THE rot has not been stopped. Last week, it seemed as if the Turkish authorities were in denial. Inflation was too high, the current account deficit was too wide but the central bank failed to push up interest rates; the lira was sinking. But the bank acted decisively last night, pushing the rate on 7-day repos to 10% (from a theoretical 5.25%) and overnight rates by more than four percentage points. The initial reaction was positive, with the lira rebounding and Asian equity markets moving higher.
But the initial reaction was short-lived and the Turkish lira is now lower than it was before the move. My mind is inevitably drawn back to Black Wednesday (September 16, 1992), when the British authorities raised rates by five percentage points in a matter of hours in a doomed effort to keep the pound within the Exchange Rate Mechanism. I was in a bank dealing room when the second rate rise was announced and was a bit surprised to see equity markets rally; the explanation from dealers was that the policy was so self-evidently bad for the economy that it would never be sustained. Their cynicism was right; by the end of the day, the rate rise was cancelled and Britain dropped out of the ERM. The reputation of the then Conservative government did not recover but the economy did; some dubbed the day "White Wednesday" in consequence.
Turkey has no exchange rate peg to manage, so it doesn't have the automatic escape route Britain had back in 1992. The problem then was that British policy was too tight; Turkish policy has not been tight enough. Citibank comments that
In a rising US rates environment (which most still subscribe to), emerging markets need to have real rates of 5% plus or so, at least when it comes to the ones that have current account deficits to finance. Otherwise, they will just not be able to attract the necessary inflows to fund such current account positions, and, on the contrary, see outflows from existing fixed income positions built up over the last years. The need for high rates is even more clear, if there is basically an absence of growth, making equity flows less likely, too. At 10% interest rates, with 7.4% inflation, real rates in Turkey are still less than 3% real rates, for example.
Indeed, Black Wednesday seems a rather more appropriate term this time since the sharp rise in rates may damage the financial sector and the rest of the economy without stabilising the currency. This is a problem if an economy gets used to very low rates; debts are taken out on the assumption that such rates will be in place for good. When it comes to tightening policy, the central bank risks doing a lot of damage. Of course, the same argument applies across the developed world; one reason why central banks will be so hesitant before they announce the first rate rise of the next cycle.
As for the rest of the world's markets, there was a slight perversity in the initial reaction; since when have massive rate hikes been good news? Emerging markets seem to be in tightening mode; South Africa pushed up rates by half a point today (without boosting the rand) and India raised rates by a quarter-point yesterday (a move that did help the rupee).
This tightening may be the delayed response to previous policy failures. Shweta Singh of Lombard Street Research comments that
Many emerging markets, largely the deficit EMs, are battling uncomfortably high inflation even as growth continues to moderate well below trend. Our analysis shows that the supply side bottlenecks are the main culprit. Easy external liquidity conditions and populist fiscal policies have kept domestic demand artificially supported. Deteriorating current account balances reiterate this mismatch. In a scenario of risk aversion, a strong US$ and higher real US yields, deficit EMs may see further weakness in the currency, adding to inflationary pressures and necessitating further domestic demand compression. A weaker currency may help competiveness in the longer term, but not without causing pain in the short run
It doesn't seem that long ago that emerging markets were claiming the US was indulging in "currency wars" by keeping rates near zero and indulging in QE, but they don't seem that happy with tapering and a stronger dollar either.
PreviousDebt: Capacity to pay
NextThe euro zone: Where has all the money gone?
I was talking about tapering with a banker friend of mine last week and he informed me of the primary challenge banks face with tapering: their current assets will still be issuing the same percentages even as rates go up.
In other words, bonds don't quicken their maturities just because interest rates rise. It takes time for financial institutions to adjust their portfolios when rates and inflation rise and fall.
So, in the current environment of expectations that rates will rise, bankers and investors are looking for bigger returns. And they have already decided that Turkey's real returns on investment are too low, despite the large and sudden rate increases.
This is because Turkey's problem isn't an overheating domestic economy, it is uninterested international investors. This makes a statement about the imbalance of Turkey's economy- too tilted towards foreign investment at the expense of domestic demand.
Yet these imbalances take years to properly address. In the short run, Turkey's economy is all about international investors, and they aren't buying what Turkey is selling.
If investors remain uninterested in Turkish assets, this acts as a booster to inflation as the economy naturally slows from the higher rates. Sure, Turkey's central bank could attempt to boost growth by slashing rates, but wasn't that the problem to begin with?
And, given its importance to international investment during the past decade, a Turkey with too low real returns, high inflation, and low growth might well act as a symbol of investor perception about troubles with emerging markets, and dimly decide they are best avoided all together.
This would be a mistake. There are great people with great ideas running world-class organizations in the rough and tumble emerging markets, and they could use some loans.
So, investors and other elitist fat cats running the world, remain rationally clear-headed and do your homework from start to finish. Given the markets overall reaction in the past 10 days, I believe investors are doing just that.
So, Masters of the Universe, good job from not making a sell-off into a panic! (Up to now...)