Turkey’s woes are only start of an emerging market crunch
The famous Lex Dornbusch of financial crises is that they take longer to hit than you think, but then unfold much faster than you ever thought possible.
Eve ry hedge fund in Mayfair knew that Turkey was an accident waiting to happen. It was odds-on favourite to be the first of the big emerging market economies – along with Argentina – to face trouble as the US Federal Reserve raised interest rates and drained the pool of global dollar liquidity.
The foreign currency debt of Turkish companies, banks and the state had reached 55pc of GDP, roughly the danger threshold in the Asian crisis of 1998. The country had become dangerously reliant on short-term dollar loans to cover a current account deficit of 6.5pc of GDP. This left Turkey at the mercy of shifts in global confidence.
All it required was a catalyst. That came when president Recep Tayyip Erdogan stopped the central bank raising rates, needed to stabilise the lira, followed soon after by a fatal clash with Washington.
Dollar funding was irresistibly cheap in the halcyon days of zero rates, when the G4 economies were adding $2 trillion (£1.6 trillion) a year to the international system through quantitative easing. The Institute of International Finance thinks events in Turkey are just the start of a long and painful hangover for those emerging markets that drank deepest from this cup, with South Africa, Indonesia and Colombia next in line as the spigot is gradually shut off.
Robin Brooks, the IIF’S chief economist, is concerned that a rise of just 60 basis points this year in 10-year US treasuries – the benchmark price of global money – has already led to an emerging market rout comparable to the “taper tantrum” of 2013, when the interest rate shock was much greater.
This suggests that the world has become hypersensitive as it grapples with a debt-to-gdp ratio of 318pc of GDP, some 40 percentage points higher than on the eve of the Lehman crisis.
The Bank for International Settlements says dollar debt in emerging markets has soared to $7.2 trillion, when both cross-border loans and “functionally equivalent” derivatives are included. This is an unprecedented figure and has never been tested in a cycle of rising Fed rates.
It is too early to tell whether Turkey is the canary in the coal mine, or an outlier with its own unique pathologies. What is clear is that the 25pc plunge in the lira over the last three trading sessions is turning toxic.
The central bank has failed to calm markets by slashing reserve requirement ratios by 250-400 basis points and opening lines of emergency dollar funding for the banks. Investors fear that the state itself does not have enough dollars to cover even a tiny fraction of Turkey’s $240bn of external financing needs over the next 12 months, should inflows dry up or turn into capital flight.
Tim Ash from Bluebay says the Erdogan regime must take three drastic steps: a rate rise of up to 1,000 basis points, a budget squeeze enshrined in law with a fiscal rule, and the release of the US pastor Andrew Brunson held for alleged terrorism.
What has made this episode so combustible is that Erdogan has lost touch with economic reality, retreating into conspiracy theories and swapping a respected Uk-trained banker as finance minister with his son-in-law. His lira policy is to exhort Turks to mobilise the euros and dollars under their pillows for the patriotic cause of “economic war”.
Aykan Erdemir, a Turkish anthropologist and politician, said
‘The lira slide risks turning into a downward spiral with systemic implications for Turkish banks’
Erdogan had acquired a taste for “hostage diplomacy”, holding nine Western nationals as bargaining chips to extract concessions – on top of the 100,000 Turks arrested after the failed coup in 2016. This has led to a catastrophic clash with the Trump administration over Brunson, a cause célèbre for the evangelical base of the Republican Party.
The lira slide risks turning into a self-feeding downward spiral with systemic implications for Turkish banks. Any sustained move beyond 7.0 to the dollar leaves lenders high and dry, leading to a credit crunch.
A whiff of contagion has spread to European banks, which together have $180bn of exposure to Turkey. BBVA, BNP and Unicredit have been pummelled over recent days but there is little risk of a pan-emu banking shock from Turkey alone. A large chunk of the exposure is through holdings in Turkish banks and entails lira deposits rather than hard currency loans.
“This is not going to blow up the euro or go global,” said Lars Christensen from Markets & Money Advisory. “The real issue is not contagion: it is that any emerging market country with serious imbalances is going to get hit as the Fed tightens. That is what happened in 1998. This looks very similar.”
In the end, that crisis was contained when the Greenspan Fed slashed rates. The Fed is unlikely to come to the rescue this time until there is blood on the floor. The Powell Fed is faced with inflationary late-cycle fiscal stimulus by the Trump administration, forcing it to compensate with higher interest rates. This is pushing the dollar higher.
There is another unsettling thought. The emerging ma rket nexus was not big enough to take down the global economy in 1998. Today it makes up over 50pc of world output, and 80pc of incremental growth. If Turkey is a sign of stress to come, batten down the hatches.