Turkey Caught Between A Rock And A Hard Place

by: Max Loh

JPM thinks the divergence in price action between US equities and emerging market equities might close, with the latter outperforming the former going into year-end.

Analysing the dynamics and economies of both Argentina and Turkey, the road to salvation for the former seems more clear than that of the latter.

Turkey is caught between a rock and a hard place. The solutions it can employ to save itself cannot be employed because of geopolitical pressures.

US equity indices hit fresh record highs last week, while equity indices outside the US have been playing catch-up for months. JPMorgan notes that this divergence in price action has never occurred before in history, and the bank expects this gap to close with international stocks poised to outperform the US market for the rest of the year - emerging markets in particular.

Will that really happen?

Emerging markets (EEM) appear to be caught in an abyss that seems to be growing deeper by the day, with Argentina and Turkey leading the way down with aplomb. The Greenback has climbed more than 100% against the Argentina Peso this year, and the government is in the midst of securing emergency $50 billion funding from the IMF. Close behind and also in dire straits is the Turkish Lira, which has lost close to 80% of its value against the Greenback this year.



When investor sentiment turns against emerging markets, it can be a very difficult task to stem outflows from the countries. Just look at the Asian Financial Crisis, where Thailand ran out of Treasury reserves to defend its currency, and was forced to de-peg the Baht from the USD. I detailed in my article "Thailand 1997 All Over Again?" that the situation in Turkey runs parallel with Thailand in 1997 with eerie similarities, such as similarly high external debt to GDP ratios as well as high current account deficits.

Both Argentina and Turkey have been running current account deficits for years. Argentina's current account has been in negative territory since 2014, and the deficit has continued to widen relentlessly. Turkey's situation is more hapless - the economy has not run a surplus for the past 10 years, save for 2 brief and meek forays into surplus territory in 2009 and 2015.

Argentina Current Account

Turkey Current Account

As mentioned, investor sentiment can turn quickly against budding emerging market economies, causing their currencies to plunge sharply. Current account surpluses serve as a natural defense against such turns in the tide. If a country has goods that are demanded by the rest of the world, there will be a natural demand for its currency. For Argentina, slightly more than half of its overall exports are agricultural products like wheat, soybeans, maize and barley. Looking at the chart of the Bloomberg Agriculture Subindex below, it is no wonder Argentina's export sector is taking such a hit. Agriculture prices, including soybeans and wheat, have been on a gut-wrenching downtrend, made worse by recent trade tariffs on agriculture products.

Bloomberg Agriculture Subindex Price Chart

Turkey's export sector is more balanced, and is largely made up of transport equipment and various machinery. However, its persistent current account deficit reflects the manner in which the country has failed to invest in its economy and raise its competitiveness. The high levels of external debt the country has racked up (about 50% of GDP) further compounds the problem. The country has borrowed a lot, but has not sufficiently turned this leverage into productive gains for the economy. Just prior to the Asian Financial Crisis, Thailand too faced the same problem. Thai banks lent recklessly and many corporations borrowed excessively for pursuits that ended up being unproductive.

Well, what can Argentina and Turkey do now?

Countries can turn to three quick-fire options to stem outflows of capital. First, raise interest rates to attract hot money back. Second, use Treasury reserves to defend the currency. Third, capital controls. The third option is a desperate last resort move that will more likely cause investors to completely lose confidence in the governance of the countries, and so far both countries are not considering it.

What about raising interest rates and using reserves to defend the currencies?

Argentina has already raised its benchmark rate to a whopping 60%. Yet, investors are not convinced. The country has about $50 bn in FX reserves to defend a sliding Peso, which is a measly amount. As such, the path to salvation for Argentina is clear - it needs funding from IMF, which will help boost investor sentiment. It is also taking steps to reduce spending and improve its current account by slashing funding for ministries and enacting an export tax for its agricultural products. Unpopular yes, but perhaps the people will understand.

Turkey's situation is more bizarre and very murky. Erdogan has vocally disapproved of raising interest rates, and the semi-autonomous Turkish central bank might well listen to the most powerful man in the country. Yet, inflation continues to climb as a result of a weak currency, with recent data showing inflation at 17.9%. This compared to the central bank's benchmark interest rate at 17.75% means the central bank has lots to think about in its October meeting. However, with corporates racking up high levels of debt, would an aggressive hike teetotal the economy?

In terms of FX reserves, Turkey has more bullets in its locker compared to Argentina at about $100 bn. Yet, that figure can drain away very quickly, and the currency will continue to face pressure if Turkey does not show that it has a more sustainable plan drawn up. Turkey's situation is made more tricky because it has decided not to turn to the IMF for help, mainly as the US sits on the board of the organisation. That means the US would have a say on how Turkey should reform its economy, should the country choose this route, something that will be hard to swallow given the deteriorating relationship between Trump and Erdogan.

In conclusion, not all emerging market economies are made the same, despite them being plagued by the same troubles - falling currencies. Argentina might be more willing to turn to the IMF for help, and that might alleviate some of the pressure the Peso is facing. Turkey however is caught between a rock and a hard place. The solutions it can employ cannot be employed due to geopolitical pressures, and as such, I think the road to salvation might be a long treacherous one for Turkey. I hardly think emerging markets are well positioned to outperform US stocks going into year-end, as per JPMorgan's call. There are many reasons for investors to avoid emerging markets while the knife is still falling, and I believe capital flows will still favour the US markets.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.