Economic and Political Quagmires
We want to briefly take another look at the situation in four of the emerging market countries that have recently been the focus of considerable market upheaval. The countries concerned are Turkey, Venezuela, Argentina and South Africa. There are considerable differences between these countries. The only thing that unites them is a worrisome trend in their trade and/or current account balances and the recent massive swoon in their currencies as foreign investors have exited their markets (this in turn has pressured the prices of securities). There is currently an economic and political crisis in three of the four countries, with South Africa the sole exception.
However, even South Africa is feeling the heat from the fact that it has a large current account deficit and the ongoing exodus of foreign investors from emerging markets. However, the country is actually used to experiencing vast fluctuations in foreign investment flows in short time periods and has the potential to relatively quickly turn its balance of payments position around. Of the four countries in question, it seems to us to be the most flexible one in this respect.
Argentina and Venezuela
Argentina and Venezuela are special cases in that their trade resp. current account positions are actually comparatively stronger, but the economic policies pursued by their governments are so utterly harebrained and repressive that everybody tries to get their money out as quickly as possible. The immediate problem is that both countries are being drained of foreign exchange reserves at an accelerating clip, inter alia a result of trying to keep their exchange rates artificially high. This is actually quite astonishing considering their considerable latent export prowess.
Both countries have governments that steadfastly deny the existence of economic laws and apparently genuinely believe that their absurd repressive decrees can "fix" their economies. The markets regard Argentina as the slightly greater credit risk, as it is still fighting the so-called "hold-outs" from its 2001 default. However, Venezuela is lately catching up, in spite of its vast oil wealth. The two countries currently have the dubious distinction of being the nations with the highest probability of sovereign debt default in the world – not even the crisis-ridden Ukraine comes remotely close (see chart of CDS spreads further below for details).
We have recently discussed the deteriorating situation in Venezuela in some detail and a more in-depth update on Argentina is in the works. Let us just note here that Argentina (the government of which is incidentally the fiercest supporter of Venezuela's president Maduro at the moment) seems to be where Venezuela was about a year or so ago. Both countries are on the same path of inflationism and growing economic and financial repression.
Argentina's balance of trade remains positive.
(click to enlarge)However, the current account balance has begun to deteriorate. The country's foreign exchange reserves have collapsed due to a doomed attempt to defend the exchange rate.
(click to enlarge)Venezuela is a big oil exporter, but needs to import 70% of the consumer goods sold in the country. Its balance of trade is therefore deeply negative, especially as the state-run ("very, very red") PDVSA is being run into the ground and produces less and less oil.
(click to enlarge)In spite of reporting a positive current account balance, Venezuela is losing foreign exchange reserves fast, due to trying to maintain an artificially high exchange rate even in the face of soaring inflation.
In Venezuela's and Argentina's case, the markets are rightly worried that the situation will probably deteriorate further. The intransigence of their governments with regard to pursuing economic policies that demonstrably don't work and the resultant growing political risks conspire to create a highly unstable backdrop. As in all such cases, one must expect knock-on effects to emerge elsewhere.
Turkey has been hailed as a shining example of how an emerging economy should grow, but as is so often the case, it has in the meantime become evident that what it has mainly done was to engage in a massive credit-financed boom, displaying all the associated bubble activities, malinvestment of capital and overconsumption. This unsustainable boom was exacerbated by the fact that the Erdogan government pressured the central bank to keep rates extremely low. Even while prices were obviously misbehaving, with the rate of change of CPI oscillating between about 6.2% and nearly 11% and the stock market rising in parabolic fashion, the central bank kept its repo rate in the low single digits (this has only very recently changed).
With his country in the middle of a serious economic crisis, Erdogan has come under fire politically because his government has turned out to be a den of corruption to boot. So what does he do? He is taking a leaf from what the Western nations have demonstrated to be de rigeur these days; since don't you know, we're all surrounded by evil terrorists hiding in caves in the Hindu Kush somewhere. In short, he is moving toward increasingly authoritarian rule. Just take a look at this recent press report:
“Battling a corruption scandal, Turkish Prime Minister Tayyip Erdogan is seeking broader powers for his intelligence agency, including more scope for eavesdropping and legal immunity for its top agent, according to a draft law seen by Reuters.
