Atilla Yeşilada

American reflation could trigger Turkish stagflation

18 November 2016

While it is not yet discussed prominently, in case Trump sticks to his guns, Turkey could become one of the leading victims

Atilla Yeşilada

In the short span of a week, Trump’s election to presidency completely altered the way investors view Emerging Markets. Potential trade sanctions on China and Mexico, coupled with reflationist policies at home spell trouble with the EM asset class. While it is not yet discussed prominently, in case Trump sticks to his guns, Turkey could become one of the leading victims.  Turkish current account deficit began to expand in August, while the government’s recent efforts to stimulate the economy through the credit channel means more F/X borrowing is needed at a time when global interest rates are rising.  Resulting pressures on the balance of payments could lead to a serious stagflationary episode.

While experts argue endlessly whether Trump can deliver on his threats of slapping high import taxes on China and Mexico, there is little doubt that in cooperation with the Republican-controlled Congress some combination of tax cut and infrastructure spend plan will be enacted. Size does matter, but even a modest plan is likely to pour fuel on the extant inflationary pressures and accelerate Fed’s monetary tightening schedule.

A recent survey by WSJ among economists resulted in the following findings:  “On average, economists marked up their growth forecasts. The economy could expand 2.2% in 2017 and 2.3% in 2018, as a fiscal stimulus kicks into gear, up from about 1.5% over the past 12 months. Inflation is seen at 2.2% next year and 2.4% in 2018. If correct, it would be the first stretch of sustained inflation above 2% since before the recession of 2007 to 2009”.

Such forecasts, if fulfilled spell 10 year bond yields in excess of 2.50%, or even 3% by the end of 2017according to most investment banks. Unless other reserve  money central banks such as BoJ or ECB match Fed in monetary tightening (very unlikely), these events should also be accompanied by some more dollar strength.

This is the scenario which can get the Turkish economy into serious trouble. By September, Turkish current account deficit (CAD) reached roughly 4.6% of expected GDP, and in our forecast it rises to 5% by the end of the year, where it hovers through 2017. With annual F/X borrowing requirement equal to 28% of GDP, Turkey has one of most daunting exposures to Fed policies in the developing world. To make matters worse, scared by the anticipated slow-down in 3Q2016 GDP and in need of popular support in the upcoming presidential referendum, the government is putting pressure on the banking system to cut loan rates to stimulate growth. It needs to be seen whether banks can deliver on this promise, given rising borrowing cost abroad and meager TL deposit growth at home, but if they do, Turkey will need to borrow more, increasing the vulnerability of the economy to American interest rates.

So far, financial markets have only priced vague promises of America reflation. If the Congress enacts tax reduction and infrastructure spending bills, faster Fed rate hikes and higher inflation will be discounted across the yield curve and in the exchange rate, which would substantially tighten global financial conditions.

It is very likely that in such a scenario credit growth would sharply shrink in Turkey, causing a slow-down in GDP, while higher F/X borrowing costs would compel some corporates to pay off loans or default rather than rolling them over. In addition, financial flows would be directed to U.S. from Emerging Markets which would also weaken currencies like TL. Finally, as we have witnessed at the beginning of 2016, access to bond and even the credit market could be shut for borrowers like Turkey which could lead to further TL weakness and a credit crunch.

TL weakness immediately leads to higher inflation, while there is a very strong positive correlation between credit and GDP growth. If Turkey can’t access F/X credit for a few months, stagflation is a fait accompli. In some sense, Turkey is more at the mercy of Trump then China or Mexico. The sad thing is Ankara doesn’t see that, viewing his presidency as a positive development for the country.

Atilla Yesilada,

GlobalSource Partners advisor

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