Emerging market crises in recent years have been mostly confined to small, marginal countries such as Belize and Jamaica. But last year saw trouble for two heavy-hitters. First, Turkey’s lira fell sharply as a credit-fuelled construction bubble turned to bust, then Argentina’s peso collapsed amid excessive foreign debt and soaring inflation. While it may sound counterintuitive, any sensible EM investor will now be concentrating efforts on building exposure to these two countries.
The question is which one to prefer. The scale of the damage inflicted on both countries last year was formidable. According to JPMorgan data, the dollar value of Turkish local currency debt dropped 29 per cent, while Argentina’s dropped 53 per cent. But history shows that when EM currencies collapse, there are opportunities for huge returns once conditions stabilise. On average, local-currency markets generate triple the average return in the year following a crisis. On paper, the potential returns on offer are impressive, especially in comparison to the skinny yields in core developed markets.
Argentina’s key interest rate is 73 per cent, while its 10-year US dollar debt yields 11.6 per cent. Turkey’s local notes yield between 18 per cent and 25 per cent, although the dollar paper has held in rather better, paying a comparatively miserly 8 per cent a year for 10 years. The sources of the countries’ problems differ.
In Turkey, banks gorged on foreign credit, pumping a credit bubble that peaked at annual growth of 30 per cent in loan growth. The country’s construction sector doubled its share of the economy. Argentina also suffered from excessive credit growth, but there the problem was explicitly on the public sector side. As the cycle peaked last year, Argentina was running a budget deficit of 6 per cent of GDP. The country’s long record of high inflation and capital controls have undermined attempts to borrow in peso at sustainable rates, and the country’s debt burden is overwhelmingly in dollars.
Both countries suffer from desperately inadequate foreign exchange reserves. The IMF judges that Argentina has 60 per cent of what it needs, although the country can draw on $40bn of IMF support. Turkey, meanwhile, has 70 per cent of the required tally. Without adequate reserves, both countries are at the mercy of the lenders of huge short-term foreign debt. Politics has created problems in both, with concern among voters sharpened by currency collapse, inflation and recession.
While the Argentines have earned IMF approval in staying the orthodox course, the populist opposition is rising in the polls, creating more worries for investors. The Turks have repeatedly tried to soften the blow — promoting bank lending, especially in the state banks, and intervening to protect the lira before recent elections.
These desperate attempts to prop up the lira ahead of April’s elections ripped a hole in the country’s meagre currency reserves. Rather than face the resulting devaluation, the authorities effectively segregated lira liquidity from foreigners, sending offshore interest rates hurtling towards an annualised 1000 per cent; meanwhile, the central bank tapped local banks for liquidity using a mechanism we can charitably describe as “badly explained”.
The preference this year for quick, dirty fixes such as massaging reserves reporting or the offshore liquidity squeeze ensure that President Recep Tayyip Erdogan retains the ability to torpedo the economy.
In Argentina, investors are worried about the prospect of a return to power of the country’s previous president, Cristina Fernández de Kirchner. While the current administration of Mauricio Macri barely deserves its status as market darling, Ms Kirchner’s record of distorted statistics, inflation and capital controls is almost calculated to send foreign money racing for friendlier places.
But Argentina’s central dilemma is of struggling to generate significantly larger amounts of foreign currency with an economy that exports relatively little. Crucially, the country faces the risk of a vicious cycle as inflation follows devaluation, the country slides into recession and the risk rises of an unorthodox, market unfriendly clampdown.
The hope of breaking this cycle is almost certainly why the IMF agreed to finance currency interventions. That means Turkey probably has the easier path towards recovery. Its relatively open economy and position as a manufacturing hub on Europe’s doorstep make generating foreign exchange much easier.
The country has a significantly lower external debt burden, and the public finances are healthy. The private banks have been able to roll over external debt, albeit in chunks. The country’s dysfunctional politics and erratic leaders seem intent on derailing a return to growth, but trade and the luck of location should come to Turkey’s support.