Is time off the hinges? Nay!

Some people always think things are always worsening. Time is always wrong, the economy is dislodged, advice is out of step with financial realities, banks will not deliver because there is such a funding cost increase of gigantic proportions awaiting EMs – and Turkey – that there will inevitably be a credit crunch, demand will collapse and suchlike. While causes for concerns are genuine enough to enquire about them from time to time, there is nothing so gloomy about the EM panorama yet. Turkey is no exception. Tax rates have been raised and this was only to be expected after a two-year rally of high public expenditure. The stupendous rise in the fiscal deficit-to-GDP ratio made a tax increase inescapable. So, the main take is that 2018 will not be a replica of 2017 because taxes will take their toll on growth, and expenditure will not fuel it as before. Only to be expected, that might be a move in the right direction. If there are no early elections in 2018, why stimulate the economy further? Nobody can expect high gains from an early electoral business cycle because 20 months from now people will forget. The memory of the ‘reasoned’ voter is AR (1), which goes at most one year back, and this is not exceptional if we take a pool of Southern European countries. It may be time to settle for less growth, but more stability and not to resort to excessive debt issuance instead of taxation. I wouldn’t opt for yet another 5-5.5% GDP rally in 2018 on top of 2017. Maybe 3-4% will suffice, give time for rebalancing and adequate preparation for the 2019 election year.

Further lira depreciation

That said, September didn’t bring any good on the currency front, and the Turkish lira depreciated. Actually, we talk about the second highest depreciation rate among EM currencies, the South African rand notwithstanding. I haven’t taken the ‘below 3.40 TL/USD’ pricing seriously because the lira had missed the 28-week rally already. Stopping at 3.3885, upside movement started again. It is especially due to the USD strength, but occasionally the Northern Iraq referendum and other political worries may have played a role as triggers. In addition, we clearly see that residents have increased their FX-denominated deposits when the lira has appreciated, either because they were in need of FX holdings to pay future debt or because they didn’t believe further appreciation was on the cards. Anyway, is this the end of the story or is it true that emerging markets may still perform on account of ongoing capital inflows next year? Let’s briefly revisit the ‘winter is coming’ argument anew. Our conjecture was that maybe winter is coming, but not yet. The ‘not yet’ part is solid but the ‘winter is coming’ part necessitates more reflection.

EMs benefit from change

Consider the latest reports from McKinsey and IIF. Because cross-border gross capital inflows have declined by 65% with respect to the 2007 peak, many people thought EMs would have been hit hard after 2007-09. Nothing of the sort happened. It did happen occasionally, but in the end EMs have even benefited from the change in the composition and origination of both debt and equity capital markets’ flows and from the proliferation of financial instruments. Eurozone banks have curtailed their overseas operations, but China and Canada took their place. Central banks played a much bigger role in terms of funding liquidity and providing guidance, and voilà, possibly a less riskier capital flow channel has been gradually built over the last decade. So, McKinsey thinks a new era of globalization has begun, with a healthier risk profile and in a more resilient vein. Furthermore, the last decade has been marked by the rise in financial connectedness among emerging markets. Indeed, the IIF has stipulated that flows to the EM universe would go unhampered in 2018, and on top of the projected $1.1 trillion in 2017 flows are expected to reach $1.2 trillion next year. In February, the forecast was only $810 million for 2017. The new estimate is $290 billion higher. Accordingly, monthly average portfolio inflows have almost doubled, and hit $23 billion in the first nine months of 2017, compared to the $12 billion of yesteryear’s equivalent months. The flow of funds continues in terms of a rising share of foreign direct investments ((FDIs), equity purchases and both debt pur-

chases and issuances and so on. Furthermore, a huge rise in EM external debt issuance awaits. There is the (in)famous Fed balance sheet contraction effect on the horizon, and we are bound to think it will have a negative impact, but flows destined to EMs would probably continue nonetheless. So, where is the winter?

