hypothesis that boom-and-bust episodes will recur. Here. 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 3 2 Credit gap Percentile threshold (70%) Sources: IFS. % 140 130 120 110 100 90 80 70 60 50 95 97 99 01 03 05 07 09 11 2 Overheating: How to measure it We start by looking at (i) credit-to-GDP ratios. Our empirical strategy is based on earlier work that we did in the context of a risk monitoring exercise. we had to drop this indicator due to data constraints for the emerging markets. Yet. For instance. we set out to identify economic indicators (and critical levels thereof) which have led to a “hard landing” in the past. Actual data Sources: IFS. Reinhart and Rogoff suggest that capital inflows and the real exchange rate serve as a good predictor of banking crisis. A note of caution is warranted: while we use past crises as a source of information to identify potentially harmful overheating trends. Research Briefing 2 | March 12. Combining the method developed by Kaminsky & Reinhart (1999) as well as later work by Borio and Lowe (2002. consumer price 3 inflation and current account imbalances are not included. overheating refers to a situation in which the economy grows above potential. see Weistroffer and Vallés (2008). Likewise. One possibility is to look at past sovereign debt crises. This deviates from the more commonly followed approach in the literature to consider full-blown systemic crises only. They are often followed by a period of uncontrolled economic contraction – a “hard landing” in which asset prices collapse and delinquency rates rise. public finances in most of the large emerging markets are in fairly good shape. Although the property price gap yields good results for the industrial countries (see Borio and Drehman. Crises were frequently preceded by a period of overheating and subsequent bust. real equity price and real exchange rate gap as well as monetary aggregates. at the current juncture. we can then use 2 banking crisis episodes as proxy for hard landings.Emerging markets: Who is vulnerable to overheating? The banking sector nexus Risk of overheating 1 In the broader sense of the term. an appreciating real exchange rate. Such periods of excessive growth are typically associated with strong capital inflows. which eventually triggers overinvestment. 2004) and Borio and Drehmann (2009) also conclude that banking crises can best be predicted by indicators of credit and asset-price growth. While the credit gap. For a detailed description of the methodology used in this paper. 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. borderline events and smaller episodes of systemic relevance. 2013 . (ii) CPI-deflated equity prices and (iii) the real effective exchange rate for a set of 36 emerging markets. up to three years ahead. other indicators tested did not significantly improve the model’s statistical properties. Given that rapid credit and asset-price growth has actually been observed in several emerging markets over the past couple of years. rapid credit expansion and galloping inflation. 2004) who narrow down the list of potential indicators to the credit gap.

as described above for China in Chart 3. However. Note that we do not make estimates about equilibrium levels of the variables. i. China. warranting a more in-depth look at possible overheating risks in these countries. are determined in a grid-search procedure. It is calculated as the percentage deviation of the indicator’s actual value from its underlying trend. 4 5 At the optimised threshold levels. as a signal today might be alerting on problems up to three years down the road.6. Malaysia. The red-marked figures in Table 2 flag that an indicator exceeds its country-specific threshold. in turn. To give a sense of the current degree of over. Five countries. credit gap. a country is experiencing financial deepening starting from a low credit-to-GDP level. Research Briefing 3 | March 12. and the amber flag shows that an indicator has signalled 70% or more during that time. the credit gap shows signs of overheating for the period between 2009 and 2010 and declines afterwards.or undershooting. this 5 may not necessarily be worrisome . Longterm trends are extracted using a recursively calculated Hodrick-Prescott filter. 93% and 86% of the in-sample crisis episodes. The difference between those two measures (“credit gap”) is shown in Chart 3. a rapidly rising credit ratio still needs to be monitored. Thresholds.8. balancing so-called “type-I” and “type-II” errors.g. Peru. where we optimise the balance between missing a crisis and producing too many false 4 alarms. Table 2 thus takes a forward-looking perspective. respectively. The same applies for the REER and stock market variables. 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. a signal will be issued if the credit gap exceeds a certain threshold. IMF (2011). for example.8 and 0. However.e. If. looking at joint signals reduces overall noise levels substantially. with monthly observations). we just compare actual performance with the trend. respectively.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 4 Long-term trend Sources: Global Insight. the Philippines and Thailand. which is depicted by the red line in Chart 3. In the example above. DB Research Our model is calibrated using a three-year forecast horizon. First. Thresholds are generally applied as a fixed percentile across countries. Noise-to-signal ratios are relatively high at levels of 0. The model thus captures excess growth in the indicators that in the past have been followed by problems in the banking sector. See e. DB Research 6 100 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). national sources. REER gap and equity price gap capture 88%. national sources. 0. Table 1 on page 6 shows the current alert level for each country and indicator. Table 2 shows each indicator’s percentage deviation from its long-term trend at present. In the case of China. which ensures that the trend does not “sneak into the future”. show alert levels (either yellow or amber) for two of the indicators. 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. For example. the red line reflects the 70% percentile of the credit-to-GDP measure for China. Greater financial depth may even help to cushion the effects of capital outflows. 2013 . it will be interpreted as an alert which will stay valid for the following three years. which yield different absolute values for each country. 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. If a warning signal is observed today. For the purpose of our empirical exercise. which has proved statistically superior among the different horizons tested. we calculate each indicator’s percentage deviations from its long-term trend. DB Research 5 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.

