As Greece exits its third bailout and the world commemorates the 10th anniversary of the collapse of Lehman Brothers amid the longest bull run in US stock market history, it may be tempting to think that the global financial crisis is now well and truly behind us.
And yet, in the bewildering world of international finance, as in any ordinary casino, the appearance of an uninterrupted winning streak often turns out to be deceiving. Investors and policymakers learned this the hard way in 2008. But if the recent crash of the Turkish lira is anything to go by, they may be in for another painful reminder.
While jittery foreign exchange markets appear to have stabilised somewhat over the past week, following limited action by the Turkish central bank and a pledge of $15-billion in direct investments by Qatar, significant damage has already been done to the Turkish economy. The lira is now down 40% to the US dollar this year, raising widespread concerns over the sustainability of the country’s sizeable dollar-denominated debts.
The immediate cause of Turkey’s troubles is clear enough: earlier this month, the US government imposed sanctions against its NATO ally in response to its continued detention of an American evangelical pastor accused of involvement in the attempted coup of 2016. The announcement by the Trump administration of a doubling of steel and aluminium tariffs on August 10 immediately sent the lira into a tailspin.
The crisis has since been aggravated by investors’ fears stemming from Turkish President Recep Tayyip Erdogan’s aggressive criticism of what he calls the “interest rate lobby” and his long-standing opposition to raising interest rates — a measure Turkey’s central bank has nevertheless had to press forward with a number of times over the past year.
At first sight, the recent market convulsions would therefore appear to be a uniquely Turkish problem, triggered by an extraordinary standoff between two populist strongmen, Donald Trump and Recep Tayyip Erdogan, and worsened by the eccentric economic world view of the latter.
In truth, however, Turkey’s problems are far from idiosyncratic. Coming on the heels of recent interventions of the International Monetary Fund (IMF) in Argentina and Pakistan, they clearly reflect a set of deeper vulnerabilities in the emerging-market asset class as a whole.
Canary in the coalmine
As a matter of fact, Turkey’s economic troubles have been a long time in the making, and are tightly interwoven with underlying weaknesses in the world economy resulting from the unintended side-effects of the international response to the global financial crisis of 2008.
After Lehman Brothers collapsed, exactly 10 years ago next month, the world’s leading central banks responded by reducing interest rates to historic lows and buying up massive amounts of low-risk assets from private banks, thereby effectively pumping $15-trillion in new money into the global financial system — a policy known as “quantitative easing” (QE).
With financial institutions now bathing in excess liquidity, traders and investors went on a global quest for yield. Some poured their money into the US stock market, feeding the current bull run. Others pumped it into real estate, fuelling the housing boom in global cities like London and San Francisco. Others still used it to buy corporate bonds or speculate on student loans and complex packages of subprime car loans.
A significant share of the money generated by QE, however, found its way abroad – in the form of loans to and direct investments in emerging markets, where profit margins were often considerably higher than in the developed world. For the better part of the past decade, Turkey was one of the main beneficiaries of this tidal wave of cheap money.
As a result, Erdogan’s Justice and Development Party (AKP) ended up presiding over a spectacular credit-fuelled construction boom that, after the violent economic contraction of 2009, rapidly transformed the skyline of Turkey’s main cities and sent its economy soaring to new heights, making it one of the most rapidly expanding emerging markets in the world.
In the process, however, the country piled up large dollar-denominated debts. At the end of 2016, almost 90% of loans to Turkish real estate companies — whose activities accounted for as much as 20% of the country’s economic growth in recent years — were denominated in foreign currencies. Since the earnings of these firms are mostly in domestic currency, the fall of the lira makes it increasingly difficult for them to service their debts.
All in all, the Institute of International Finance estimates that the foreign-currency debt of Turkish firms, financial institutions and households now stands at 70% of annual economic output. Turkey’s banks are in a particularly precarious position: with over $100-billion in external debt falling due over the next year, there is a real risk of systemic defaults.
If a large enough number of Turkish banks and businesses were to fold over the next year or two, the economic consequences would quickly spill beyond Turkey’s borders.
First in the line of fire would be the European banks that carry the largest exposures to Turkish borrowers, which happen to be concentrated in Spain ($82-billion), France ($38-billion) and Italy ($17-billion) — three countries whose banking sectors are still reeling from the aftershocks of the global financial crisis and the European sovereign debt crisis.
The second pathway through which financial contagion would be likely to occur would be through a sudden stop of capital inflows and a run on the currencies of other vulnerable emerging markets like India, Indonesia, Pakistan, Argentina and South Africa.
Some markets in sub-Saharan Africa — like Angola, Ghana, Ethiopia, and Mozambique – have also been identified as highly vulnerable. The same even holds for more developed economies like Chile, Poland and Hungary, all of which carry relatively large foreign-currency debts in excess of 50% of GDP.
Turkey, in this respect, appears to be but a canary in the coalmine.
A perfect storm
Indeed, for several years now, a perfect storm has been brewing in the global financial system, centring — as in previous crisis episodes of the 1980s and 1990s — on those emerging markets that are most acutely dependent on foreign capital.
According to the Bank for International Settlements, the amount of dollar-denominated debt in the world has nearly doubled to $11.4-trillion since the start of the recession of 2009, with emerging markets accounting for $3.7-trillion of the total increase. Between now and 2025, governments, companies and financial institutions in these countries will need to find a way to repay or refinance $2.7-trillion of this external debt mountain.
The problem is that these dollar-denominated obligations will become increasingly difficult to service as the US Federal Reserve moves towards a policy of monetary tightening and an unwinding of its QE programme in the face of a relatively buoyant US economy. Officials at the Fed have signalled that they may raise interest rates at least five times in the next 15 months alone.
As a result, a growing number of emerging markets will find themselves squeezed between rising borrowing costs, diminished capital inflows and a stronger US dollar, all of which will conspire to make the servicing of their dollar-denominated debts increasingly expensive — and in some cases outright unaffordable.
Meanwhile, the marked slowdown in China means that the Chinese government is unlikely to come to the rescue of emerging markets this time around — as opposed to 2009, when it flooded its own economy with credit and unleashed a massive construction boom of its own, raising the growth prospects of most commodity-exporting developing countries in the process.
The reason that Turkey now finds itself on the front line of this emerging-market debt crisis is because it happens to suffer from a particularly dangerous combination of high short-term dollar-denominated debt, an overheated economy, and growing geopolitical risks associated with Erdogan’s perceived authoritarian turn — including the crackdown in the aftermath of the 2016 coup attempt, which has increasingly alienated his NATO allies in Europe and North America, and his hostile policies towards the Kurds.
But if the current trajectory of monetary tightening in the developed countries continues (and there is no reason to believe that it will not), the pain of further currency-and-debt shocks is unlikely to remain confined to Turkey.
Below what appears to be the relatively calm surface of the world economy, the global financial system has been storing up immense vulnerabilities resulting from a decade of speculative investment fuelled by historically low interest rates and the unprecedented monetary experiment of quantitative easing.
With the world’s leading central banks finally unwinding their QE programmes and beginning to raise interest rates, these systemic vulnerabilities are now coming to a head. The tidal wave of cheap money is about to recede. And as American investor Warren Buffett famously put it, it is only when the tide goes out that you discover who has been swimming naked. — Al Jazeera