Can shades of global re­ces­sion help risky EMs?

Dünya Executive - - ANALYSIS - Gunduz FINDIKCIOG­LU Chief Econ­o­mist

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.

Now what?

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.

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