Arjun Goyal
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Turkish Contagion and Threat to Emerging Markets

By: Arjun Goyal

Is the recent fall of the Lira going to send aftershocks to the vulnerable emerging markets?

There is a certain excitement in the air of a trading floor when a significant story regarding global markets breaks on Bloomberg. I can attest to this feeling, because the news of the Turkish lira slide broke when I was in the middle of a fixed income trading team in Singapore. Turkey’s crisis has been all over the news, and President Erdogan’s controversial statements and his feud with President Trump has scared many investors off from Turkey. What’s concerning is that Turkey’s woes seem to be having severe repercussions on other countries around the world.

Istanbul under Fire

Turkey has enjoyed healthy real GDP growth in the recent past due in large part to the construction boom. However, most companies took advantage of this boom by being financed by debt, primarily foreign debt. In addition to this, Turkey has been running a trade deficit, and like the aforementioned firms, it has also been running mainly on foreign debt. Unfortunately, Turkey’s economic health has taken a tumble. In 2017, inflation rose to 15% even though the central bank set the target rate at 5%. Investors highly doubt President Erdogan’s economic policy measures, and consequently stock market gains have been meager.

High inflation and low investor confidence led to gradual decline in the Lira over 2017, which only made things worse for Turkey. As its currency declined (the Lira is the worst performing currency this year), its financial burden to repay its debts started to mount. To illustrate this, we can take an example of a country which owes $100 in foreign debt, and have a local exchange rate of 10X/$ (10X = 1$). This means that it owes 1000 Xs in its own currency to foreign creditors. However, over time if its currency depreciates to 20X/$, its obligations become 2000 Xs. This is exactly what is happening to Turkey, and so the currency depreciation is making investors worried about Turkey’s ability to repay its debts.

What bothers investors more is that President Erdogan refuses to increase interest rates; he is widely known for calling interest rates the enemy. It seems unlikely that Turkey’s economic condition will improve without a major intervention. Things came to a head when confrontation between Turkey and the United States escalated. The detention of an American evangelical pastor not only increased the geo-political tensions but also prompted doubling of tariffs on Turkish goods. This made stock markets tumble in Turkey, and investor confidence was at an all time low. This, along with the Fed increasing interest rates, led investors to pull out money from Turkey to safer investments in the US and Europe.

All of this has led to the Lira falling 34% to the US Dollar since January. That is akin to being able to afford a Lamborghini in January and finding out in August you can’t even afford the replacement tires. It also means that if you’re not Turkish, there is a chance you may be able to buy a Lamborghini in Istanbul for the price of its replacement tires (before they adjust the prices, of course). This kind of fall is not unprecedented, but it reminds us of the situations in Zimbabwe and Venezuela; one doesn’t need to be too well versed in economics to know that this is disastrous. It also doesn’t help that Erdogan has taken executive control of the central bank (which is usually kept separate from the executive branch of the government), and shows unnerving nonchalance to the matter, once saying while investors had dollars, Turkey had God on their side.

Contagion Alert

Unfortunately for other emerging market, investors have been spooked by the crisis in Turkey. They fear that the current situation might turn out to be like the 1997 Asian currency crisis. As a quick primer, the East Asian crisis started in Thailand with the crash of the Thai baht, and proceeded to spread to countries like Indonesia and South Korea. There was a fear that this contagion would spread further to cause a global economic meltdown.

It is possible that this scenario could be recreated in emerging markets after Turkey’s meltdown. One of the reasons this is a possibility is that banks with large holdings in Turkish bonds would have to slow-down lending because of this credit threat. Consequently, goods and services in countries where these bank operate would become more expensive, and economic activity would slow down. This dampening further scares investors away from investing in these countries (mainly emerging markets due to their higher risk profile), and might even incentivize them to pull their money out from these markets. Precursors to this could be seen after the news broke about the Lira slide.

India and Indonesia

Both India and Indonesia suffered heavily in the wake of the Turkish crisis. The rupee (INR) slid amidst fears of a contagion from Turkey, and broke the INR 70/USD barrier (almost a 2% drop in a single day). However, the rupee had troubles far before the US-Turkey confrontation: it had slid almost 9% in 2018. The Indian finance ministry blamed external forces for this drop, but India’s wide current account deficit has definitely contributed to the slide. It is also important to note that this drop is seen by many traders and analysts as a correction in the value of the rupee, which had been seen as overvalued for the past 3 years or so. But it seems to me the steep decline was triggered mainly because of the fear of contagion, and slide could have been more gradually in a world without the Turkish crisis. To add to India’s problems, it was speculated that the Reserve Bank of India was to raise interest rates to counter this slide, slashing both the Sensex and NIFTY (India’s primary stock indices), and dampening expectations of short-term economic activity.

The Turkish crisis had its ripples reach Indonesia as well, which has already experienced its fair share of economic turmoil. Just like the Indian rupee, the rupiah slid in response to the Turkish crisis, 7% over the year in this instance. Indonesia should be especially worried about its currency depreciation and the Turkish crisis because like Turkey, it too is dependent on large amounts of foreign debt. Spooked investors may spell bad things for Indonesia if the 1997 crisis presents itself in a renewed form. Fortunately for Indonesia, the central bank could salvage some of the damage: the Bank of Indonesia decided to raise interest rates quite quickly in response to the crisis, mitigating some of slide in the rupiah. However, market sentiment in fixed income circles still remain uncertain and mixed regarding the near future.

To Indonesia … and beyond?

The tremors from Turkey are not limited to just India and Indonesia. The MSCI Emerging Markets Index, a good indicator for performance of emerging market, has fallen more than 10% this year. Countries like Brazil, Argentina and South Africa, who rely on foreign investment, are all under threat of investors pulling out their capital. On top of this, all these countries have large current account deficit, which makes these currencies more susceptible to devaluation.

Analysts say that Europe is not safe from this contagion either. Countries like Spain and Italy are large holders of Turkish debt, and the currency crisis puts banks with these investments in jeopardy. If the contagion enters one of these countries, there is a good chance it may spread throughout Europe.

Is this the Tipping Point?

Many economists say that this Turkish crisis is not going to snowball into a larger economic issue, especially among emerging markets. They cite that the factors leading to the crisis are specific to Turkey, and it seems unlikely that other emerging markets would suffer the same consequences.TD Securities strategists say that the Turkey crisis is largely idiosyncratic, although its triggers have been external factors.

However, any volatility from the Turkish crisis does not spell good news for the emerging markets. A full-blown trade war between the US and China, along with sanctions on Iran, have made it difficult for emerging markets to grow at their potential in the recent past. The way current events are shaping up, with interest rates expected to rise in the US and a major selloff in material and tech stocks around the world, emerging markets will still have to face an uphill battle for some time.

As for Turkey, economic salvation will only be achieved when fiscal and monetary reform takes place. President Erdogan’s gusto may have saved him some political capital in his country, but if things keep going the way they are, investors will not flocking Istanbul and Turkey’s only hope may be an IMF bailout. Even so, Turkey has not scared away one particular group of people: shoppers. Nowhere else in the world could you buy a Louis Vuitton bag at 40% markdown like you can in Istanbul right now.


Politics and economics: The rupee’s Turkish worries

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