The Economist on Turkey

From the Economist


Cold Turkey

Aug 2nd 2007
From The Economist print edition
Why some emerging markets may suffer from withdrawal

WHEN investors get twitchy, developing countries are usually the first to pay the price. In the financial swoon of May-June 2006, emerging-market shares fell 25%. The current sell-off may be even more dangerous because it follows a recent bout of exuberance. According to Morgan Stanley, inflows into emerging-market funds hit a record $11.1 billion in the four weeks to July 25th.

So it is possible that some emerging markets could be among the worst casualties of the latest wave of risk aversion. In particular, it is time to worry about some of the beneficiaries of the “carry trade”.


The trade assumes that markets are irrational. Investors who succumb to its lure borrow in low-yielding currencies, like the yen, and invest in higher-yielding assets. This is a relatively recent phenomenon. In the 1970s, low-yielding currencies were highly coveted; the Swiss were able to offer negative interest rates by charging people to hold bank accounts.

In theory, the long-term expected return from a currency carry trade should be zero, since the assets should only be offering a higher yield because of their higher risk. In practice, however, investors have been making money from the carry trade for years. This may well be due to the “Great Moderation” in the world economy. In many countries both growth and inflation have been more stable than expected. Economies with a poor inflation record have thus tended to overcompensate investors for the risk they have taken.

But the carry trade has also allowed some countries to get away with economic policies that they might never have dreamed of in the 1980s or early 1990s. As this column recently noted, Latvia and Iceland have been running current-account deficits of 25-30% of GDP without suffering a currency crisis.

Turkey has been another beneficiary. Its current-account deficit has not hit the Icelandic extreme but, at around 7.5% of GDP, it is still a gaping hole. However, short-term interest rates of 18.7% have encouraged investors to take the risk of buying the currency; the lira has risen 18% against the dollar in the past year.

A strong currency has created some odd-looking anomalies. Tim Lee of pi Economics calculates that, in dollar terms, the Turkish economy has grown at a 22% annual rate over the last five years; in terms of GDP per head, Japan was 14 times richer than Turkey in 2001; now it is only five times better off. On that basis, Mr Lee suggests, Turkey looks the kind of miracle economy that puts China to shame.

A strong currency has encouraged Turkish companies to borrow abroad. Mr Lee cites figures from the Istanbul Chamber of Industry showing that foreign borrowings had more than doubled to $72 billion between 2003 and 2006. Were the lira to collapse, the cost of repaying dollar-denominated debts would be a big burden for Turkish companies.

Currency strength is also the “wrong” response to Turkey's current-account deficit because it will make the country's exports less competitive. As a result, Mr Lee reckons the deficit may head towards 10% of GDP during the second half of this year.

Until recently, markets have been reluctant to punish Turkey for its dodgy economic fundamentals, perhaps hoping it will be a long-term winner if it manages to pull off greater integration with Europe's economies. The business-friendly policies of Recep Erdogan, the recently re-elected prime minister, have also helped sentiment. Neil Shearing, emerging-Europe economist at Capital Economics, reckons that Turkish bonds ought to trade at a premium of nearly three percentage points to Treasury bonds, rather than their current two-point spread.

However, investors may at last be opening their eyes to the risks in Turkey. Figures from Morgan Stanley show that, in dollar terms, it was the worst performing emerging stockmarket in the week to July 27th, falling 12%.

Turkey may have been helped by the perception that, because many emerging markets have improved their economic positions, all of them are less risky. Emerging-market bond spreads (the excess rate over Treasury-bond yields) reached a record low of around one-and-a-half percentage points in June. When investors were only getting 6% for lending money to investment backwaters such as Peru, a 6.7% yield from Turkey must have looked like a bargain.

But it is in the nature of emerging markets that, every so often, they kick investors in the teeth. This looks like being one of those moments. Of course, within 12 months, investors are bound to be back, their smiles expensively restored. Fast economic growth and high yields are just too alluring.