In our blog post of June 13 we argued that, on the whole, emerging markets are in generally better shape to withstand higher US interest and exchange rates than they have been in previous periods of stress. In general, growth across the emerging market complex is stronger, external imbalances are smaller and inflation is lower than it was over the 2013-2015 period.
While systemic risks are therefore lower than they have been in the recent past, individual countries with idiosyncratic structural weaknesses will be punished in times of stress.
In our June post we highlighted Argentina and Turkey, particularly for their deteriorating external imbalances at a time when US exchange and interest rates were rising and global liquidity is reducing as central banks end/taper/reverse quantitative easing programs. This raises questions about the ability of countries with deteriorating current account deficits to fund those imbalances.
Since then Turkey has come under increasing market pressure. Along with the deteriorating external and internal imbalances, inflation is rising and recently re-elected President Erdogan gave markets cause for concern about the political independence of monetary policy. An earlier adjustment to building inflationary pressure may not have staved off the inevitable but would have given markets comfort that the central bank was still able and willing to respond as necessary.
The Turkish Lira saw a significant sell-off last week as a political scrap with the US over the Turkish detention of a US citizen culminated in a threat from the US administration of tariffs being imposed. Being a NATO ally counts for little in Donald Trump’s White House.
There are few options available to Turkey. In June, Argentina opted for an IMF program that brought some degree of stability. So far Erdogan has intimated he is disinclined to pursue such an option, no doubt in large part due to the policy conditionality such an option would bring with it not the least of which will be painful austerity measures. Should Turkey opt to go it alone, the end result will probably be the same but it will just take a bit longer to get there!
Capital controls are also an option, but will still require a painful domestic economic adjustment. The reality is some combination of central bank action, capital controls and austerity will be required.
The crisis in Turkey is leading to the usual speculation of contagion through to other emerging economies, especially those with similar structural weaknesses, and to the European banking sector.
So far the contagion has been most noticeable in currency markets with weakness in the South African rand and Mexican peso. As we said in our June post, the emerging market complex is in a better place, on average. But the longer the crisis in Turkey persists, the contagion risk grows.
With respect to the banking sector, Turkey itself does not pose an unmanageable risk. But again, the longer the crisis persists without credible and decisive action, the greater the risk of contagion.
While with the exception of some European Banks that have lent to Turkey there are few direct interdependencies with other regional Emerging Markets (unlike, say, Thailand and Malaysia in 1997) there is a degree to which the Turkish situation is a “canary in the mineshaft.”
That is, the widespread underestimation and underpricing of credit risk that is among the legacies of a decade of easy money around the world will from time to time claim victims, as external obligations that built up when global investors were searching the world for higher yields and thus lending into riskier economies and sectors begin to reflect underlying economic reality.
The sharp downward price adjustments that can follow are a salutary warning that credit quality matters, and our approach remains to treat highly-indebted investment markets or those that require the “best case scenario” to function, with an extra degree of caution. As the QE tide slowly continues to ebb, there will be more isolated but potentially-disruptive instances of economies that are caught “swimming naked.”
Thanks to Greg Fleming for additional comments.
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