A more difficult picture for EMs: What does that mean for Turkey?
Risks seem rising for the EMs, what does that mean for a country like Turkey with a large credit impulse?
The year to date has seen several market events that, while seemingly disconnected and idiosyncratic, combine to paint a less friendly picture for EM markets.
Here are a few examples that Institute of International Finance (IIF) mentioned its recent report: (i) January saw a sharp sell-off in the Argentinian Peso; (ii) February accelerated the bond market sell- off in the US with ensuing SPX volatility; (iii) March brought a rapid widening in the Libor – OIS spread; and (iv) April saw a decline in the Russian Ruble and Turkish Lira. While the underlying driver of these moves is obtuse, two things stand out.
After a remarkable period of coordinated global growth, desynchronization is setting in, something that is perhaps being accelerated by mounting global trade tensions. Separately, we see US fiscal stimulus as a game changer for the Fed, which is likely to revise up its terminal rate for the policy rate in the coming year, signalling more tightening for longer.
All of this translates into a more difficult picture for EMs with large external funding needs. Turkey is arguably at the epicenter of this shift, given that last year’s large credit impulse widened the current account deficit considerably, even as the funding composition of that deficit is deteriorating. We estimate that the Turkish Lira – even with the sizeable real depreciation in recent years – may still be overvalued.
The Turkish Lira has weakened close to 25 percent in real effective terms since 2013, the largest depreciation across all major EMs. The root cause of this weakening is the current account deficit, which has been on a widening track.
In fact, the current account deficit reflects an internal imbalance, a large credit impulse in 2017 that pushed the economy into overheating territory, although accelerated gold imports also played a distinct role. Monthly balance of payments data show that the deterioration in the current account deficit coincides with a funding picture that is steadily deteriorating, with the share of net FDI inflows falling to the lowest level in over a decade.
The key analytical question is whether the real depreciation that has already occurred accurately reflects internal and external imbalances, or whether more Turkish Lira weakness is needed. Our trade imbalances model, which we introduced in January, addresses this issue. It estimates an underlying current account position for Turkey, allowing for lagged depreciation effects to feed through. We estimate that, factoring in these lagged effects (red bars), the underlying current account balance (black line) is widening less rapidly than the headline number (blue bars).
But it is still deteriorating, which means that the Turkish Lira is still overvalued on our estimates – on the order of 10 percent – even with all past depreciation effects in the pipeline.