our model indicates frothiness in stock markets over the past three years. For example. Thailand (Chart 6) is the country with the strongest signals. % 70 60 50 40 30 20 10 0 03 04 05 06 07 08 09 10 11 12 Poland Turkey Sources: IFS. With respect to Latin America. seem to have avoided the credit “bust” altogether. The real effective exchange rate is almost 10% above trend and credit-to-GDP about 8%. The current stock market gap (vs the long-term trend) is no less than 66%. we observe amber signals for a real-exchangerate overvaluation in Peru and Brazil for the 3-year period (Table 1). in 2012. The overheating signals for Malaysia. Ukraine. respectively – although in the case of Thailand there were large basis effects from the devastating floods of 2011. keeping up a fairly steady financial deepening process for several years now (see Chart 9). In China. Poland. including the latest observations. That is particularly the case in the Baltics. is back to its pre-crisis growth trend in the credit-to-GDP ratio.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 7 In the case of Peru and China. DB Research 8 Ukraine Kazakhstan CEE: Financial deepening (II) Credit to private sector-to-GDP. close monitoring is warranted. a 6 pp increase in the credit-to-GDP ratio in 2012 and 12 pp since 2010). In Central and Eastern Europe there are no signals for any country with respect to overheating in credit. The Middle East and Africa region exhibits some strong signals for real exchange rate overvaluation over the past 3 years (vs trend). Research Briefing 4 | March 12. Still. the Philippine stock exchange index rose by a whopping 30% (CPI-deflated). given that signals were issued within the 3-year period relevant from a financial cycle point of view. our findings show a fairly strong real appreciation in recent years (Chart 4). As said above. but recent developments 6 show more moderate credit-to-GDP growth (as mentioned above for China) .6% and 6%. which is not surprising given that many countries in the region already experienced a “boom-and-bust” cycle in recent years. Indeed. our colleagues think the RMB is overvalued but point to caveats in this estimation given data issues. Growth in credit-to-GDP was very robust in 2011 but has since slowed down. another country which was hard hit by the 2008-09 crisis. % 140 120 100 80 60 40 20 0 03 04 05 06 07 08 09 10 11 12 Latvia Hungary Sources: IFS. 2013 . Kazakhstan and Hungary (see Chart 8). Still. the Philippines and Thailand seem at first sight to be in line with recent macroeconomic developments. In Peru. as mentioned on page 3. DB Research CEE: Financial deepening (I) Credit to the private sector-to-GDP. The three countries were among the strongest growth performers in Asia (and in the whole EM universe) in 2012. for Brazil (Chart 7) the overvaluation signal lasted until early 2012 and weakened thereafter (pace “currency wars”). alert signals for credit growth are concentrated at the beginning of our 3-year period. with real GDP increasing by 5. Whatever one’s opinion about the fair value of the 7 renminbi . the persistence of the signals indicates that overheating pressures may be accumulating.e. both over the past 3 years and at present. some of these values may be contaminated by basis effects due to the strong economic rebound in 2012 from the year-earlier floods. For Peru. For Malaysia (Chart 5). DB Research 9 Czech Republic Russia 7 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. the Czech Republic and Turkey. Russia. Yet another group of CEE countries. the REER signal comes on top of a signal for excess credit growth. See Deutsche Bank (2013a). the REER signal has been very persistent.6%. In the case of the Philippines. the strongest and most persistent signal is for the REER – it has flagged since early 2008. 6. By contrast. so that current levels of financial deepening are a far cry from exuberance. since the share of non-bank lending in total financing has increased substantially over the past couple of years. namely in 2010. The case of Egypt 6 Long-term trend Sources: Global Insight. including recent months. 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.

