Turkey proves to be a good teacher of some old (and painful) lessons

The collapse of the Turkish lira and the threat of contagion across emerging and also developed stock and bond markets look to be catching many investors off guard but this is just an another example of what the economist J.K. Galbraith once termed ‘the extreme brevity of financial memory’, because (unfortunately) we have been here before.

The current Turkish situation bears all of the hallmarks of the Asian and Russian economic crises of 1997-98, which finally spilled over into the West and led to a short, sharp bear market in developed market share prices.

Meanwhile Turkey itself last got into serious trouble in 2000-01 when the lira collapsed.

The Turkish lira lost half of its value during the 2000-01 crisis

Source: Thomson Reuters Datastream

That crisis followed a period of rip-roaring growth funded by a rising budget deficit and rampant overseas borrowing that left the economy overheating – which all sounds very familiar today, given Turkey’s $200 billion-plus of overseas debt, inflation in the high-teens and a current account deficit that represents nearly 6% of GDP.

When the smash came in 2000, the Turkish lira halved in value and GDP plunged while unemployment and inflation soared. This all happened under the supervision of the International Monetary Fund (IMF), which offered more than $20 billion in financial assistance between 1999 and 2003, in return for a package of interest rate hikes and fiscal austerity.

Wriston’s Law

This economic disaster paved the way for the 2002 general election victory of the newly-created Justice and Development (AKP) Party under Recep Tayyip Erdogan, so no adviser or client should be surprised by how Mr. Erdogan is now responding.

His rise to power was at least partly fuelled by public discontent with the IMF’s version of economic orthodoxy, so it is no wonder he is determined not to follow the path of higher interest rates now.

Given that he also called interest rates ‘the mother of all evil’ in a speech last May, raising the question of whether he wanted to pay interest and repay overseas loans, let alone could do so, all it needed was some unexpected development to puncture confidence in Turkish assets and prompt capital flight. After all, ‘capital will always go where it’s welcome and stay where it’s well treated’, as one-time Citigroup chairman Walter Wriston once said, and it may well be that Turkey now no longer fits that bill.

That catalyst duly arrived in the argument with the USA over Turkey’s detention of an America pastor and the White House’s decision to use tariffs to try and get some leverage in the negotiations with Ankara.

Five options

Turkey has five options to try and solve its debt problems

  • Jack up interest rates to stem capital flight and persuade money to stay – after 2000-2002 this seems unlikely
  • Devalue its currency to lower interest bills on lira-priced debt, slow imports and help exports to tackle the current account deficit – but this makes servicing dollar-priced debt more expensive and so hardly helps and it will hit the economic growth that Mr Erdogan needs and craves
  • Find a fresh source of funds. The IMF is unlikely to be considered as an option and Pakistan has just spurned an IMF package in exchange for Chinese assistance. Mr Erdogan could turn to China or Russia.
  • Default on the debt. This remains a possibility although it would lock Turkey out of financial markets for some time to come (not that Mr Erdogan may care)
  • Capital controls, a concept already being floated by legendary emerging market fund manager Mark Mobius. Turkey would simply shut up shop and prevent foreigners from withdrawing their cash.

In a call with investors last week (16 Aug) finance minister, Berat Albayrak, asserted that Turkey would not call in the IMF but he did float the idea of government spending cuts of 10% to 30%, to try and calm fears that the economy was overheating.

That stemmed the sell-off but not for long because Turkey still suffers from lofty inflation (16% before the crisis), still runs a current account deficit and still has substantial dollar borrowings which are becoming still more expensive to service as the lira falls. The core problems remain.

Loss of control

At least Mr Albayrak rejected the option of capital controls. That may reassure some, although fresh capital flight could still force Mr Albayrak and Mr Erdogan’s hands if they are determined to get the central bank to keep a lid on interest rates.

Malaysia went down the path of capital controls in 1998 with horrible results for financial markets. The Malaysian stock market plunged and those investors who found themselves with assets stranded in ringgit on the Kuala Lumpur exchanges looked to sell assets in other emerging markets, to avoid the risk of similar moves in other emerging markets and also raise liquidity to protect themselves (and in the case of emerging market funds to meet redemptions from their own nervous investors).

This shows how even smaller economies and stock markets such as Malaysia can have a potentially huge impact on global financial prices, through contagion. It took around a year for the ripple effect to reach its maximum, as the FTSE All-World stumbled in the second half of 1998.

Malaysia’s experiment with capital controls came at a wider cost

Source: Thomson Reuters Datastream

The UK was hard hit, too. The FTSE All-Share fell by 24% between June and October 1998 as investors fretted over the prospects for global growth and the damage done to financial markets and institutions by losses in Asia and then Russia, which defaulted in August 1998 prompting in turn the collapse of the Long Term Capital Management hedge fund.

UK caught a cold in the wake of the Asian and Russian crises of 1997-98

Source: Thomson Reuters Datastream

It remains to be seen whether Turkey leads to a similar rout this time around but there is a risk that the lessons of 1997-98 in Asia and Russia and 2001-02 (mixing current account and budget deficits and overheating emerging economies funded by too much dollar debt) have been forgotten in London, New York and other major financial hubs – but not Ankara or Istanbul, where the memories of IMF-enforced austerity are still very fresh.

AJ Bell Investment Director

Russ Mould’s long experience of the capital markets began in 1991 when he became a Fund Manager at a leading provider of life insurance, pensions and asset management services. In 1993 he joined a prestigious investment bank, working as an Equity Analyst covering the technology sector for 12 years. Russ eventually joined Shares magazine in November 2005 as Technology Correspondent and became Editor of the magazine in July 2008. Following the acquisition of Shares' parent company, MSM Media, by AJ Bell Group, he was appointed as AJ Bell’s Investment Director in summer 2013.