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. Last Updated: 07/27/2016

Developing Crisis Resistance

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As another bout of risk aversion rocks the waters of international capital markets, we may be about to see who has been swimming naked as the tide goes out, to adopt Warren Buffett's well-known phrase. It is therefore high time to assess the real sources of vulnerability in emerging markets.

By some accounts, Eastern Europe is among the riskiest regions in the emerging-market asset class. The transition region has gone through rapid opening to international capital and domestic financial liberalization. Yet while some of the macroeconomic and financial strains of this process are now becoming apparent, it is hard to believe that the region is on the verge of a financial crisis such as the one that engulfed Asia a decade ago. Strong domestic institutions and continued productivity increases will underpin further growth in most Eastern European countries.

For many markets in the eastern half of Europe, traditional macroeconomic vulnerability indicators indeed resemble those observed in the run-up to the 1997-98 Asian financial crisis. Rapid credit growth has fueled a consumption boom across the region and contributed to external deficits well above thresholds that would normally be considered prudent. Fiscal policy, while certainly not reckless, has on the whole failed to stem demand. Inflationary pressures persist. Joining the euro zone, Europe's monetary goal post, continues to fade into the distant future. Should exchange-rate adjustments become necessary, private-sector balance sheets will be hit by the pervasive exposures to foreign currency-denominated credit.

Markets seem to have picked up on this. On the first day of the recent market selloff, Feb. 27, the Hungarian forint was down by 2 percent at one stage, with slightly lower declines in the Polish and Slovak currencies. The Latvian lat had already caught some of the jitters, prompting a hike in short-term interest rates. Emerging-market bond spreads have already started to widen.

A return of risk aversion should be welcomed if that leads to yields that are more in line with underlying credit quality. But the risk of overreaction is considerable and, what's worse, the focus is on the wrong variables.

Perhaps the main lesson from the Asia crisis, as well as the 1998 Russian downturn, was that measures of institutional quality, rather than macroeconomics alone, explained which country was hit and how severely. Protection of property rights, strength of regulators, transparency of banking operations and corporate governance determined whether investors withdrew capital. Macroeconomic indicators like current account imbalances, credit growth and reserves are important, but they must be seen in their institutional context. It is in the quality of institutions and decision making that we see the most dramatic changes compared to Asia in the 1990s. In the new EU member states there is better regulation of commercial banks, the cornerstone of financial systems in emerging markets. Supervisors are making genuine efforts to contain imprudent credit growth, particularly in foreign currency. Banks' capacity to screen credit and manage risk in assets has on the whole kept pace with the extremely rapid expansion of balance sheets.

Importantly, local-currency capital markets have developed in many countries. The rapid emergence of Russian money and bond markets over the last two years is just the most recent example of this trend. These markets provide an important alternative funding source to bank finance that is much less prone to periodic liquidity contractions. Our research shows that in all but a few countries in Eastern Europe, corporate governance and transparency continue to improve markedly. Consequently, equity markets now convey more information about enterprise-specific developments, as opposed to undifferentiated common-market events. On the whole the region now compares favorably with other emerging markets.

Just as significantly, new capital-market instruments, such as securitized or collateralized assets, have begun to transfer local risk to global markets. These instruments raise their own issues in terms of transparency and regulation, but there is no question that they allow the financial systems to support economic growth better.

Despite the events of the last couple of weeks, there should still be time to complete a large unfinished agenda of institutional reform. In particular, enforcement of existing laws and regulation need to be strengthened and sustained.

But even more progress is needed. Because at some stage the tide will turn -- and when it does, it will do so quickly and without pardon.

Erik Berglof is chief economist at the European Bank for Reconstruction and Development. This comment appeared in The Wall Street Journal.