Now that emerging markets, especially those with current account deficits, have started to stumble due to concerns about the effects of tapering and rising US Treasury yields value, investors are looking for assets that got caught up in the panic and which may now be undervalued. Societe Generale analysts Paul Jackson and Ida Troussieux have tried to answer this question with a two pronged approach. First, they use five criteria to determine which emerging market countries present the most macro risk, then they look for asset classes in low-risk that look like they have lost more value than you would have expected and could be ready for a rebound.

Building on the work of their colleague Daniel Fermon, they look at private sector debt, housing prices, financial stability, inflation, and governance to determine macro risks. China immediately jumps out as having a lot of macro risk, with a risk of property bubbles, high private sector debt, credit growth that outstrip GDP. Some other Asian EM markets like Thailand, Malaysia, and Hong Kong are similarly at risk.

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EM household debt 0214

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Foreign reserves can provide stability for a country’s banking system, but there is a cost to holding assets with such low returns, so it follows that there is an optimal amount of foreign reserves relative to GDP, and Fermon figures that China is probably just past the optimal level of holdings.

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Ukraine has worst mix of corruption and inefficiency

Inefficiency and corruption are an unfortunate reality in many emerging markets, but the level of problems varies widely. China and a handful of other Asian EM have high combinations of both, but Ukraine tops the list (not to mention that its government has recently been overthrown), with Mexico, Russia, Indonesia, and the Philippines not far behind.

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Emerging Markets: China, Indonesia, and Russia are high risk

With these factors in mind, Fermon determined that China, Indonesia, and Russia are the highest risk emerging market countries and that the Czech Republic, Chile, Korea, Taiwan, and Poland are the least risky. With that as an initial screen, Jackson and Troussieux look for assets that have already been punished by nervous DM investors in those low risk markets.

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EM equity v current account 0214

“We identify the following assets from low-risk countries that have suffered too much: equities in Chile and Korea and the currency of Taiwan. High-risk country assets that have escaped lightly are: equities in India and Russia (Argentina could also be added) and the Chinese yuan,” they conclude.