Mind the KF* Gap: EME Vulnerabilities to Global Shocks

Emerging market economies (EMEs) have historically been vulnerable to external shocks. Recently the global economy has experienced several major shocks yet EMEs have been remarkably resilient. Some of this improved performance can be attributed to prudent policies and stronger economic fundamentals, but the existing literature points to an overperformance mystery by some EMEs with weaker fundamentals. We evaluate an alternative measure of vulnerability based on the concept of a natural level of capital flows (KF*). Specifically, we hypothesize that EMEs are more vulnerable when prior to a large global shock capital flows—portfolio inflows, to be specific—exceed KF*. Results indicate that for major global shocks over the past two decades the pre-shock gap between actual portfolio and KF* has substantial predictive power for the post-shock performance of EMEs.