Can shades of global recession help risky EMs?
It is kind of awkward, compared to the 1990s and early 2000s. There is no ‘sudden stop’ these days, arguments to the effect that Fed interest rates would stochastically dominate EM rates or else EM currencies would depreciate don’t work – at best they work partially and from time to time, etc. Old school development macroeconomics may have turned into historical wallpaper, or a textbook at best, with many obsolete parts. While this could be considered normal – things change all the time - what has replaced olden days’ wisdom –both deeds and words - doesn’t look particularly convincing either. At negative rates, we now have “embedded floors”, “hidden swaps” and many novelties that arise from the moment zero rates meet swaps and suchlike. At the end of the day, there is always some money that slips through to come to the temporary rescue, even for the riskiest of EM markets. Strangely enough, some EMs look forward to seeing the developed world enter into recession, so EM interest rates can fall also. Would the new motto be “don’t do anything, every now and then there will be a recession, and some money wil pour in regardless”?
Well, it doesn’t exactly work that way but it is coming close to that. Economic program, growth strategy, financial stability, education, experience, prowess none
of it makes any significant difference in a world of zero – or close to - rates, a world mostly on the edge of recession. What was the point in making all the computations as regards the malevolent impact of Fed rate hikes and balance sheet contractions on EMs? According to 2013 February projections – Fed projections, make no mistake - US 10-years would now carry five percent? Do you remember the arguments around bond convexity, whether Turkish banks would be able to shorten durations at the right moment, etc., when Bernanke spoke in May 2013? Reserve depletion, yes; currency depreciation on a roller-coaster, yes; an incredible lot of FX debt; yes… But in the end, this is a different financial world. No matter what mistake you make, you somehow manage to stay afloat. In the short run yes, one is impelled to say loud, but not always.
So, nobody seems to care about S400 or F-35 or İdlib or whatever. Can this be true? Can serious and geographically grounded politically-motivated risks evaporate simply because the Fed is easing? Well, there are those who aren’t only not well-versed in the theory of games, but not even aware of its basic heuristics. The ill-founded “win-win” phraseology is one such example that one can often encounter in the press. There are many kinds of games, and information, the strategy space, if it is a repeated game or what kind of game it is, etc. Postulating a principal-agent game admitting a “folk theorem” with respect to the subgame-perfect (Nash) equilibrium – characterized by bargaining, struggle or tit-for-tat as it happens - could be one way of capturing this idea. Then, the question becomes: is the game a “folk theorem” game and does the equilibrium of this game entail bargaining, appropriately represented in game-theoretic terms? Indeed, if there is a (locally) unique Nash equilibrium with tit-for-tat looking features but ultimately giving way to co-optation when the rate of discount approaches one, and if there is a(nother) (locally) unique Nash equilibrium without it when the rate of discount approaches zero, then the (political) game may not be a “folk theorem” game. Tit-fortat is not continuous for all parameter values in an open neighborhood around the equilibrium and there is no game-theoretic heuristic representing the claim that such behavior always matters. Hence, which is which? What players can wait most? Indeed, if the whole idea is about who will give up first, as the CAATSA and hearings approach, then we have about a couple of months before the dust dissipates. I think it is a sensitive situation because what still looks tractable might easily turn into a mess. On paper, before deciding what long-term course of action to follow, Turkey has a few months still, but then the road might be bumpy. In parlor games, sometimes people “overplay” their hands.
I am not sure if this is “overplaying” because Mr. Trump changes course all too often, and he tries to give the impression that he can bypass the congress if need be. True, the American polity has changed a lot after 9/11 but this is a deeply entrenched system of checks and balances. On the other hand, claiming that reconciliation between the U.S. and Turkey in the end is either inevitable or at least a distinct possibility forgets one thing: Postulating the existence of a closed-loop equilibrium for political history, which is by definition independent from path, is tantamount to arguing that the political process is the unfolding and the realization of a conserved essence. This is so because in such a closed
loop history’s beginning and its end would be independent from whatever happens in between. The image of a self-regulating ecosystem seems to perfectly fit such path-independence and, if such history is not totally static the uttermost dynamic it can admit is a linear drift. No, there may lie many non-linearities ahead and every actor may end up finding themselves in an entirely different configuration. I tend to think we may have one month and one month only until risks temporarily perceived as nonrisks pop up again.
