Investors must understand the factors that make certain nations more susceptible to contagion in financial markets. By David Payne, Staff Economist February 5, 2014 When a somewhat disappointing report was released on January 23 on China’s private manufacturing sector, investors viewed it as a kind of If You Give a Mouse a Cookie story. Their thinking: “If China’s growth prospects need reevaluation, then other Asian emerging economies will as well. And if other Asian emerging economies need reevaluation, then other emerging economies may also need it.”See Also: Invest in Emerging Markets With Less Stress While there is some loose logic in that, because economies are intertwined, the real problem is that such expectations become self-fulfilling prophecies. They trigger a wave of contagion that quickly spreads problems from one country to another. Indeed, the disease analogy is quite apt. In a contagion-type event, the currencies and stock markets of many countries are attacked, just as an outbreak of influenza touches people of all ages, social classes and states of health. But the virus is riskiest and most debilitating where it finds existing problems. In this case, a currency attack on an emerging market with a severe trade deficit, a high inflation rate and a lot of debt owed to foreigners is the economic equivalent of an asthmatic child catching the flu. If a country is buying more than it produces for the world market, then more of its currency is typically going into the hands of those who don’t particularly want it, so its value easily declines. Similarly, if a country is experiencing a high inflation rate, the interest rates that it offers may not be enough to protect an investor from real declines in value. Finally, if a country owes debt to foreigners of more than two times its reserves of foreign cash, then it may have to cheapen its own currency to get foreigners to renew their debt purchases. So, when the report on China’s private manufacturing came out, the value of currencies of all other Asian emerging economies declined by 1% to 2% and then stopped dropping. The declines in those countries’ stock markets were similarly limited (at the time). Against them, the attacks faltered. Why? Because these countries typically run trade surpluses and will continue to do so even if growth slows in China, their most important export market. In addition, their inflation rates are moderate, so investors are not overly concerned about having to find investments that will beat the inflation rate. Advertisement However, when the wind from China brought the flu to Turkey, South Africa and Argentina, those countries’ currencies fell apart -- even though China is not their largest export market. What was different? Turkey and South Africa are vulnerable because both have large trade deficits (6%-7% of GDP) and high inflation rates (6%-8%), and debt owed to foreigners is three times their reserves. In fact, their currency values had already been declining, even before the China report. Although import controls in Argentina mean it doesn’t have much of a trade deficit, its high inflation rate (unofficially reported at 28%) and its overvalued official exchange rate make it vulnerable. Brazil, Colombia, Chile and Ukraine, among others, also have significant trade deficits and have seen their currencies decline. Hungary and Poland have been hit because of foreign debt that is four times their reserves. India and Indonesia, with high inflation, foreign debt that is two to three times reserves and trade deficits of 3%-4% of GDP, should be susceptible but have largely escaped unscathed so far, perhaps because of their recent progress in cutting their deficits. A more recent report on China’s manufacturing sector – this time on critical government demand for capital improvements and investment -- also indicates slowing growth in the Asian behemoth. As investors and others try to gauge the impact on various emerging markets, it’s important to remember another children’s story. When the big bad wolf huffs and puffs, it matters very much whether a house is made of straw or bricks.