Assessing the Financial Vulnerability of Emerging Markets

Assessing the Financial Vulnerability of Emerging Markets

Fahad Mansoor Pasha (Bogazici University, Turkey) and Neslihan Yilmaz (Bogazici Univerisity, Turkey)
DOI: 10.4018/978-1-4666-9484-2.ch020
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The consequences of the recent financial crises during the last two decades showed how important it is to monitor financial performance and try to predict a coming crisis. In an effort to predict a coming crisis, the authors calculate a vulnerability index based on a number of financial and economic indicators. This chapter analyzes the financial vulnerability of sixteen emerging countries as these countries are more vulnerable to financial fluctuations. The findings show that Peru, Russia, Indonesia, and Thailand are less vulnerable to a crisis, whereas, South Africa, Turkey, India, Egypt, and Hungary are more vulnerable to a crisis.
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Capital Inflows

Kaminsky et al., (2003) observe the trends of the last 20 years and argue that defaults and devaluations can trigger financial contagions when the three conditions of unholy trinity are present; they follow a large surge in capital flows; they come as a surprise; and they involve a leveraged common creditor. Thus, even if a country is well connected financially or through trade with another country, no financial contagion occurs if these three conditions are not present.

The presence of huge capital inflows is an important requirement for vulnerability since these Inflows might come to an abrupt halt in case of a crisis. The halt can generate a liquidity crisis. If the debt is short-term, the resulting outflows worsen the crisis, and result in an increased liquidity crisis, thus, may cause currency devaluation.

Versteeg (2008) focuses on the role of capital inflows and outflows in dealing with a financial crisis. He shows how capital outflow controls implemented by Malaysia in the late 1990’s and the capital inflow controls by Chile during the 1990’s helped to stabilize these economies during times of financial crises. The case of Chile shows that the importance of having controls to stop investors from exploiting loopholes within the financial structure and help increase the maturity of debt obligations. This also is important for limiting the real appreciation of the currency, especially when the domestic interest rates are high.


The element of surprise also plays an important role. If the common leverager is surprised, portfolio re-balancing may take place and may result in panic. However, if it is anticipated, enough time may be available for portfolio re-balancing and as a result, there may not be any panic. In order to measure this effect, the authors analyze Standard and Poors’, and Moody’s credit ratings for the periods before the crisis and results show that for crises where there are frequent downgrades, contagion did not occur.

Leveraged Common Creditor

Some important implications of Kaminsky et al., (2003) are that countries with more internationally-traded financial assets and more liquid markets should be more vulnerable to a crisis. Small, highly illiquid markets are likely to be under-represented in international portfolios and should be shielded from this type of a crisis. Trade linkage is not considered a significant factor in the spread of a financial crisis. The presence of a common leverager, like the U.S. mutual funds that can sell assets from one country to another when prices fall, is required to spread the financial crisis from one country to another.

Key Terms in this Chapter

Financial Contagion: A sudden loss of confidence in the financial assets of a country due to circumstances in another country.

IMF: Short for the International Monetary Fund, a cooperative institution that seeks to maintain an orderly system of payments and receipts between nations.

Herd Behavior: Tendency for individuals to mimic the actions of a larger group.

Financial Crisis: The situation in which come financial assets lose a considerable amount of their value.

Emerging Market: A market that is in the process of becoming an advanced economy where an advanced economy is characterized by high level of GDP per capita and industrialization.

Market Risk Premium: The difference between the expected return on a market portfolio and the risk-free rate.

World Bank: An institution that focuses on promoting shared prosperity and ending poverty.

Financial Vulnerability: The degree to which the economy is susceptible to a financial crisis.

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