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Emerging Markets: Who's the Fragilest of Them All?

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Given the kickback scandals enveloping its prime minister and the paralysis expected during upcoming elections, Turkey seems to be the top contender.

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Man, it is looking ugly out there in emerging markets. Exchange traded funds holding shares and bonds from developing nations experienced record withdrawals of $7 billion in January, Bloomberg tells us. The widely held iShares MSCI Emerging Markets Fund (NYSEARCA:EEM) lost about 9% of its value last month, compared to a 1.6% drop in the S&P 500 (INDEXSP:.INX), bringing its decline for the past 12 months to some 13%. The P-word, panic, creeps increasingly into EM-related sound bites from the relevant experts.

All of which means, of course, that a rebound is coming at some point, and fund managers who piled in while everyone else was fleeing will look like geniuses. That is inevitable, eventually. The daunting questions are when and where, since the emerging markets category covers a vast range of countries from South Korea to Nigeria. Some quiet numbers buried within the avalanche of economic data generated by the World Bank offer a bit of guidance.

We all know what's supposed to be wrong with emerging markets by now. While the Federal Reserve and European Central Bank beat interest rates down to historic lows in order to resuscitate their domestic economies, investors in search of yield flooded the developing world with cash on easy terms. Now the expectation of rate hikes from the Fed (if not the ECB) has sent all that money flooding back home, leaving overextended EMs swimming naked if not beached entirely.

Last year Morgan Stanley (NYSE:MS) researchers coined a memorable phrase, the Fragile Five, for countries in the greatest peril from Fed-instigated retrenchment. They were Brazil, India, Indonesia, Turkey, and South Africa. Technically Morgan Stanley was talking about currencies not stock markets, but for foreign investors the two are very closely linked.

The Wall Street wizards basically took a view from the outside looking in. What linked the Fragile Five, they wrote, was "high inflation, weakening growth, large external deficits, and high dependence on fixed income inflows." The World Bank data adds a key internal indicator, measuring the pace of domestic credit expansion in countries across the globe from 2009-2012, and the overall ratio of credit to gross domestic product. As we Americans know all too well now, leverage is destiny when an economic downturn comes, or a big part of destiny anyway.

It stands to reason that the nations that gorged most heavily on credit during the EM boom years would be feeling most fragile now. This roster coincides only partially with Morgan Stanley's sick list.

From the broadest global perspective, almost all emerging markets increased their debt-to-GDP levels from 2009-12, while advanced economies deleveraged. Outstanding credit in the US dipped by 6% relative to output during these slow-recovery years to 184% of GDP. German domestic lending contracted by 11% to 101% of GDP. The wrenching post-crisis readjustments in countries like Ireland and Estonia show up in the World Bank numbers -- credit-to-GDP ratios sinking by 20% and 27%, respectively.

How do the Fragile Five look when held up to this particular mirror? Brazil and Turkey look very wobbly indeed. Both increased domestic credit-to-GDP levels by almost half in the four years covered by the World Bank data, virtually defining the expression "economy on steroids." Brazil had higher total leverage, at 68% of annual output compared to 54% for Turkey. But given the kickback scandals enveloping Prime Minister Recep Erdogan and the paralysis expected during upcoming presidential and parliamentary elections, Turkey seems the top contender for Fragilest of Them All at the moment.

Credit expanded much more moderately in India, by 9% to 52% of GDP, and actually contracted a tad in South Africa to 151% of GDP. That's a high gross number, but South Africa is a highly developed economy in terms of its productive capacity, and its mining industry is very capital-intensive.

Indonesia looks on the frothy side, though not in Turkey or Brazil's class. Private-sector credit expanded by one-fourth relative to GDP, to 35%. Thailand is a problem child from outside the Fragile Five, with credit expanding by 27% to 148% of output -- a vertiginous figure for a middle-income developing country whose political divisions make Turkey's seem polite by comparison. Credit in China officially increased by just 5% vs. GDP from 2009-12. But the gross ratio is also very high for an emerging market, 134%, and that presumably does not count the country's notorious shadow banking system. On the other hand, with $3.5 trillion in hard-currency reserves, China can pay for any financial bailouts its leaders deem necessary.

Other emerging markets with credit growth exceeding 20% over three years were Colombia and Mexico, though the latter's total leverage came to just 28% of GDP as of a year ago. Credit-virtuous markets included Russia, whose private-sector indebtedness remained little changed at 46% of GDP; Chile, rock-like as ever with a 3.5% increase to 73% of GDP; and Poland, with a 6.7% expansion to 54% of GDP.

These varying macro pictures of the far-flung emerging markets are reflected to some extent in equity performance. ETFs tracking Brazilian and Turkish stocks -- the iShares MSCI Brazil Index ETF (NYSEARCA:EWZ) and the iShares MSCI Turkey Inv. Market Index Fund (NYSEARCA:TUR) -- have been hammered ferociously, each losing more than 12% in the month of January and more than 20% over the past three months. But less fragile markets are being punished, too. Poland's main exchange traded fund, the Market Vectors Poland ETF (NYSEARCA:PLND), has lost 6.7% of its value so far this year and India's iShares MSCI India ETF (NYSEARCA:INDA) lost 5.6%.

Then there are emerging markets in name only, led by South Korea. This remarkable country walks, talks, and acts like a highly developed economy, but for technical indexing reasons is stuck within the EM category, where it is walloped accordingly. The iShares MSCI South Korea Index Fund (NYSEARCA:EWY) slid by 8.7% in January and 6.3% over the past three months, even though the Korean won has historically appreciated against the dollar and held even over the last year of greenback strengthening.

The distinctions between the various emerging markets will become more dramatic once the mood turns and the next rally begins. Investors should start digging into the numbers now.
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