March pp. Carmen M. Monitoring banking sector risks: An applied approach. 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. Kaminsky. No. christian. July. at least for now. No. “Ranking policy weapons for currency wars” in: Emerging Markets Monthly. 3. Securing sustainable price stability: should credit come back from the wilderness? BIS Working Paper. Borio. This Time is Different: Eight Centuries of Financial Folly. Assessing the risk of banking crisis – revisited. the equity market gap is very wide. Research Notes 29. there are strong and persistent signs of overvaluation. 89. The explanation probably lies in the extreme depreciation of the Egyptian pound in the early 2000s. Asia seems to be the one to watch for a possible build-up of overheating pressures. Borio. Global Markets Research. Reinhart (1999). at 21%. American Economic Review. Maria Laura Lanzeni (+49 69 910-31745. 2009. Deutsche Bank (2013b). Deutsche Bank. which led to a weak long-term currency trend in our model. Deutsche Bank (2013a). For the emerging markets overall there is little reason for immediate concern. pp. pp.157. “Emerging markets capital flows – what has changed?” in: Global Economic Perspectives. Princeton University Press.lanzeni@db. Global Markets Research. The Twin Crises: The Causes of Banking and Balance-of-Payments Problems. Similarly. going by the frequency and distribution of alert signals. Claudio and Mathias Drehmann (2009). IMF (2011). Staff Discussion Note “Financial Deepening and International Monetary Stability“. 5 | March 12. This may mitigate overheating pressures emanating from the other two indicators. 13 February 2013. including the latest data: our current REER measure yields a 30% gap with respect to the long-term trend. Deutsche Bank Research. Of the individual regions. Weistroffer. December. 2013 Research Briefing . and Kenneth Rogoff (2009). Credit growth. possibly related to Nigeria’s past banking problems. Evidence from other indicators not included in the model such as housing prices seems at least not to contradict our findings.weistroffer@db. Reinhart. BIS Quarterly Review. 29-46. real currency appreciation and/or real stock market gains.com) Christian Weistroffer (+49 69 910-31881. Deutsche Bank. pp. BIS Quarterly Review. 43-54. remains subdued. 473-500. 2011. Vol. on the other hand.com) ___________________________________________________ References Borio. In Nigeria.Emerging markets: Who is vulnerable to overheating? appears counterintuitive given the currency’s weakness of recent months. Christian and Veronica Vallés (2008). and Carmen M. Claudio and Philip Lowe (2004). Graciela L. Assessing the risk of banking crises. Claudio and Philip Lowe (2002). 7 February 2013. June. 24-30. maria-laura.

1% -2.0% 2.5% 12.9% 7.1% 30.4% -28.0% -9.4% -0.9% 5.8% 20.8% 9.7% -15.1% 3.1% 5.4% 5.4% 23.6% -5.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* -14.4% -3.9% -13.3% -4.8% 6.7% 19.7% -3.9% 21.6% 5.2% 9.1% 3.7% -7.9% 9.5% -6.1% -0.9% 3.1% 1.7% -24.0% 79.8% -1.3% Central and Eastern Europe Bulgaria Croatia Czech Rep.3% -2.0% -5.1% -4.8% -9.8% 0.9% 2.1% -5.9% * Current indicator levels (most recent data available).0% 0.3% 8.2% -12.2% -1.6% -6.6% -2.6% 6.1% 12.5% -16.4% 22.0% -12.5% 2.7% -1.3% -3.1% -6.5% 3.9% 0.6% 9.7% 3.7% -15.2% 4. 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 12.6% -4.7% -5. >70% (amber) Source: DB Research calculations Central and Eastern Europe Bulgaria Croatia Czech Rep.9% -24.3% -1. 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).0% 10.0% 65.4% -8.0% -0.9% -4.1% 4. signals (red) based on country-specific thresholds Source: DB Research calculations 6 | March 12.8% -13.7% 16.9% 0.9% 11.3% 3.7% -6.6% -6.2% 7.1% 1.9% 20.6% 3. 2013 Research Briefing .9% -68.6% 8.1% -24.5% 21.2% 5.6% -1.4% -7.7% 32.5% 103.0% 6.3% -3.0% 0.2% -7.3% 5.6% -12.1% -5.3% -7.7% -11.1% 21.2% 3.0% 1.

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