Emerging market economies have been the main losers from US protectionism and higher US interest rates.
Capital has flooded out of emerging economies to the US to benefit from rising interest rates. This has meant less liquidity and has sent some emerging economy currencies through the floor. Emerging market governments or businesses which borrowed in dollars, and many have, are having to cope with rising financing costs and a heavier local currency debt burden.
US protectionism has added to the headwinds. Uncertainty and tariffs are the direct problem. Commodity-producing economies are also at risk from a Chinese slowdown exacerbated by US protectionism.
Events in Turkey illustrate how US monetary tightening has interacted with structural weaknesses, poor policy and a diplomatic row to create a full blown crisis.
The latest phase of that crisis reflects tensions over Turkey’s imprisonment of an American pastor, Andrew Brunson. After a deal to release Mr Brunson collapsed, the Trump administration imposed sanctions on Turkey and doubled tariffs on Turkish steel and aluminium imports to the US.
Underlying this spat is a story all too familiar from earlier emerging market crises. Turkey has a high-risk mix of a sizeable current account deficit, heavy overseas borrowing by businesses and rising inflation. Exacerbating these problems, and specific to Turkey, is the reluctance of the central bank to raise interest rates.
Turkey runs a current account deficit of around 5% of GDP and needs inflows of foreign capital to finance imports. A significant proportion of this funding takes the form of foreign purchases of Turkish equities and bonds. This capital is footloose and sensitive to investors’ changing appraisal of prospects for Turkish assets and returns elsewhere. A deteriorating outlook in Turkey and rising US interest rates have caused capital to flow out of the country in recent months.
Neither the Turkish government nor the country’s businesses run particularly high levels of debt by emerging markets standards. What makes the corporate sector vulnerable is that around half of its debt is denominated in foreign currencies. Companies borrowed heavily in dollars and euros during Turkey’s construction boom. A 40% fall in the Turkish lira since the start of the year and rising US interest rates have sharply raised financing costs for business.
Lira weakness has also pushed up import prices, helping propel inflation to almost 16% in July.
The natural policy response to rampant inflation would be to raise interest rates. Yet Turkey’s central bank has raised interest rates only once in the last two years. Investors’ faith in the management of the economy has been further tested by President Erdogan’s claim to exclusive authority over appointments to the Central Bank and the elevation of his son-in-law to head of economic policy. In an inversion of conventional wisdom Mr Erdogan appears hostile to the use of interest rates to combat inflation. After his recent election victory he called interest rates “the mother of all evil”, urged citizens to convert dollars into lira and told them not to worry, saying that "If they [overseas investors] have the dollar, then we have Allah."
With foreign currency becoming scarcer Turkey is drawing-down on its finite reserves of foreign currency. This is not sustainable.
Turkey may be able to secure loans from the International Monetary Fund (IMF) or from one or more countries, possibly in the Middle East. But those loans are unlikely to come without strings attached. To ensure they get their money back any creditor is likely to require major changes in policy, just as the IMF and the EU did in Greece. The path that follows, and one that many emerging economies have been down, involves a squeeze on credit and living standards, less spending on imports and slower growth.
These are serious challenges for the Turkish economy, but do they pose a risk to global growth?
The Turkish economy is relatively small, somewhat smaller than the Netherlands. Losses on holdings of Turkish assets by non-nationals provide an obvious channel for transmitting the crisis around the world. But the size and value of such holdings is not of a scale to suggest that losses would trigger a wider, global crisis.
The real meaning of what is happening in Turkey is different. It illustrates how frailties which are largely invisible in the good times can be cruelly exposed as interest rates rise. Countries with high levels of overseas debt and a dependence on foreign capital are particularly vulnerable.
Bad government policy can turn a problem into crisis, a truth powerfully illustrated by the plight of Venezuela. Geopolitical tensions, which for Russia, Iran and Turkey have resulted in the imposition of US sanctions, add to the challenges.
Each emerging crisis is different. Turkey’s current problems illustrate how geopolitics, changes in US monetary policy and market dynamics can quickly turn an economy’s fortunes. Weakness in other emerging market currencies and equity markets testifies to potential vulnerabilities elsewhere. With US rates on a rising path, and protectionism on the rise, the challenges facing emerging market economies are likely to mount.