The proposals submitted by Erdogan's AK Party late on Wednesday are the latest in what his opponents see as an authoritarian backlash against the graft inquiry, after parliament passed laws tightening government control over the Internet and the courts this month.
The bill gives the National Intelligence Organisation (MIT) the authority to conduct operations abroad and tap pay phones and international calls. It also introduces jail terms of up to 12 years for the publication of leaked classified documents. It stipulates that only a top appeals court could try the head of the agency with the prime minister's permission, and would require private companies as well as state institutions to hand over consumer data and technical equipment when requested.
"This bill will bring the MIT in line with the necessities of the era, grant it the capabilities of other intelligence agencies, and increase its methods and capacity for individual and technical intelligence," the draft document said.
The "necessities of the era" – we couldn't have put it in a more Orwellian fashion. And guess what? The vaunted "defenders of freedom" in the West probably aren't going to object for even a millisecond.
Turkey's economy is a shambles right now, and Erdogan wants to cling to power by any means possible – that is what the "necessities of the era" are really all about. For a long time it was held that the world as a whole was moving toward more, rather than less freedom. We regret to inform you that this trend has reversed more than a decade ago, on the day the WTC towers crumbled.
Meanwhile, what is now also crumbling is Turkey's economy. However, we would argue that Turkey's economic situation isn't "unfixable" if the proper policies are implemented quickly. After all, there has been a very successful period of economic liberalization under Erdogan's government as well, which has left the economy more flexible and thus better able to deal with adverse developments. A wrenching adjustment is nevertheless unavoidable at this point.
(click to enlarge)Turkey has a large current account deficit. The fact that foreign investment inflows have now dried up is putting enormous strain on the economy. Consumer confidence has plunged, as has the currency.
(click to enlarge)During a time when inflation remained stubbornly high, the central bank left its repo rate at 4%.
As one analyst sagely remarked:
“From 2009 to 2013, Turkey was considered by many to be a rising star among the emerging markets, but currently it may be the triggering force for worsening the emerging-market outlook globally in 2014."
South Africa's case is in many ways comparable to Turkey's – the country also sports a large current account and trade deficit, for example. However, while South Africa's CPI "inflation" rate has always been high by developed country standards, it has on average been much lower and less volatile than Turkey's, fluctuating between 5% and 6.4% in recent years. Contrary to Turkey's central bank, South Africa's central bank is fiercely independent and focused solely on keeping CPI in check. In fact, it may well be one of the world's most conservative central banks. It also refuses to intervene in the currency market and allows the Rand to go to wherever market forces push it. This non-intervention policy was actually quite difficult to defend while the Rand was among the world's strongest currencies during the emerging markets boom of the 2000s. A plethora of special interests in South Africa were pleading with the central bank to do something to weaken the Rand, but it remained steadfast.
While the current account deficit means that more currency weakness is probably in store, South Africa does have a vibrant export sector. During the apartheid years, it had a perennial trade surplus, partly a result of being forced to conserve foreign exchange reserves in the face of economic sanctions. Similar to Turkey, South Africa imports all the oil it uses, which is a key vulnerability of both countries. However, the weakening of the Rand already has an effect: the trade balance has recently turned positive for the first time since 2010.
South Africa's current account is still deeply in the red.
However, a trade surplus has begun to emerge on the back of the weaker Rand.
Investors in emerging markets like to use the Rand as a hedge for EM currency exposure, due to its relatively good liquidity and the fact that the central bank isn't going to intervene directly. At times this fact probably exacerbates the moves in the Rand.
The political situation in South Africa is almost always somewhat dubious, and the Zuma presidency is no exception to that rule. There is a lot of corruption and quite a few economic policy decisions appear to us to be misguided. One must keep in mind in this context that the ANC government is continually under pressure to deliver an improvement in living standards to the formerly oppressed parts of the population, which often leads to the adoption of populist positions that are not economically sensible.
