Monthly Archives: August 2011

Giving Turkey’s Central Bank the Benefit of the Doubt

Posted on by emmuser
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Analysts bashed Turkey’s central bank following a surprise cut on August 4 that brought the policy rate to 5.75% from 6.25%. The move formed part of a broader policy mix that, on balance, resulted in monetary easing.

The main bone of contention is that many analysts believe Turkey’s economy is overheating, making a rate cut seem reckless.  However, a variety of data suggest overheating concerns are misplaced and point to a sharp global downturn as the bigger worry, as I will detail below.

While the central bank (CBRT) could certainly improve its signaling of policies, I am willing to give the CBT the benefit of the doubt for now. The real test will be whether the CBT proves as proactive at raising the policy rate when conditions require it.

Criticism of the CBT

The quote below from Tim Ash of RBS, as published by the FT, is representative of many in the overheating camp:

“The danger with this totally out of the box move is that investors will seriously begin to question the credibility of the CBRT as an institution, given that foreign investors prime concern at present on Turkey are fears of overheating as reflected in the CAD.”

Also, see this comment from Danske Bank:

“Turkish GDP growth is still in double-digit territory and the current account has clearly grown to an unsustainable level. Any normal inflation targeting central bank with this kind of data would tighten and not loosen monetary policy.”

Rejoinder to Overheating Claims

The domestic economy is showing signs of moderating, rather than overheating. Yes, GDP has grown strongly, but this has to be seen as part of a natural bounceback in the wake of a sharp downturn. This rapid pace of growth is not expected to continue.

Below I highlight some data that suggest Turkey’s economy is not overheating.

Figure 1: The capacity utilisation rate sits below pre-crisis levels and dipped in July

Source: CBT

Figure 2: The annual rate of growth of industrial production has fallen steadily for the past five months

Source: CBT

Figure 3: The real sector confidence index – an indicator of business conditions and an important leading indicator of growth – dipped in July to its lowest level since 2009

Source: CBT

Figure 4: Inflation is above the year-end target of 5.5%, but not far above, and it’s quite low in a historical context

Source: CBT

Sidenote: Many in the overheating camp point to a high current account deficit, approaching 10% of GDP in 2011, to support their claims. The current account deficit is certainly high and this is quite worrisome. However, the deficit is largely structural (owing to Turkey’s heavy dependence on energy imports as well as a chronically low savings rate). This means that it’s not a short-term problem and neither the central bank nor government can simply wave a magic wand and fix it. I will tackle this issue in a later blog post.

Worrying Signs in Advanced Economies

While the domestic economy is showing signs of moderating, the data above do not by any stretch of the imagination justify a rate cut. So it’s necessary to look at the worsening outlook in the US and eurozone, which I detail below, to understand why the CBT opted to slice the policy rate. As the global financial crisis showed, Turkey’s economy is quite vulnerable to developments in the advanced world.

US

  • The Fed Open Market Committee recently highlighted the downbeat state of the US economy in its August statement and said economic growth in 2011 is slower-than expected.
  • In July, the US government released its latest set of growth figures – including revisions going all the way back to 2003 that show the recession was worse than expected. The contraction in real terms, from peak to trough, was 5.1% – one percentage point worse than thought. See related article from BBC.
  • In his August 26 speech at the Jackson Hole conference, Bernanke noted that output in the US has still not returned to pre-crisis levels and that unemployment continues to hover at rates of over 9%. He also said that the Fed has revised down its US growth outlook. At the same time, he made no commitment to any new quantitative easing measures.

Eurozone

  • There is no resolution to the eurozone crisis on the horizon given ongoing political wrangling, and problems seem to be intensifying with Italy moving into the spotlight. The ECB’s bond buying is only a stopgap measure, as Marc Chandler notes in his recent post: Why I Am Going to Worry About Italy on My Summer Vacation.

Other Factors

In an April presentation, the CBT notes its desire to keep interest rate differentials as low as possible in order to prevent large inflows of speculative capital into Turkey. The concern is that such flows can rapidly reverse in the event of an external shock or shift in investor sentiment. The CBT’s decision to cut the policy rate supports this objective as it narrows the interest rate differential vis-à-vis advanced economies.

Note of Caution: Political Pressure May be a Factor

Yavuz Canevi, who helmed the CBT in the mid-1980s, gives voice to worrisome rumblings that pressure from the government may have helped motivate the surprise rate cut.

According to Bloomberg, Canevi said: “I really would not say that the central bank had pressure, but psychologically you can call it pressure. The current governor is much closer to Deputy Prime Minister Ali Babacan than the previous governor. They were childhood friends” and Basci is trying “to accommodate the policies of the current government.”

I believe the real test will be whether the central bank proves as proactive at raising rates when conditions change and this is something to carefully track.

Bottom Line

A range of indicators show domestic economic activity is moderating. Turkey has a wide current account deficit, but that’s largely a structural problem (a very big problem!) and there are no quick fixes. Meanwhile, the global economy looks headed for increasingly choppy waters.

