Argentina and Turkey Lead the Sudden Stop
“Destination anywhere so far gone, I’m almost there”
—Joe Elliott
2017 was a strange year. Despite warnings about rising debt and soaring deficits, despite concerns about trade wars and political turmoil, markets soldiered on to all-time highs and investors, as well as economists, started to believe that this time was different.
Cheerful comments about synchronised growth flooded the specialized media, while the world ignored rising imbalances.
Then, throughout the first months of 2018 markets witnessed the collapse of emerging market currencies against the US dollar, led by Argentina’s peso, Turkey’s lira, Brazil’s real and Russian ruble.
The collapse of the Argentine Peso and other emerging currencies was more than a warning sign.
It showed the arrival of a “sudden stop” as we explained in Chapter 4. The extraordinary and excessive flow of cheap US dollars into emerging markets suddenly reversed and funds return to the U.S. looking for safer assets.
The central bank “carry trade” of low interest rates and abundant liquidity was used to buy “growth” and “inflation-linked” assets in emerging markets. As the evidence of a global slowdown added to the rising rates in the U.S. and the Fed’s quantitative tightening (QT), emerging markets lost the tsunami of inflows and face massive outflows, because the bubble period was not used to strengthen those countries’ economies, but to perpetuate their imbalances.
The Argentine Peso started the domino effect. Followed by the Lira of Turkey.
What explained this drop?
Many economists had warned for years of the mistake of massively increasing money supply and using high liquidity to avoid much-needed structural reforms.
In Argentina, the government of Cristina Fernández de Kirchner left a monetary hole close to 20 percent of GDP and massive inflation after years of trying to cover structural imbalances with increases in the money supply greater than 30–35 percent per year.
Unfortunately, as in other emerging markets, the urgent reforms were abandoned by the next government, and an alternative formula was tried. Gradualism. Issue great quantities of debt and continue financing a growing public spending with central bank money printing expecting economic growth and cheap debt would offset the growing fiscal and monetary imbalance.
This wrongly-called “soft adjustment” was justified because of the enormous liquidity in international markets and appetite for emerging markets’ debt driven by consensus estimates of a continued weakening of the US dollar. Many Latin American and emerging market economies fell into the trap. Then, when it stopped, and the US dollar recovered some of its weakness, it was devastating.
High fiscal and trade deficits financed by short-term dollar inflows became time bombs.
Argentina even issued a 100-year bond at a spectacularly low rate (8.25 percent) with a very high demand, more than 3.5 times bid-to-cover. That $2.5 billion issuance seemed crazy. A 100-year bond from a nation that had defaulted at least six times in the previous hundred years! Worse of all, those funds were used to finance current expenditure in local currency.
The extraordinary demand for bonds and other assets in Argentina or Turkey was justified by expectations of reforms and a change that, as time passed, simply did not happen. Countries failed to control inflation, delivered lower than expected growth and imbalances soared just as the U.S. started to see some inflation, and rates started to rise. Suddenly, the yield spread between the U.S. 10-year bond and emerging markets debt was unattractive, and liquidity dried up faster than the speed of light even with a modest decrease of the Federal Reserve balance sheet. Liquidity disappears because of extremely leveraged bets on one single trade—a weaker dollar, higher global growth-unwind.
However, another problem exacerbated the reaction. An aggressive increase in the monetary base by the Argentine central bank made inflation rise above 23 percent in 2017.
With an increase in the monetary base of close to 28 percent per year and seeking to finance excess spending by printing money and raising debt to “buy time,” the seeds of the disaster were planted. Excess liquidity and the US dollar weakness stopped. Local currencies and external funding faced the risk of collapse.
When most of the emerging economies entered into twin deficits-trade and fiscal deficits-and consensus praised “synchronized growth,” they were sealing their destiny: When the US dollar regains some strength, US rates rise due to an increase in inflation, the flow of cheap money to emerging markets is reversed. Synchronized indebted growth created the risk of synchronized collapse.
The worrying thing about Argentina and many other economies is that they should have learned from this after decades of similar episodes. But investment bankers and policymakers always say, “this time is different.” It was not.
Argentina decided to push interest rates to 40 percent to stop the bleeding. With rampant inflation and economic growth concerns, the peso bounce was to be short-lived.
When confidence in the currency disappears, raising rates does not send citizens running to the bank to leave their deposits, rather the opposite.
