‘90’s Flashback

Posted on August 15, 2018 by Gemmer Asset

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Ahhh, that takes me back to simpler times. Pets.com, flip phones, Netscape web browsers. Now while Prince’s song was referring to the world ending at the turn of the millennium, for emerging market investors the world actually came close to ending in 1997 and 1998. Both Thailand and Russia ran into some financial difficulties and Long-Term Capital Management managed to implode in an entertaining fashion. The Fed cut rates as a result and this helped turbo charge the tech bubble.

 

Why the walk down memory lane? Well, some are drawing parallels between the emerging market crisis in the late ‘90’s and the problems plaguing Turkey today.

 

The Turkish stock market has managed to lose about 25% in local currency terms since late January, but in dollar terms the market is down a whopping 80%.

 

 

The Turkish currency, the lira, is down about 45% so far this year. The reasons behind the problems in Turkey are pretty familiar to anyone who has watched previous emerging market train-wrecks.

 

  • A country pursues a ‘growth at all costs’ strategy.

 

  • This works for a while, but growth also means rapidly expanding debt levels (chart below).

 

 

  • Much of the new debt is denominated in dollars because it is initially cheaper.

 

  • Throw in a central bank that isn’t totally independent and errs by keeping rates too low, and you have a recipe for rising inflation.

 

  • Add a touch of authoritarianism in the form of President Erdogan.

 

  • This sets the scene whereby an otherwise minor trigger (in this case the jailing of American pastor Andrew Brunson) sets off a cascade of problems.

 

  • As things unwind, pronounced currency weakness makes all that dollar denominated debt unserviceable. A weaker currency also makes the inflation problem even worse, and interest rates shoot higher as a result. A classic negative spiral.

 

 

We should keep in mind that the Turkish economy is pretty small – about $850bn at the end of 2017. This is about 1% of world GDP, slightly bigger than the Netherlands but 20% smaller than Indonesia. As a result, the economic fallout should be pretty small.

 

For investors, the crucial issue is contagion. Will Turkey’s problems pull others down with it. After all, it isn’t just Turkey that has a lot of dollar denominated debt. As you can see below, Hungary, Poland, Chile, Argentina, etc. are carrying a lot of debt, and much of it is dollar denominated.

 

 

This is obviously a problem for the banks and investors that hold all this debt. The banks, as always, are the key. In Turkey’s case, about half of Turkey’s foreign debt, or $265bn is owned to foreign banks, largely Spanish, French, and Italian institutions. About 2% of Spanish banking assets are invested in Turkey. France and Italy have about 0.5% exposed. If these bonds go to zero it will hurt, but it is manageable. U.S. banking exposure is negligible at roughly 0.3%.

 

The bigger risk is that the combination of dollar strength and investor fears starts to pressure other countries. For example, Argentina was forced to raise rates a couple days ago and the South African currency recorded its steepest drop in 10-years.

 

Can the problems spread? Certainly. Will they? That is a tougher question. Turkey is small enough that this storm could easily blow over on its own, but no one can know for sure.

 

If the problems do spread, what are the implications? Probably more dollar strength. A steady bid for safe havens such as U.S. Treasury bonds. The outperformance of U.S. assets.

 

And if the problems spread what’s the solution? When Greece’s problems were spiraling out of control, policy actions both inside Greece (new government, austerity budget) and outside (ECB action) eventually calmed the markets. In the 1997/1998 crisis ultimately default and rate cuts from the Fed prevented contagion from spreading.  Stay tuned.

 

 

 

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