In light of these events, the central bank’s decision to cut the policy rate does not look so absurd and could even be hailed as ahead of the curve. While part of the CBT’s motivation to cut rates may be due to indirect political pressure, I am willing to give it the benefit of the doubt for now.

Forex Reserve Diversification: Is Mauritius a Trendsetter?

Posted on by emmuser
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Emerging market countries hold the lion’s share of the world’s foreign exchange reserves. China is far and away the biggest holder with roughly US$3.2 trillion, or roughly 30% of the world’s total. As seen in Figure 1 below, the bulk of the world’s reserve stockpile is held in US dollars and euros.

As the eurozone is now battling for survival and the US’ safe haven status begins to tarnish, will emerging markets finally take action and diversify their forex reserves? Well, Mauritius looks ready to do so. Is this the start of a broader trend?

Figure 1: Almost all the world’s forex reserves are in US dollars or euros

Source: BIS, IMF, U.S. Treasury, Ashmore (Here’s the link).

*as of September 2010

In early August, the Mauritian central bank governor Rundheersing Bheenick said: “We are busy looking at the possibility of buying Chinese bonds, also South African and Indian bonds just to diversify away from too much dependence on the well-known euro and dollar currencies.”

The Mauritian central bank has already diversified its reserves into new commodity currencies such as Canadian, Australian and New Zealand dollars, as well as the Norwegian kroner. Nevertheless, given the small size of Mauritius’ reserve holdings (roughly US$2.9 bn), their diversification is unlikely to have much more than a symbolic impact.

The key question remains….will the big emerging market powerhouses follow suit? The short answer is no, at least not in the near-term.

Yes, the US and eurozone look increasingly wobbly, and the global economy is certainly becoming more multipolar as emerging markets’ clout grows. Yet, EM central banks – at least the big ones – are not ready to diversify their forex reserves in any significant way for at least two reasons.

1) The simple fact is that there’s no real alternative to the US dollar and euro (particularly for the big emerging markets with large reserve stockpiles to manage) given their unparalleled liquidity, and many central bankers seem resigned to this fact.

After S&P cut the US credit rating earlier this month, Russia’s Deputy Finance Minister Sergei Storchak was quick to say there were no plans to restructure the country’s reserves, noting that the US debt markets are still among the most liquid and reliable. Russia is the world’s 3rd largest holder of forex reserves.

2) The other major reason that large reserve stockpilers, such as China, have their hands tied on diversification is their desire to hold down the value of their own currencies against those of their big export markets – the US and eurozone – in order to keep their exports competitive.

China has talked a good game about forex reserve diversification, but it appears to be nothing more than lip service. Analysts estimate roughly 70% of the country’s reserves are in US dollar assets. See this blog post from Michael Pettis on why China won’t sell US bonds anytime soon. Basically, it boils down to the fact that the following two policy goals – greater forex reserve diversification and maintaining a currency peg – are pretty much mutually exclusive.

So far, policymakers – particularly in Asia – have chosen to keep their de facto currency pegs in place and this looks unlikely to change in the near-term.

EM Currencies: Same Same But Different*

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Investors fled out of EM currencies at the height of the global financial crisis and retreated into safe haven currencies, such as the Swiss franc and Japanese yen. The recent market turmoil triggered a similar pattern, as EM currencies continue to be risk-sensitive. But there’s now greater variation. Certain EM currencies have shown considerable resilience and I expect greater differentiation among EM FX going forward.

Flight to Safety – Where’s That?

The VIX index – which measures the implied volatility of the S&P 500 and is used as a proxy for risk sentiment – rose to its highest level in over two years on August 8 and remains elevated. In reaction to this spike in risk aversion, most EM currencies slipped against the US dollar, as seen in Figure 1 below.

Figure 1: Most EM currencies weakened against the USD in early August when risk aversion spiked

Source: Oanda, author’s calculations

Investors’ gut reaction in times of market stress is to retreat from emerging market currencies. However, there are signs of gradual change. Some – such as the Chilean peso, Czech koruna and Indonesian rupiah – showed considerable resilience in early August, in contrast to their sharp weakening at the height of the global financial crisis. (See Figures 2, 3 and 4 below.) Financial commentator Martin Hutchinson recently went so far as to call the Chilean peso a ‘safe haven’ currency.

Figure 2: Select South American Currencies in Comparison

Source: Oanda, author’s calculations

The Brazilian real and Chilean peso have steadily strengthened against the US dollar since the height of the global financial crisis, albeit to a lesser degree than the Swiss franc, a major safe haven. When the S&P 500 plunged in early August, the Chilean peso held relatively steady, while the Brazilian real weakened, though it so far has not plunged like it did in late 2008-early 2009.

Figure 3: Central European Currencies in Comparison

Source: Oanda, author’s calculations

The Czech koruna, Hungarian forint and Polish zloty are all highly correlated with the euro, which is not surprising given these economies’ strong ties to the eurozone. As a result, these currencies are vulnerable to an intensification of the eurozone crisis.

