Since the beginning of this year, one of the keys to the evolution of assets in emerging countries has been the rise in interest rates in the US. History tells us that when there is a significant rise in the cost of financing in USD, those countries with levels of external debt (in the hands of non-national investors) and also denominated in USD, suffer a notable volatility in their financial variables in general and exchange rates in particular. This is due to an outflow that occurs from those assets considered riskier (debt from emerging countries, especially that denominated in local currency), in the face of an increase in the expected profitability in the “risk-free” (US debt). ).
However, this does not necessarily have to be the case and the IMF has pointed this out recently in an article. A rise in interest rates in the US does not have to be inherently negative for emerging countries, but will depend on the reason for this movement. In the event of a surprise effect on monetary policy (an anticipation of interest rate hike expectations by the Fed on this occasion, anticipating a tightening of accelerated monetary policy), yes it tends to lead to an outflow of investment flows from emerging countries. This occurred in 2013, when the Fed’s QE programs (taper tantrum) were soon to exit, and in 2018, when the Federal Reserve raised interest rates four times.
However, If these interest rate rises were produced by the perception that economic activity is being better than anticipated or, in the current situation, because the vaccination campaign is being successful, it does not have to lead to these frictions. In fact, what is found in the IMF study is that on these occasions investment inflows are observed in emerging markets. Although this is the general trend, differences may occur between countries, since the least benefited, which could even observe tensions in investment flows, would be those countries that have a limited percentage of exports to the US and a high volume of external debt. Turkey, South Africa or Argentina are examples of countries that meet these characteristics: low trade volume with the US and high external debt ratios.
But we can’t let go idiosyncratic cutoff factors, which, in some cases, may accentuate the problems that emerging markets will face in the coming months. This would be the case of Turkey, who is immersed in an institutional crisis.
During the past month, Erdogan removed the Governor of the Central Bank of Turkey and, weeks later, the deputy governor. This decision could have been due to the open conflict of interest in relation to the intervention interest rate hikes carried out by this institution since last November (+875 basis points). This tightening of financial conditions leads the country into an economic recession and raises the risk for the political stability of the Erdogan government. (In recent weeks, rumors of possible electoral advancement have circulated due to the growing discontent of the population).
The uncertainty about the next steps of the Central Bank of Turkey, the place of its supposed independence and doubts about the governance and quality of the country’s institutions has already led to a strong outflow of flows abroad which is reflected in the depreciation of the TRY in all its crosses (more than 13% depreciation against USD accumulated from decision to 04/12) and the collapse of the Turkish stock market (over 11%).
Turkey currently has two macro-level problems that a monetary tightening would help address: on the one hand, a high and out of control inflation (it has doubled since the end of 2019 to about 16%); on the other, a strong need for external financing (The needs derived from the payment of debt coupons, short-term foreign debt repayment and current account deficit amount to USD 250,000 million over a 12-month horizon).
In this context, the application of a very restrictive monetary policy, that would need additional increases in intervention rates, would contribute to the stabilization of inflation in the medium term (disincentive to consumption, brake on the depreciation of the currency and its pass-through effect towards inflation), in addition to attracting capital flows from abroad to cover financing needs. In any case, a monetary restriction strategy must be credible, for which it must have greater certainty of quality and institutional stability, precisely the factor that is now (rightly) in doubt.
If this path is chosen, the tightening of financing conditions would push Turkey into a recession that could be similar to the decline in growth observed in 2018. The contraction in domestic demand sharply reduced external financing needs (reduction of the current account deficit, with a sharp drop in imports).
A refusal to maintain the upward bias in interest rates (Erdogan has on numerous occasions expressed his opinion that it is high interest rates that cause high inflation) will slow down the attraction of investment flows to Turkey and will cause a sudden stop. Capital flight in an environment of growing financing needs would make it necessary to impose capital controls. The stabilization of the currency would go through a strong sale of reserves which, given Turkey’s reduced position (negative net reserves), would lead the country to request aid from the IMF.
The last country among the largest emerging countries to request an aid program from the IMF was Argentina in 2018, after the imposition of capital controls, in a situation in which the outflow was greater than the central bank itself could. manage. Months after the request, the adjustments to the public accounts, among other measures, ended up deteriorating the political position of then-president Macri, who lost the elections the following year.
Although there could be a third escape route for Turkey (for another country to serve as a lender to compensate for the outflows suffered), the situation facing the Turkish executive will not be easy in the coming months. All eyes will be on the following meetings of the Central Bank of Turkey. The decisions of this institution will be key to determine the independence and credibility of the institution, as well as the duration of the chapter of institutional uncertainty in this country.