However, there exist also many misconceptions about SA and the ANC's political legacy in the West. In spite of being formally allied with the communists (SACP) and the trade union umbrella body COSATU, the ANC has for instance privatized many of the companies that used to be state-owned under the national-socialist regime of the National Party (NP) that ruled the country during the apartheid years (a funny aside to this: the NP has dissolved itself and has been amalgamated with the ANC a few years ago). One slightly worrisome development is that the government deficit has grown sharply since 2010. While the government previously ran an almost balanced budget, the annual deficit amounted to more than 5% of GDP over the past four years. Nevertheless, due to the tight fiscal policy implemented previously, the public debt-GDP ratio is still below 40% – a number most developed countries can only dream of.
Sovereign Credit Risk
(click to enlarge)5 year CDS spreads on the sovereign debt of Argentina, Venezuela, South Africa and Turkey. Keep in mind that the scaling is different for each of the data series.
As can be seen above, the markets consider Turkey the second-smallest sovereign credit risk among the four nations at the moment. Its debt-to-GDP ratio is very similar to South Africa's, at just 36%. The budget deficit has fluctuated between 2.8% and 5.5% of GDP over the past four years. Both data points are however what we would term "remnants of the bubble," as the government's tax revenues soared along with the economic boom. With the boom faltering, a sharp deterioration in these data points should be expected.
South Africa is actually in a slightly better position in this regard, as it has not experienced comparable boom conditions. Consequently, the fact that the CDS spread on its sovereign debt is actually slightly below that of Turkey makes sense.
Argentina is currently considered the worst sovereign credit risk in the world – not least due to the fact that its foreign exchange reserves have declined dramatically and the trend is ongoing.
(click to enlarge)Argentina's reserves are falling sharply.
This throws more and more doubt on the country's ability to service its foreign debt, which in the light of the 2001 default and its aftermath has made the markets wary. 5 year CDS spreads at 2,206 basis points reflect a great deal of risk (this represents an annual default probability of roughly 17% at an assumed 40% recovery rate).
Venezuela is lately catching up – its 5 year sovereign CDS spreads have soared to almost 1,700 basis points from less than 1,200 at the end of last year. This is testament to the fact that the economy has begun to implode under the Maduro government. While Maduro himself is just as bad as Chavez was in terms of economic policy, it should be pointed out that Chavez's policies are what laid the foundations for current events. It has taken a while for this South America-style goulash-socialism to fail, as it allowed a remnant of the market economy to operate most of the time. However, the impositions on the private sector have simply become too onerous and galloping inflation has delivered the coup de grace, as economic calculation has become extremely distorted, if not nigh impossible.
The crisis in emerging market economies vulnerable to capital flight is unlikely to be over. Note that we have picked merely four cases, but there are several other developing countries that are currently in various states of political and economic crisis as well (e.g., India, Thailand, Brazil, to name a few). We have looked the two worst cases here, one of medium severity (Turkey) and one of the better cases (South Africa) in order to present as broad an overview as possible. The fate of Argentina and Venezuela is up in the air – it will require massive political change to alter their prospects.
However, other emerging market economies are bound to eventually bounce back and exhibit strong economic growth again. The imbalances can all be overcome, but the adjustments required are liable to play out in the form of economic and financial market crises of varying severity.
One must not forget in this context that Japan continues to pursue a mercantilist currency policy, which redounds on its competitors in Asia, which in turn affects their main suppliers. We continue to believe that Japan's decision to weaken the yen has been a major contributor to recent currency turmoil elsewhere (of course, this does not mean that many of the countries concerned have not been wanting in terms of their own policies).
Moreover, China is hanging over the proceedings like the proverbial Sword of Damocles. HSBC has just reported its latest flash estimate on China's manufacturing PMI (pdf), which was quite weak at 48.3, a seven month low indicating a worsening contraction. In view of the enormous credit bubble China has embarked on since 2008 (about $15 trillion in additional debt have been created since then), the danger of a larger setback being set in motion by a sharp slowdown or even recession in China cannot be dismissed.
Charts by: Tradingeconomics, Reuters, Bloomberg