The potentially widening EM crisis and Turkey’s alliance with Russia and China

I don’t think we are at a point yet where what’s happening in Turkey can be called an emerging markets crisis. Right now, it’s mostly about Turkey, though there are signs of contagion via currency effects and concerns about creditors of Turkish debtors.

But, unfortunately, the Turkish crisis has multiple dimensions from which contagion can occur. And so, the worry is that what happens in Turkey is a harbinger of worse to come. That was my thesis a month ago. So let’s go through some of the latest issues.

That sucking sound is US dollar liquidity

First, let me say that this crisis has been building for some time. I actually flagged Turkey as “the country to watch in 2017” 21 months ago because of the deteriorating fundamentals there. But it’s taken a long time for the poor fundamentals to catch up with Turkey, with the trigger coming via currency risk.

I am looking at the Turkey crisis as a dollar crisis. It’s been brought on by Turkey’s unique vulnerability to the withdrawal of US dollar liquidity as the Federal Reserve tightens policy.

Now, if you look at the currency alone, EM countries have been weakening for years versus the dollar.

US dollar EM index

And inexplicably, as the Fed began to raise rates from 2015, EM currencies rallied. Perhaps this was a case of credit demand being pulled forward as I always explain happens during rate hike cycles. Nevertheless, the EM currency selloff resumed late in 2017, and accelerated as the regime shift under new Chairman Jerome Powell became clear.

That’s when Argentina ran aground and fell into the waiting arms of the IMF. Turkey was the next weakest link. Back in May as Argentina was going off the rails, I explained why I’m not an emerging markets bull. And the principal reason was dollar liquidity and hot money flows.

From their highs, the Brazilian real has gone as low as 21% down. The South African rand  has plunged more than 20%. The Hungarian forint has collapsed 13%. And the Polish zloty has sagged 12%.

Now that the EM crisis has jumped from Argentina to Turkey, we should start talking about this as a general case of dwindling liquidity and less as idiosyncratic vulnerabilities of this country or that country.

Contagion: currency and interest rate effects in EM

So when we see the Brazilian Real and the South African Rand dropping, we are seeing countries where both the sovereign and individual companies with large exposures to US-dollar denominated debt are in peril.

Even Argentina is feeling the impact of Turkey, despite having an IMF loan. The peso lost 7% since Friday, forcing the central bank to raise the base rate 5% to 45%. Contrast that to Turkey where there is no IMF loan and no willingness to raise rates that high and you can see why this crisis has legs.

Turkey will be under pressure, then, until it adopts measures that demonstrate a willingness to tackle the inflation and external debt problems. Yesterday, the iShares MSCI Turkey ETF saw its worst one-day decline since 15 October 2008, losing more than half its value so far this year. The fund is in jeopardy of falling below its lowest closing value since November 2008.

Instead of addressing Turkey’s vulnerabilities, the country is now getting into a trade war with the US. The latest is that Turkey President Erdogan has promised to implement a boycott of US electronics. So, because Turkey will remain under pressure, other countries in the EM universe will be dragged in tow.

Other forms of contagion

Then there are the creditors. That’s another potential avenue for contagion to go. Shares of European banks with large operations in Turkey were hit hard yesterday. That includes BBVA of Spain and UniCredit of Italy in particular. Spain has the greatest exposure, followed by France, the UK, the US, Germany and Italy. European banks combined have almost $200 billion in exposure to Turkey.

Some people are even talking about macroeconomic governance issues more generally. Italy comes up in that discussion because of the government’s unorthodox configuration and populist bent.  Italian 10-year government bond yields were up to 3.09% yesterday, That’s 11 basis points in a single day, much greater than with other euro area countries. With the ECB potentially set to end QE shortly, a tightening of euro liquidity should be a concern for investors in Italy and in the emerging markets.

Although Asian currencies and markets have dropped, there is less concern there because the macro fundamentals are better and because the central bank governance issues give investors more confidence. Maybe they learned from the Asian Crisis twenty years ago.

Silver linings?

The Guardian is saying the US tariffs that caused the spike in volatility yesterday may be the result of a simple misunderstanding.

Turkish leaders say a synchronised release of the pair – Ebru Özkan, jailed for alleged links to Hamas, and Andrew Brunson, a preacher from North Carolina – was discussed at a Nato summit on 11 July. The conversation predated the confidence crisis now enveloping the Turkish economy, but is seen as a political raison d’etre for a series of US measures that culminated in new tariffs imposed on Turkey on Friday.

Öskan, 27, was released the day after the summit, but Brunson remains under house arrest in the coastal city of İzmir. The pastor has been a central figure in a fast escalating crisis that saw the Turkish lira plunge to a new low of 7.2 to the dollar before stabilising later on Monday, amid broader fears that the country’s economy is seriously overheated and propped up by unsustainable levels of foreign debt.

While Turkey’s economic fundamentals have troubled global markets for some time, an apparent political backdrop to Turkey’s travails has been less clear. An informed Turkish observer close to decision-makers said the conversation between Trump and Erdoğan had been misconstrued by the US president, who believed he had secured a deal from his counterpart to free Brunson after persuading the Israeli leader, Benjamin Netanyahu, to seek Özkan’s release.

On the other hand, Erdoğan believed he had agreed to a process – transferring Brunson, a resident of Turkey for 23 years, from prison to house arrest – before his eventual release. The US pastor was indeed moved to house arrest on 25 July.

And I am hearing elsewhere that Erdogan is willing to climb down on the Pastor issue. Let’s see what happens. This won’t make the governance issues go away. But it could de-escalate the trade spat with the US and serve as enough ammunition to tamp down the crisis conditions.

Nevertheless, in my view, this is fundamentally about a Federal Reserve tightening cycle. Dollar liquidity is drying up. And the most vulnerable debtors, the ones who were bathing in dollar liquidity just months ago, will find themselves starved. Eventually, there will be defaults.

Turkey switching teams and aligning with Russia and China

From a geopolitical perspective, the biggest outcome to watch is how Turkey decides to align itself going forward.

Here’s the South China Morning Post:

There is a decent chance that China will offer some financial assistance to Turkey, including buying some yuan-denominated bonds that it is expected to issue, as Ankara reaches out for “new friends” to defend its currency and economy amid an escalating conflict with the United States, analysts said.

However, Beijing will carefully weigh its options in assisting Turkey and will not offer a major bailout package due to the risk to broader support would further provoke the US.

Turkish President Recep Tayyip Erdogan said on Saturday that his country was now looking to form alternative economic alliances from “Iran, to Russia, to China and some European countries”, after the US “upset and annoyed” its Nato ally with sanctions that greatly exacerbated the lira’s existing troubles.

Is Erdogan just bluffing? Or does he really want to switch away from a Western-oriented stance? I think a shift away from the EU and away from the US would be of enormous geopolitical importance. Turkey may only represent 1% of the world’s GDP. Nevertheless, from a geostrategic perspective it is very important. This is Turkey’s main card to play when the chips are down. But it’s unclear if Turkey would be bluffing or whether it really would follow through and switch sides.

Lots more to come

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