Rising debt causes vulnerability

The possibility for a ‘winter of discontent’ lies in valuations. Equities are less attractive because they have already performed, and bonds can be hit through Fed balance sheet contraction because the amount to be refinanced is about $1.8 trillion. Also, rising debt is a cause for vulnerability and Turkey fits into this gloomy picture. It is good to be able to issue debt, but if you go too far, the risk premium would go up. Basically, I see it as a matter of pricing; it means rising funding costs for banks, corporates and eventually households, but not as a matter of quantities, at least not as much. Of course, we know volumes are also sensitive to the FFR, and USD liquidity tightness, but the order of magnitude compared to $1.2 trillion would not be that high. International investors’ risk appetite is still key. In the last couple of years what mattered most was the overseas risk premium so to speak, and large swings in the risk aversion coefficient either hampered or reinforced the dynamics of portfolio flows. Domestic developments in EMs came only second. Major central banks’ global guidance has been mostly in terms of forward guidance – that is words more than deeds. ‘Fed watching’ has won the day since anticipations of the timing of the Fed’s coming monetary policy shift drove the flow of funds towards EMs. In all, the Fed is still the built-in stabilizer in the system because it is the leading central bank – and because the advanced world is more connected financially than before Lehman, the other major central banks act in tandem. Interest rate forecasts and the expectations regarding the Fed’s security holdings also play a role. In the end, the whole Fed operation, unless somebody removes bricks from the wall one by one, can possibly lead to 1/10-1/8 of portfolio inflows to be redirected towards havens. Maybe $30-35 billion is important to make a difference, but the total flow is so large that if it is cut by 10-12% I believe the main effect will be on pricing. It will not, by itself, create a stop-go cycle so to speak.

Public spending must slow down

The first part of the argument, therefore, reads as: flows are likely to continue although there will be a price to be paid, and some volume contraction lies ahead. The order of magnitude of the impact should be c. 8-12% of total portfolio flows to the EM universe. Considering other cross-border capital movements, that is not a big number. Coming to the second factor, the domestic scene, we do observe a necessary recess in the run-up to elections that normally lie far ahead. There is no mechanism that could be yet implemented in lieu of the Credit Guarantee Fund, and we don’t yet know whether Turkey’ (Sovereign) Wealth Fund will make a difference. What we do know is (1) more taxes are needed (2) even though public spending cannot go on forever at the current speed.

Balanced picture

The picture is balanced. Construction accounts for most of the capital formation. Construction goes up whereas the yearly capital formation rate heads south in the machinery and equipment sector. The investment/savings balance is always in deficit, except the crisis year of 2001 when nobody invested, and this will remain so in the coming years. It doesn’t convey any especially bad news because it has always been so. The sectors investments have been channelled so as not to signal any sea change, which merely replicates the past decade. As a result, corporate debt has risen in the last seven years. The debt that the corporate sector has already incurred has not been spent on productive investments, which is not good. The good news is that since 2014, corporates have been able to prolong the maturity of their debt. Furthermore, we know from Central Bank of Turkey research that medium-size corporates with FX debt have either long-term debt or earn part of their revenue in foreign currencies.

A question of gold

On the other hand, the foreign trade data is problematic as we mentioned last week. One way it is problematic resides in the enigma of gold trade, notably with the UAE. Ratios become distorted, imports look extremely high at times, but the story is different. Turkey imports gold and exports probably the same gold without any reprocessing locally, albeit at a price advantage. To be precise, Turkey imports gold from the UAE and Switzerland mainly, but also from other countries. However, Turkey has exported 86.3% of total gold exports to the UAE alone.

We don’t know what is happening, but the foreign trade balance is better in the first seven months of 2017 than the equivalent period of 2016 if gold is excluded, and worse if it is included. Whether the gold trade volume is also fed into GDP data, assuming imported gold is processed here and therefore ‘produced’ to some extent, we don’t know. By definition the gold reserves of the central bank are not included in the foreign trade data; so, this doesn’t explain it. The adverse impact on the foreign trade balance is about $6 billion in the first seven months of 2017; hence, it may exceed $10 billion by the end of the year if it continues at that speed. Without gold, imports are actually only $7.32 billion higher than the same period last year. Hence, the first seven months, if we exclude gold imports, have increased by less than half of the increase including gold. In terms of demand’s resilience, we need to keep track of that item also; it makes a qualitative difference. If that translates into the CAD, there will be a huge difference both in dollar terms and in terms of the ratio-to-GDP. This also changes to some extent our assessment as to the intensity and location of demand.

I don’t impute much weight on idiosyncratic shocks, and look mainly at the cross-border capital flows. This has been the ‘common factor’ that shaped economic performance and financial returns of many EMs in the past and will remain so in the future. As long as funding doesn’t dry up, there will be room for manoeuvre and the possibility of achieving respectable growth rates. I don’t understand analysts who always tend to think in the much-celebrated downcast mood of Hamlet, later replicated by Derrida in the early 90s: “The time is out of joint. O cursed spite, that ever I was born to set it right.” Nay!