The Roots of Turkey’s Woes and What it Could Mean Next
Turkey is suffering a currency crisis, which may progress into an economic crisis. Whether it leads to a political crisis remains to be seen. The extent of the problems mean that Turkey’s predicament has already generated headlines here in the UK, but what are the reasons and consequences?
The catalyst has been the rise in US interest rates and aggressive posturing over potential US tariffs on steel exports, but the root cause is problems in the Turkish economy, including that Turkish firms have borrowed a large amount in foreign currency.
The rise in US rates has been proceeding for a couple of years now, albeit at a gradual pace. The general expectation is that such tightening will continue, as the US economy grows strongly, with the US Federal Reserve raising rates to both curb inflation and also to give itself more room for future policy manoeuvre – hiking rates in good economic times, as now, allows it to cut rates in a few years if there is a slowdown. Then it would be able to do so from a higher level.
In a globalised world economy, however, the actions of central banks can have a much wider impact outside of their own country.
Turkey’s three problems
The problem with Turkey is threefold. One, many Turkish firms borrowed in dollars. They did this because US rates were low and the Turkish lira was much stronger versus the dollar than it is today. As more firms behaved like this, it added to the competitive pressure on others to copy.
Over the last decade, these overseas borrowings have almost doubled to a widely quoted 25% of GDP, a sizeable $225 billion on present exchange rates, spread across the corporate sector. As US rates have risen and the lira weakened these debts have become more expensive. Now, the cost of servicing these overseas borrowings has become exorbitant – US interest rates rose eight-fold, from 0.25% to 2% in under three years, while the US dollar has doubled in strength versus the Turkish lira in the past 12 months – adding to economic problems at home.
The second problem in Turkey has been the macroeconomic fundamentals. When countries run large trade deficits they need to finance this by attracting inward capital flows and they can thus be vulnerable to shifts in sentiment. Therefore, they can be said to depend on the kindness of strangers.
As global interest rates rise, risk appetite changes; slowly to begin with. Investors who previously may have put their money into high yielding economies may withdraw their money.
Also, a common response to combat these capital outflows is to hike domestic interest rates further in an attempt to defend the currency. However, in Turkey’s case, the central bank has been reluctant to act decisively, seemingly influenced by President Erdogan’s comments that ‘interest rates are the mother and father of all evil.’
It is this lack of response that has spooked investors further. However, hiking rates aggressively when a currency is in freefall rarely works and often hits the domestic economy even harder. So perhaps they were right to hold off.
Lessons from before?
Ahead of the 2008 global financial crisis there was not enough ‘pricing for risk’. Some investors were greedy. There were also many ‘crowded trades’ where people made the same investment knowing it contained risks but they each felt they could get out in time when the situation changed. They couldn’t. It’s a bit like everyone trying to get to the exit door at the same time at the cinema.
This does not mean we are about to have a crisis now, but in markets like Turkey similar behaviour was evident. Indeed, this year, as US rates and the dollar have risen, attention has been focused on emerging economies that may be vulnerable to this change in circumstances: it was South Africa and Argentina earlier this year. Now it is Turkey.
Ripple effects mean that speculators then start to be on the lookout for other potentially vulnerable currencies to attack. We need to be wary of such speculative behaviour because, although our portfolio exposure to Turkish assets is very limited, dependent on risk level, if it spills over into other markets it can add to volatility and affect our other emerging market exposures. In these circumstances, as always, it is best not to panic. The fundamentals tend to come back to the fore in driving behaviour.
Also, events like Turkey lead to a focus on contagion risks. Will the problems spill over from one country to another? In this instance attention will either be on other economies that look vulnerable – and here all too often it is countries where trade deficits are high or where firms are seen to have borrowed heavily in overseas currencies. Or, as we are also seeing now, it leads to a wider debate about emerging economies.
Emerging economies are more robust, but vulnerable to shocks
Here, too, one should not panic. Emerging economies – led by China – are accounting for a greater share of the world economy and contributing to more of its growth. Thus, they offer long-term value. However, many of these markets do not have – yet – deep capital markets like the UK or US. As their economies grow, they may be vulnerable to economic shocks or to shifts in investor sentiment.
Earlier this week I followed closely this debate in Asia. There the main focus was on what would happen to the Chinese currency as it was seen as holding the key to whether contagion to other emerging markets would ensue – and I agree that this question is very important. The world economy has grown steadily, helping Asian economies. Some have seen higher inflation – witness the latest rise in interest rates in the Philippines last week as an example.
But the main worry across Asia and across other emerging regions is whether trade tensions between the US and China could slow trade and export growth. This would be exacerbated if there then was a bout of competitive pressure from a weaker Chinese currency.
In recent weeks China has already taken steps to ease policy and to boost their domestic economy. The latest was last weekend when they asked banks to lend more. This may be a sign of worries that the Chinese economy will slow – it is also a way of China signalling to the Americans that they are taking steps to boost their economy so that they can stand firm in any trade war.
At Netwealth, we constantly monitor potential concerns
Overall, we are on top of these issues. None of these events are completely unexpected. Earlier this year we also drew attention to the rise in global debt, a full decade after the financial crisis, and to the need to be aware of the amount of outstanding dollar debt. Current problems in Turkey do not need to trigger contagion elsewhere. They will likely, however, encourage speculators to search for other vulnerable currencies to attack – or create more attractive valuations in other markets where fundamentals are stronger. It may even cause the Fed to pause for breath before raising rates again.
Turkey’s difficulties should be a reminder to keep on top of risks. But above all it will remind us of the need to prepare for the consequences of higher interest rates and to focus on which markets are fully priced and on those where there is value, particularly for the longer term. There will be volatility and setbacks, reinforcing the message of the importance of spending time in the market, as opposed to attempting to time the market.