Massive money supply growth does not buy time or disguise structural problems. It simply destroys the purchasing power of the currency and reduces the country’s ability to attract investment and grow.
Argentina, like so many emerging markets, did not borrow massively in US dollars because they were insane or stupid. They did it because there was no real demand for local currency bonds due to the high risk of devaluation and inflation.
Here is where the MMT crowd always get it wrong. A country with monetary sovereignty cannot borrow all it wants in local currency and print it at will. There is no demand for that credit unless you have a credible economy and strong financial capabilities.
Structural imbalances are not mitigated by carrying out the same monetary policies that led countries to crisis and discredit.
Having seen this, the Turkish Lira collapse of 2018 should have surprised no one.
The lira decline against the US dollar had been ongoing for many years before 2018, and it had nothing to do with the strength of the US dollar, which only recovered in 2018.
The collapse of Turkey was an accident waiting to happen and was fully self-inflicted.
It is yet another evidence of the trainwreck that monetarists cause in economies. Those that say that “a country with monetary sovereignty can issue all the currency it wants without risk of default” are wrong yet again. Like in Argentina, Brazil, Iran, and Venezuela, monetary sovereignty means nothing without strong fundamentals to back the currency.
Turkey took all the actions that MMT lovers applaud. The Erdogan government seized control of the central bank, and decided to print and keep extremely low rates to “boost the economy” without any measure or control.
Turkey’s Money Supply tripled in 7 years, and rates were brought down massively to 4.5 percent.
However, the lira depreciation was something that was not just accepted by the government but encouraged. Handouts in fresh-printed liras were given to pensioners in order to increase votes for the current government, subsidies in rapidly devaluing lira soared by more than 20 percent (agriculture, fuel, and tourism industry) as the government tried to compensate the loss of tourism revenues due to security concerns with subsidies and grants.
Loss of foreign currency reserves ensued, but the government soldiered on promoting excessive debt and borrowing. Fiscal deficits soared, and the rapidly devaluing lira led to a rising amount of loans in US dollars.
This is the typical flaw of monetarists, they believe monetary sovereignty shields the country from external shocks and loans in foreign currencies soar because no one wants to lend in a constantly-debased currency at affordable rates. Then the central bank raises rates but the monetary hole keeps rising as the money supply continues to grow to pay for handouts in local currency.
Now the risk is rising for the rest of Europe.
On one hand, the exposure of eurozone banks like BBVA, BNP, Unicredit to Turkey is very relevant. Between 15 percent and 20 percent of all assets.
On the other hand, the rise in non-performing loans is evident. Turkey’s loans in US dollars account for around 30 percent of GDP according to the Washington Post, but loans in euro could be as much as another 20 percent. Turkey’s lenders and governments made the same incorrect bet that Argentina or Brazil made. Betting on a constantly weakening US dollar and that the Federal Reserve would not raise rates as announced. They were-obviously wrong. But that erroneous bet only adds to the already existing monetary and fiscal imbalances.
Money supply continues to grow at almost double-digit rates, the government’s outlays exceed the diminishing reserves and capital flight starts to be evident as savers and investors fear that the Erdogan government prefers to take the option of capital controls in order to seize complete power than to restore economic credibility with sound money policies.
Like Argentina before, raising rates too late does not calm the market when the risk is capital controls and a bank run. Raising rates to 18 percent does not encourage anyone in Turkey to keep money in the bank when the risk is to lose all the money. Rates went from 8 to 17.5 percent and the crisis worsened. It will not stop because of slightly higher rates.
Because the problem of Turkey is monetary and fiscal. Turkey will need a massive adjustment program and a credible opening of its institutions and markets to attract capital and restore growth. Unfortunately, the route seems to be more government control of institutions, less investment security and deepening the crisis blaming the inexistent external enemy.
Erdogan is fighting against a very dangerous economic foe. Himself.
For Europe, this is a devil’s alternative. Bailing out Turkey will give further control to Erdogan and increase the imbalances of the economy while imposing higher restrictions to freedom.
Not bailing out Turkey, on the other hand, would cause a much larger crisis than Greece was. Because too many eurozone funds and bank investments have been directed toward Turkey as a way to get access to some growth and inflation. What they got was a risk of capital controls and currency debasement.
The biggest risk for Europe will be to try to cover this mess with some aid in exchange for refugee and border support. Because what is already a relevant risk, but contained, will likely balloon to unmanageable proportions.