Which emerging market is going to be the next South Korea?

For the forward-looking investor, Asia is so five minutes ago. The question is where the next trouble spot is going to be. Of course, if the recent crisis has put you off emerging markets altogether, this isn't interesting at all, but the case for diversifying into higher-risk, higher-return countries has not disappeared in a puff of smoke along with South Korea's economic prospects.

For all kinds of reasons, from their youthful populations to their potential for catching up with more advanced economies, emerging markets as a group should not be written off. But how do you tell the genuine trend-setters from the fashion-victims? After all, Korea seemed such a safe bet.

Answering the question does involve looking backwards, and one of the main credit rating agencies, Fitch IBCA, has published a fascinating post-mortem of why it misjudged Korea. As it admits: "Clients are entitled to expect us to perform better in future ... the Korean downgrades are the most dramatic instances of sovereign rating downgrades, bar none."

The background to recent criticism of the ratings agencies, Moody's and Standard & Poor's too, is that all sharply downgraded Korea but, unfortunately, after the event. In the summer the country was still on an investment- grade AA minus (or A1 on Moody's scale). Between the start of its financial crisis and late December it was marked down four times to near-junk ratings.

To paraphrase Tolstoy, healthy economies are all alike, but every crisis is different. So a cynic might raise a languid eyebrow at anybody claiming that events in Korea marked a new kind of crisis. However, this does seem to be true. As the Fitch IBCA report spells out, all the conventional, prudent measures of the country's financial soundness suggested that nothing was wrong.

For a start, Korea had recently been admitted to the ranks of the high- income club, the Organisation for Economic Co-operation and Development, and had been given a clean bill of health in the IMF's regular economic analyses. As recently as October it was predicting that its GDP growth would be unchanged at 6 per cent in 1998, only slightly lower than the rates seen in the early 1990s. As far as official reports went, Korea was still an economic miracle.

In addition, commercial banks had continued to lend cheerfully, increasing their exposure quite dramatically in the first half of this year. The total claims foreign banks had on Korean borrowers soared from $108.8bn in December 1996 to $116.8bn in June 1997, a faster annual rate than the rise during 1996. Banks rely less than the buyers of bonds on the verdict of the ratings agencies because most of them have their own, in-house research. So at least the agencies were in good company.

All of this brainpower was applied to certain measures of the riskiness of investing in Korean debt. Some warning signals are pretty obvious. For example, a fixed exchange rate accompanied by a rapidly ballooning current account balance is a clear signal of an overheating economy unable to rely on devaluation as a safety valve. Thailand was in this position, but Korea far less so. Its previously large trade deficit was already declining, partly because the exchange rate, though still managed, had fallen somewhat, and partly because the government was not running a huge deficit.

The fixed exchange rates had, however, encouraged Asians to borrow in dollars because there was no currency risk. But most analysts had been trying to keep an eye on each country's total level of foreign indebtedness, in dollars as well as local currency.

This was not easy, as there is no requirement on countries to produce consolidated figures. Even the IMF required the publication of government debt only, not private sector indebtedness, even though the total is relevant to creditworthiness. As the Korean crisis blossomed, there was a good deal of uncertainty about the figure - it turned out to be much larger than the number anybody first thought of.

However, South Korea is by no means a heavily indebted country. As a proportion of GDP, debt is higher in countries like Canada and Australia, never mind other emerging markets. A high and rising share of its debt was very short term - which had been Mexico's problem too - but analysts overlooked it in the Korean case because of the low total.

Fitch IBCA concludes now that a high proportion of short-term debt always matters and especially in markets which are not very liquid. And if much of the debt is owed by the banking system, its soundness and liquidity are crucial. The solidity of the country's market institutions has been proved fundamental by the Korean crisis.

If there are any concerns about any of these - the composition of the foreign debt, liquidity, or the health of the banking system - overseas investors ought to look for substantial foreign exchange reserves as evidence that the country could weather a credit crisis.

What's more, the need for evidence about the level of reserves means the IMF ought to require countries to publish details of the operations in forward currency markets, as these make a nonsense of official figures based on spot transactions. The UK has only just started to publish details of forward transactions. Thailand's reserves fell sharply early in 1997 because of its previously hidden future liabilities.

Finally, there is the role of the financial authorities themselves. In Korea's case, the presidential election prevented a wholehearted response to the crisis. For example, the Bank of Korea prevented short-term interest rates from rising enough to attract new foreign capital as debts came due in December. If this had happened, the situation might not have taken such a dramatic turn for the worse before the IMF forced an increase in rates.

The report's verdict: "We over-estimated the sophistication of Asian policy makers, who have proved good fair-weather navigators, but very poor sailors in a storm."

The morals can be summarised as: take account of all measures and dimensions of indebtedness; only completely trust countries for which the economic and financial data are fully transparent; and scrutinise carefully its particular institutional and political situation. If that seems to rule any emerging market, well, that still leaves gilts and US Treasury bonds for the faint-hearted.