Please remember that when investing your capital is at risk.
The catalyst has been the rise in US interest rates and aggressive posturing over potential US tariffs on steel exports, but the root cause is problems in the Turkish economy, including that Turkish firms have borrowed a large amount in foreign currency.
The rise in US rates has been proceeding for a couple of years now, albeit at a gradual pace. The general expectation is that such tightening will continue, as the US economy grows strongly, with the US Federal Reserve raising rates to both curb inflation and also to give itself more room for future policy manoeuvre – hiking rates in good economic times, as now, allows it to cut rates in a few years if there is a slowdown. Then it would be able to do so from a higher level.
In a globalised world economy, however, the actions of central banks can have a much wider impact outside of their own country.
Turkey’s three problems
The problem with Turkey is threefold. One, many Turkish firms borrowed in dollars. They did this because US rates were low and the Turkish lira was much stronger versus the dollar than it is today. As more firms behaved like this, it added to the competitive pressure on others to copy.
Over the last decade, these overseas borrowings have almost doubled to a widely quoted 25% of GDP, a sizeable $225 billion on present exchange rates, spread across the corporate sector. As US rates have risen and the lira weakened these debts have become more expensive. Now, the cost of servicing these overseas borrowings has become exorbitant – US interest rates rose eight-fold, from 0.25% to 2% in under three years, while the US dollar has doubled in strength versus the Turkish lira in the past 12 months – adding to economic problems at home.
The second problem in Turkey has been the macroeconomic fundamentals. When countries run large trade deficits they need to finance this by attracting inward capital flows and they can thus be vulnerable to shifts in sentiment. Therefore, they can be said to depend on the kindness of strangers.
As global interest rates rise, risk appetite changes; slowly to begin with. Investors who previously may have put their money into high yielding economies may withdraw their money.
Also, a common response to combat these capital outflows is to hike domestic interest rates further in an attempt to defend the currency. However, in Turkey’s case, the central bank has been reluctant to act decisively, seemingly influenced by President Erdogan’s comments that ‘interest rates are the mother and father of all evil.’
It is this lack of response that has spooked investors further. However, hiking rates aggressively when a currency is in freefall rarely works and often hits the domestic economy even harder. So perhaps they were right to hold off.
Lessons from before?
Ahead of the 2008 global financial crisis there was not enough ‘pricing for risk’. Some investors were greedy. There were also many ‘crowded trades’ where people made the same investment knowing it contained risks but they each felt they could get out in time when the situation changed. They couldn’t. It’s a bit like everyone trying to get to the exit door at the same time at the cinema.
This does not mean we are about to have a crisis now, but in markets like Turkey similar behaviour was evident. Indeed, this year, as US rates and the dollar have risen, attention has been focused on emerging economies that may be vulnerable to this change in circumstances: it was South Africa and Argentina earlier this year. Now it is Turkey.
Ripple effects mean that speculators then start to be on the lookout for other potentially vulnerable currencies to attack. We need to be wary of such speculative behaviour because, although our portfolio exposure to Turkish assets is very limited, dependent on risk level, if it spills over into other markets it can add to volatility and affect our other emerging market exposures. In these circumstances, as always, it is best not to panic. The fundamentals tend to come back to the fore in driving behaviour.
Also, events like Turkey lead to a focus on contagion risks. Will the problems spill over from one country to another? In this instance attention will either be on other economies that look vulnerable – and here all too often it is countries where trade deficits are high or where firms are seen to have borrowed heavily in overseas currencies. Or, as we are also seeing now, it leads to a wider debate about emerging economies.
Emerging economies are more robust, but vulnerable to shocks
Here, too, one should not panic. Emerging economies – led by China – are accounting for a greater share of the world economy and contributing to more of its growth. Thus, they offer long-term value. However, many of these markets do not have – yet – deep capital markets like the UK or US. As their economies grow, they may be vulnerable to economic shocks or to shifts in investor sentiment.
Earlier this week I followed closely this debate in Asia. There the main focus was on what would happen to the Chinese currency as it was seen as holding the key to whether contagion to other emerging markets would ensue – and I agree that this question is very important. The world economy has grown steadily, helping Asian economies. Some have seen higher inflation – witness the latest rise in interest rates in the Philippines last week as an example.
But the main worry across Asia and across other emerging regions is whether trade tensions between the US and China could slow trade and export growth. This would be exacerbated if there then was a bout of competitive pressure from a weaker Chinese currency.
In recent weeks China has already taken steps to ease policy and to boost their domestic economy. The latest was last weekend when they asked banks to lend more. This may be a sign of worries that the Chinese economy will slow – it is also a way of China signalling to the Americans that they are taking steps to boost their economy so that they can stand firm in any trade war.
At Netwealth, we constantly monitor potential concerns
Overall, we are on top of these issues. None of these events are completely unexpected. Earlier this year we also drew attention to the rise in global debt, a full decade after the financial crisis, and to the need to be aware of the amount of outstanding dollar debt. Current problems in Turkey do not need to trigger contagion elsewhere. They will likely, however, encourage speculators to search for other vulnerable currencies to attack – or create more attractive valuations in other markets where fundamentals are stronger. It may even cause the Fed to pause for breath before raising rates again.
Turkey’s difficulties should be a reminder to keep on top of risks. But above all it will remind us of the need to prepare for the consequences of higher interest rates and to focus on which markets are fully priced and on those where there is value, particularly for the longer term. There will be volatility and setbacks, reinforcing the message of the importance of spending time in the market, as opposed to attempting to time the market.
Please remember that when investing your capital is at risk.
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