Meanwhile, high levels of Swiss franc borrowing among Hungarian households’ [See related post: Hungary Mortgage Relief: Another Move to Delay the Pain) and moderate levels of franc borrowing among Polish households are also weighing on these currencies. As the Swiss franc has surged (given its safe haven status), there are concerns that it could slow economic growth and potentially even threaten financial stability. Notably, the Czech Republic – which has scant levels of fx-denominated borrowing and a lower public debt burden relative to the rest of Central Europe – has seen its currency diverge from the other two since mid-2010.

Figure 4: Select Asian Currencies in Comparison

Source: Oanda, author’s calculations

The Indonesian rupiah and Philippine peso showed considerable resilience against the USD, relative to other EM currencies, at the beginning of August. Authorities in both these countries have traditionally not shied away from intervening to smooth out volatility. In fact, Indonesia’s central bank recently said it plans to support the currency by purchasing IDR-denominated government bonds if there’s a large sell-off. As for India, the rupee dipped considerably against the USD in early August. India’s high current account deficit and large public debt burden make the INR more vulnerable to sell-offs in times of market stress.

Structural Change Afoot

Problems in advanced economies look to be more structural than cyclical, suggesting they’re not going to be resolved anytime soon. The US lost its prized triple-A rating from S&P on August 5 – the first downgrade in the country’s history. Meanwhile, the eurozone crisis continues to gather momentum, with Italy and now France coming into the spotlight. The broad political consensus needed to tackle these issues is lacking.

We’re moving toward a more multipolar world where the economic clout of emerging markets will grow ever larger, as Lupin Rahman of PIMCO describes. I also touched on this gradual structural shift in my post: Can Emerging Markets Replace the US as the World’s Consumer of Last Resort?.

The bottom line is that emerging markets are not immune to ripple effects from problems in the US and eurozone given their strong trade and financial ties. Nevertheless, their longer-term prospects are generally brighter than those in the developed world (with certain exceptions) given their lower debt burdens, more favourable demographics and faster economic growth.  (See related posts: The Double Whammy: Debt and Demographics and Emerging Markets: Fiscal Health Check)

As a result, I expect old patterns – where investors automatically flee away from all EM assets in times of trouble – to gradually change. Signs of that shift are already apparent, as noted above.

*See Wikipedia for explanation of title phrase ‘same same but different.’

Hungary: Finally on Investors’ Radar

Posted on by emmuser
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The spread on Hungary’s credit default swaps rose to a six month-high of over 335bp this week. Some of the rise is attributable to general global market turmoil, but local government debt woes are also partly to blame.

I first discussed the country’s shaky local government finances in a post back in early June. See Local Government Woes: Next Leg of the Crisis. The problem is that municipalities have borrowed extensively in Swiss francs (around 60% of total borrowing as of end-2010), and the franc has strengthened by almost 14% against the forint since June 1. As a result, local governments are pleading for help.

From Reuters:

Hungarian local governments have asked Prime Minister Viktor Orban to help some of them win a one-year moratorium on principal repayments for over $3 billion worth of Swiss franc loans, a move that analysts said could amount to restructuring.

The local government debt problem is not an isolated one. Banks are exposed as well.  According to the latest Financial Stability Report, their exposure to municipalities exceeded HUF 1,000 bn (US$5.2bn/€3.7bn), accounting for 5% of total bank loans at the end of 2010. The FT’s Beyond Brics blog also has a post on the topic and it notes that a couple of banks are far more involved than others without naming names. Any thoughts on who these might be? Perhaps OTP?

See related Hungary posts:

Local Government Woes: Next Leg of the Crisis

Hungary Mortgage Relief: Another Move to Delay the Pain

Fitch Raises Hungary’s Outlook: Odd Timing

The Double Whammy: Debt and Demographics

Posted on by emmuser
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A country’s ability to pay down its debt is inextricably tied up with its demographics. An aging population tends to have a negative, double-whammy effect on public finances:

  • Government spending on pensions and healthcare ramps up as the population grays.
  • A smaller working age population eats away at the consumer and tax base, dragging down government revenue.

The FT recently provided a series of excellent graphics, created by economist Eswar Prasad, that compare public debt across emerging market and advanced economies.  The graphics illustrate emerging markets’ relatively healthy public finances (a point I made in an earlier post Emerging Markets: Fiscal Health Check).

However, not all emerging markets are created equal. Of particular interest is the graph that looks at the amount of debt per working-age person. Even if public debt stands still in terms of absolute value, the debt burden per person increases as the population shrinks.

Hungary stands head and shoulders above other emerging markets in terms of public debt with the government now owing an estimated $13,800 per working age Hungarian. By 2016, the debt figure is projected to rise by one-third to $18,400.  Hungary’s population has steadily declined since the 1980s, while public debt has climbed to over 80% of GDP, providing the ingredients for a demographic trainwreck.

The figures below are outtakes from Prasad’s graph and compare net public debt across emerging markets. However, the actual graphs in the FT also include advanced economies in the comparison so I highly recommend clicking through to take a look. Here’s the link.

Figure 1

Source: Eswar Prasad (via FT)

Figure 2

Source: Eswar Prasad (via FT)