A politico-economic equilibrium still warranted
There is a sense in which economic woes are intertwined with regional politics. True, the structural problem is deeply rooted. Again true, the real sector is heavily FX-indebted. It is also correct that financial flows have been less favorable since May 2013, a fact that wasn’t fully acknowledged. However, the triggering moves mixed in late, in early May 2018 and in early August 2018. The two episodes of rapid currency depreciation need not have been so drastic and shocking, although the lira would have depreciated to some degree anyway. Now that the genie is out of the bottle, risks are once more highly correlated, as if they were arguments of a single portfolio. The question is: will there be a quick turnaround shortly and if there will be, would its fueling device, its ignition switch, be political or economic? Well, it is more likely to be a political volition that would render a new beginning credible. Piling up one inapplicable bout of a program on top of another won’t do the trick. And the clue conducive to the ignition ought to be international.
Why is that so? Everyone knows Turkey needs structural reforms – that are at a technical and micro level partially set and discussed already. Nevertheless, what is a structural reform in its very essence? It is a politico-economic bargaining among the elites. Furthermore, many a micro-level interest matter, but bargaining as such should be an aggregate phenomenon. There may be a solution to the bargaining problem if and only if (i) parties involved have no sizeable advantage in escalating conflict; (ii) parties involved have great concerns about the future consequences of present decisions, i.e. they are not myopic with respect to the bulk of the time horizon; (iii) parties involved know that aggregate appropriable rents matter, i.e. the marginal cost of fueling conflict is higher than the expected marginal benefit from such action. Reform and restructuring may come to a halt and conflict may pick up if any of the above is not satisfied. That the appropriable economic rents are relatively big in Turkey is beyond question. However, the first two issues are not that clear-cut. Some pressure groups may have incentives to escalate conflict and stop bargaining, if they sense that they will lose from such negotiations. Conflict may indeed be preferable by at least one player if that player feels she will not be given enough compensation for the future losses. Furthermore, this story assumes the existence of perfectly rational players. If there is a chronic cognitive deficiency syndrome that reduces rationality to less-than-full, the three conditions mentioned above may not be satisfied. In the past decades, many an analyst pointed to the possibility of myopia. Hence, structural reform is a nice word, but it doesn’t stop at that; it takes a lot of political entrepreneurship. And the political ignition switch should be somewhere near. I don’t see any switch of that kind nearby. So, at best nothing will happen, the normal business cycle will take over from here, and inflation will fall to low double-digits in Q4 2019 and in Q1 2020. So will growth: zero-growth on average is a good target if we consider a window of 6 quarters – Q4 2018 to Q1 2020.
Run-ups in house prices is a must
Well, interest rates rose so sharply that people are still on hold. Recently, a possibly temporary window of opportunity opened up because public banks now lend at low mortgage rates. People queued because there exists pent-up demand. It is very difficult to come up with a general mortgage rate reduction scheme so a partial solution has been attempted at. Will it work? The move as such certainly testifies that the real estate and the larger construction sectors, the main driver of fixed capital formation according to the new GDP series and according to the impartial observer in the street, risks becoming the locus of a long stagnation – after being the locus of the current recession, a recession that is slowly fading away. In fact, recession is a technical term only but slowing all the way down from 7.4 percent to negative, then to zero average growth for more than a year is bad enough even if it isn’t called recession. Actually, run-ups in house prices and debt growth are better indicators of recession than the current account deficit in the current case. This may not be the case in the U.S. but it is in Turkey. Equity prices don’t matter much because capital markets are shallow. Current account deficit is only a flow variable, and what will have to be financed in the remaining four months of 2019, for instance qua deficit, is nothing. Turkish firms are net debt payers this year, and this was the hard part. Debt is still so large that even the debt service matters more than the current account deficit. A similar argument applies to the real estate sector. Return on capital invested risks going all the way down to very low levels indeed. I don’t envisage an all-in package that could solve the problem there because homes are no longer a good investment opportunity, and the excess supply is huge. Mortgage rates are still generally high and banks can no longer be eager to lend there even if there were demand. With such rates monthly payments are inordinately high relative to incomes. This is an extremely risky situation. Unless house prices rise again – at least on a par with inflation - most real estate companies may not survive. But low mortgage rates throughout are a must for that, and that doesn’t seem possible to me except episodes of low rate campaigns.