The decision late on Tuesday night by the Central Bank of Turkey to increase interest rates substantially has taken many observers by surprise. Yet there was no other way to stem the decline in the currency and alleviate the threat of a damaging exodus of foreign capital. Even so, it may not have been enough. The monetary squeeze buys some time before elections but also intensifies the political and economic crisis. Turkey is not alone in facing these problems. In many ways the country is a dark star in a volatile emerging market firmament.
Turkish economic growth was spectacular in 2010-11. It is pedestrian now. The official forecast that the economy will grow by 4 per cent in 2014, hardly ambitious to begin with, cannot now be met. This matters a lot to investor confidence, and also to a country that needs its economy to grow if it is to supply jobs for young people entering the labour force.
Turkey’s underlying problems are weak savings, rapid credit creation, rising import dependency and an external deficit of 7 per cent of gross domestic product, three-quarters of which is financed by volatile short-term capital flows. Turkey’s currency reserves can satisfy no more than one-fifth of its external financing needs this year. Raising interest rates cannot solve these problems without bringing the economy to its knees. This week’s rate decisiondoes little to address the serious problems that beset the country’s economy.
Turkey has its own script. But it is not alone in being caught between the tightening in US monetary policy and the Chinese economic slowdown. As interest rates rise in the world’s two biggest economies, capital that previously flowed into emerging markets is now leaving. To manage the instability of capital flows and currencies, Brazil and India have also been raising rates; their most recent increases came just before Turkey’s announcement. One day later, South Africa did the same. Other emerging countries will doubtless follow suit.
It is important to consider the broader context. Many emerging markets have arrived at a hiatus after a long period of growth that enabled some to climb up (or into) the middle-income league. But it has become harder to achieve growth while maintaining stability. Building robust and inclusive institutions is essential. Elections this year in Thailand, Turkey, India and Brazil will be scrutinised closely for clues about future policy. So, too, will the reforms promised by the Chinese leadership.
It is true that many emerging markets look stronger today than in the 1990s – they have larger currency reserves and better financial governance. At the same time they are also more vulnerable to shocks. They have lifted their share of global GDP from 40 per cent in 1997 to almost 55 per cent (on a purchasing power parity basis); now more than ever, the impact of a slowdown will be felt around the world. Most emerging economies are sustained by western export markets rather than local demand. This is a strategy that has passed its sell-by date.
Dependency on capital inflows, especially to finance rising local currency borrowing, makes these economies vulnerable to changing conditions in overseas markets. Credit cycles in China, Brazil and other countries are peaking. Commodity prices are falling from record highs. China’s success in exploiting its demographic dividend, or the absorption of a vast pool of former agricultural workers into the industrial workforce, may not be repeated so well elsewhere.
Just as China’s ascendancy had dramatic positive consequences for emerging markets, so its slowdown can be expected to have opposite effects. The challenge of pursuing important economic reforms without eroding the power of the Communist party, and of trying to slow down fast and often weakly regulated credit creation, are China’s principal concerns now. Rising bond yields, illiquidity and instability in financial markets are the early signs.
The current crisis in emerging markets is still viewed by many as being just about Turkey. But the tequila crisis in 1994 was initially about only Mexico, the Asia crisis in 1997 about Thailand and the financial crisis of 2007-08 about US subprime lending. A crisis must make landfall somewhere. But the effects of the current storm will be felt beyond Turkey’s borders.
George Magnus
FT
