Commentary on Political Economy

Monday 22 March 2021


Turkey Isn't the First Domino in an Emerging Markets Bust

Erdogan is a one-of-a-kind autocrat who doesn't understand economics. That means contagion should be limited.

One of a kind.
One of a kind. Photographer: ADEM ALTAN/AFP/Getty Images

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Turkish Delight

Recep Tayyip Erdogan, Turkey’s increasingly autocratic premier, inflicted a vintage emerging markets crisis on us over the weekend. Four months after ousting his previous central bank governor, he fired Naci Agbal, who had raised rates by 200 basis points last week, and replaced him with Sahap Kavcioglu, who apparently agrees with Erdogan’s novel theory that higher interest rates cause inflation. It’s plenty possible to be an effective political leader while having eccentric views about economics — but not if you are able to fire and replace central bankers at will. 

International capital markets didn’t like this. Turkey’s lira tanked, as did the stock market. In dollar terms, Istanbul’s main benchmark equity index fell 16.4%, exactly equal to its performance on the day three years ago when then President Donald Trump ordered sanctions on the country. Its only worse day this century came in early 2001 when the lira was floated, in an effective one-off devaluation, as it was Turkey’s turn to suffer from a contagious series of emerging market devaluation crises:

Turkish stocks equaled their worst performance since 2001

It’s hard to call this an overreaction. Turkish economic policy appears to be fully under the control of an unchecked autocrat who doesn’t understand economics.

International markets like central bank independence, particularly when the country is governed by someone they might otherwise dislike. A number of other emerging economies, such as Mexico and Brazil, have managed to avoid serious financial crises in the last two decades, despite electing some market-unfriendly populist presidents, by maintaining central bank independence. As U.S. bond yields have risen in the last few weeks, and emerging markets have suffered the capital flight that is customary on these occasions, independent central banks have acted as a shock absorber. Their credibility has also enabled them to keep rates lower than in Turkey. Brazil’s real has suffered even more than the lira since the beginning of last year, and the country saw a drastic 75 basis point rate hike of its own last week. But Brazil has a target rate of 2.65%, while Turkey’s is 19%. Russia, which also hiked last week, has a target rate of 4.5%.

Rate increases in other large emerging markets show that higher U.S. yields have caused generalized pressure. The critical point is that Turkey is seen as an idiosyncratic situation. Erdogan’s actions haven’t spilled over into problems elsewhere in the foreign-exchange market. Indeed, Bloomberg’s index of eight emerging market carry-trade currencies, which includes the lira, was up on Monday:

The Lira's problems are yet to cause contagion for other EM currencies

Put differently, Capital Economics of London shows that the lira was an outlier over the weekend. There are no falling dominoes this time:

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Turkey accounts for only 3.5% of JPMorgan Chase & Co.’s EMBI Global Diversified index, so there should be minimal contagion via bondholders.  General distrust had prompted international investors to sell off their holdings of Turkish bonds. That had shown some signs of reversing in the last few months, as this chart from Societe Generale SA shows, but the latest news has likely snuffed out that enthusiasm:

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Spain’s banking system has the biggest exposure to Turkey, at $59.7 billion, according to Bank for International Settlements data, though that’s a fraction of Spain’s total banking assets of about $3.36 trillion. 

The debate now is over how Turkey opts to stem the weakness in its currency. As the new governor is likely to try to undo the latest 200 basis point rise in rates, the chance is that the lira will come under renewed fire. The preliminary consensus among foreign-exchange analysts seems to be that capital controls will be the most likely solution, given that Erdogan has shown he cannot tolerate increasing borrowing costs.

According to Sebastien Galy, economist at Nordea Investment:

The new governor promises permanent price stability but also believes as president Erdogan does that interest rates lead to inflation, against economic orthodoxy. The next meeting is set for the 15th of April where at least 2% in interest rate cut is to be expected. The bigger problem is that with extremely low foreign reserves and a large current account deficit, the currency falls if it is not supported by high enough interest rates. In real terms, they were only 3% as inflation is around 16%. Any cut below 3% in interest rates would lead to more weakness in the currency and likely capital controls. All of this is of course unhelpful for affiliates of some European banks.

Phoenix Kalen of SocGen maps out a route in which Turkey treats the world to all the classic steps of an emerging market crisis — which means that it will lose in the end:

The new CBRT Governor Kavcıoğlu has expressed in a statement on the central bank’s website that future MPC meetings will be held as scheduled, meaning no imminent emergency rate cut meeting between now and the 15 April 2021 MPC meeting. Our very preliminary expectation is that the new governor will attempt to undo the latest 200bp hike at the 15 April meeting, deploy substantial reserves between now and then to try to stabilize TRY, subsequently lose the currency battle with markets, and ultimately have to engage in emergency hikes down the road to halt [the lira]’s decline.

All of this is very sad for Turkey, but the contagion is unlikely to spread further, unless other countries start to elect Erdogans of their own.

Stickiness in Japan

If there are fewer workers, they should have greater negotiating power, and so they can win higher wages — which will likely spill over in the long term into inflation. Except in Japan, the country which has to date had the greatest experience of ageing, and where the labor force has shrunk relative to the growing number of retirees.

That is a summary of a debate I covered yesterday. Charles Goodhart and Manoj Pradhan argued in The Great Demographic Reversal that the forthcoming shrinking of the workforce across the Western world would help inflation to re-establish itself. Gerard Minack argued in response that Japan’s history suggested a shrinking workforce was no guarantee of inflation. This was his killer chart:

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This is startling, but powerful empirical evidence that we don’t after all need to fear a new wage-price spiral as the labor force contracts. We can expect Goodhart and Pradhan themselves to re-enter the debate before long. In the meantime, I received an important argument about the Japanese experience from Philip Pilkington of GMO in Boston. He suggests that Japan might be a special case. 

The reason gets to the heart of one of the most important issues in labor market economics; nominal wages are “sticky.” In other words, employers can generally get away with cutting pay in real terms, after inflation, but it is almost impossible to get a workforce, unionized or otherwise, to accept an outright nominal reduction. This means that when workers manage to win a good increase in good times, it is very hard to claw it back from them in bad times. That isn’t necessarily the case in Japan, though. This is because workers are paid via a bonus system that is unusual elsewhere outside of finance. As this chart from GMO shows, about 20% of Japanese salaries are “special cash earnings” or bonuses:

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So Japanese employers can cut pay and get away with it — and have done so several times over the three decades since the country began to sink into its deflationary malaise. Thanks to the heavy bonus element, total cash earnings have varied widely in that time, even as consumer prices have been stuck:

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This process makes life much easier for employers, and leads to great pay days in good times. It also allows for deflation to take hold. As the average Japanese worker has a “pay packet that looks very like that of a finance professional,” to quote Pilkington, companies can avert the risk of having to pass on rising labor costs to consumers via higher prices. The lack of wage-stickiness has thus helped to trap Japan in deflation. 

This is Pilkington’s conclusion:

So, what does this mean for the demographic inflationary hypothesis? Well, it means that Japan is a special case. Most countries do not rely as heavily on bonuses to compensate workers as Japan does. This means that there is far more stickiness in their wages. Perhaps when the demographic collapse begins in earnest Western economies will find some way to maintain extreme wage flexibility – although this will lead to deflationary problems like the ones Japan experiences. However, it seems more likely – to me at least – that they will see bargaining power tip in favour of labour. That probably means inflation.

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