Near-term headlines may be focused on the travails of the Argentinian economy following the Central Bank of Argentina’s eye-watering raise of the local base rate to 60%. It is Turkey, however, that remains the real problem child for global markets.
The situation in Turkey could be the crisis that shows how difficult it is to wean the global economy off the monetary policy accommodation that underpinned the recovery.
So, why Turkey and not Argentina?
For one, belligerence. The Argentinian leadership has been engaging with the IMF and effectively pleading with them to increase the pace of bailout funding.
But Turkish President Erdogan is proving to be as pugnacious as ever in holding US, EU and international investors and institutions in fairly obvious contempt.
Argentina is prepared to engage with markets and the IMF to protect their economies and populations, Turkey, so far, is not.
Contagion risk
Dominos is an emerging market investor’s least favourite game. Idiosyncratic risks quickly become market dislocations and the good work of an emerging market economy’s institutions are undone by the profligacy or inadequacy of another economy halfway round the world.
The first round of sell-offs in the Turkish lira coincided with weakness in the South African rand. The weekend of August 11-12 saw South Africa’s government announce a raft of changes to local government to reform an unwieldy bureaucratic system and streamline state-owned businesses.
Normally this would trigger a slight concern over deficit spending and exposure of the local banking sector. But the fact that it coincided with the lira losing 11% in a few days meant South Africa became a target too.
The fact is that - whether it should be the case or not - when conditions are good and liquidity is abundant, the search for yield can paper over a fair few systemic risks. But, once liquidity starts to dry up those chickens come home to roost very quickly.
What to watch?
While most will be watching the Central Bank of the Republic of Turkey (CBRT) for another roll higher in the interest rate corridor, the true inflection point for the Turkish economy and the lira will be the ability of its local banks to recycle and refinance outstanding debts in foreign currencies and owed to European banks.
Similarly, one of the sensible things that the CBRT has done has been to limit the ability of speculators to be able to roll their positions onwards against the Turkish currency. They did this by limiting the ability of local banks to lend lira to foreign counterparties at 50% of their regulatory capital. Without the ability to roll, those lira have to be settled, causing the speculator to sell his or her dollars, leading to a lower USDTRY in this example.
These positions will need to be rolled at the next IMM date – September 20th, one of four dates which most futures and option contracts use as their scheduled maturity date or termination date – and this will be a crucial time for the markets perception of both investor appetite to further pressure the lira and their ability to do so.
Waiting for a rescue
In the longer-term, beyond a settlement date in a few weeks’ time, inward investment is likely to remain weak. Corporates will be unwilling to commit capital to a country that may still bring in capital controls, and with whom the hedging of currency risk is not a given.
Similarly, we have to believe that, despite Erdogan’s protestations to the contrary the International Monetary Fund (IMF) is going to have to get involved with a rescue package for the Turkish economy, representing a good time for investors to turn bullish on the lira.
Until then, why would you want to hold Turkey assets? Carry can only trump economic fundamentals for so long.
Jeremy Thomson-Cook is Chief Economist and Head of Currency Strategy at WorldFirst.
