Turkey finally hikes rates

While the 300 basis point hike by the Turkish central bank on 23 May was more than the market was expecting, it may not be enough to stabilise the lira, especially if the dollar strengthens from here. But it is not just dollar strength that is weighing the lira down. The Turkish economy is overheating and grappling with double-digit inflation. The corporate sector runs a significant dollar short position through the use of cheap dollar-denominated debt to fund local currency assets, the majority of which is unhedged. In addition, Turkey runs twin fiscal and current account deficits and is a net importer of oil. This makes it susceptible to inflationary spikes when the oil price rises which leads to a sell-off in the lira and the requirement to raise interest rates.

Too little too late?

However, a populist president, a central bank that appears to have lost independence, and elections just around the corner have left the administration reluctant to raise rates and damage the job market. The hesitation to act has added to pressure on the lira, worsening currency mismatches on corporate balance sheets, which in turn has led to further currency weakness. The central bank’s belated decision to hike rates aggressively in defence of the currency will probably force the economy into a painful adjustment.

This is a classic emerging market foreign exchange crisis, witnessed many times before and made worse by the strengthening grip of President Erdogan. Turkey experienced a similar episode as recently as 2014. Then, the central bank hiked by 400 basis points to defend the lira, which had fallen by 16.5 per cent in nominal terms. Today, the lira has weakened by 25 per cent since January, inflation is much higher than in 2014, corporate sector debt has risen from 50 per cent of GDP to 70 per cent and the fiscal deficit is one percentage point higher as a proportion of GDP than in 2014 – yet the central bank has hiked by a smaller amount.

Source: Thomson Reuters, Fidelity International, May 2018.

Immediately after the hike the lira strengthened but quickly gave up half of that gain as the news was digested. The short end of the currency forward curve has not collapsed as might be expected, signalling the markets are unconvinced that one hike of 300 basis points will be enough to entice foreign investors back without structural changes, such as fiscal tightening or a more hawkish stance from the central bank. However, Turkey is a very small trading partner for other emerging market economies globally and is therefore unlikely to precipitate a broader crisis on its own.

Argentina and Indonesia

The fact that Argentina was able to sell a 100-year bond recently is bewildering, indicative of how desperate fixed income funds had become in their search for yield. Argentina requires a root and branch overhaul of its institutions and infrastructure before it can genuinely be considered as a viable, long-term investment opportunity. Starting from such a low base, there will always be pockets of opportunity but a change of president and some comments about economic reform do not equal genuine, fundamental economic change; there was never any guarantee that the new administration’s economic reforms could be enacted.

Indonesia is slightly more challenging as the pressure on the bond and foreign exchange markets is predominantly a consequence of the US 10-year yield breaking 3 per cent. Indonesia is one of the biggest carry trade markets in emerging market debt and has benefited from low dollar rates globally and, more recently, an improvement in its terms of trade as commodity prices have recovered. This makes the carry attractive and currently around 30-40 per cent of the bond market is owned by foreigners, who have a very small window to escape when they decide to exit (which is usually everyone attempting to leave at once).

Indonesia has also been under some selling pressure since the Jakarta elections, won by a member from outside the ruling party. This raises the prospect of the government taking populist measures to shore up support ahead of the forthcoming elections. That aside, the story being played out in Indonesia is similar to that of Brazil, where the rise in the US ten-year yield is making local currency debt less attractive, the real has sold off, and the central bank has stopped cutting rates as a consequence.

Source: Thomson Reuters, Fidelity International, May 2018.

Therefore, much depends on the direction of the dollar from here. Fundamental demand remains relatively healthy and commodity prices appear to be holding up. However, we should take note of the signals that the bond and foreign exchange markets are sending about the future direction of global demand and commodity prices. Another bout of commodity price declines would be negative for emerging markets’ currencies across Latin America, EMEA and parts of South East Asia.

What is bad for China is bad for all emerging markets

However, an even more important factor for emerging markets could be the direction of demand growth in China, which for now seems reasonable though probably not accelerating. Internal demand in China is probably strong enough to keep the Chinese economy ticking over, but other emerging markets do need a strong China and robust global trade to support their currencies and drive economic growth in their economies. This is why what is bad for China is generally really bad for emerging markets more broadly.

Investors have been particularly worried about Chinese debt of late. However, the situation is not as bad as some fear. While household leverage has picked up, this is against a backdrop of rising household incomes and a household-to-GDP ratio that is no cause for alarm. Local government debt has been completed via swaps for the past three years so does not pose a significant risk to banks.

Corporate defaults have picked up recently but this is isolated to lower-quality private companies that had no access to capital markets or banks for funding. These companies tend to be in traditional industries where the inefficient players drop out and their market share is taken by larger, more efficient companies. It is no secret that state-owned enterprises need to deleverage, and we expect to see further consolidation in this part of the market. However, restructuring often allows improved access to financing.

In summary, debt issues in China are relatively well contained within certain parts of the market – state-owned enterprises and inefficient private companies. The key risk remains policy mishap. If the government does not strike the right balance (either by being too aggressive with the pace of deleveraging or by falling behind the curve with financial regulation) then the private sector could suffer, with a significant impact on the employment market. Given trade related issues with the US and China’s recent policy path, the government is likely to ensure domestic demand remains intact.

No EM-wide crisis, unless China mismanages its path

Emerging market sovereign balance sheets as a whole are far more resilient than they were in past cycles because many key economies have paid down dollar-denominated debt and built up dollar reserves. This enables the majority of central banks and governments to act counter-cyclically and proactively when it comes to supporting their domestic economies in times of stress. The situation that Turkey finds itself in is far less widespread than was the case in the 1990s and early 2000s.

There are certainly risks to be aware of and at the margin the market does seem to be telling us something, particularly in Indonesia and Brazil. But it is too early to be deemed a full-blown emerging markets foreign exchange crisis unless something bad happens in China.