Khan Capital | June 2018
Key Takeaways
- The Turkish lira and Argentine peso have fallen 20% and 35% respectively against the dollar in 2018, as rising US interest rates and a stronger dollar expose the vulnerabilities of emerging markets with large dollar-denominated debts and twin deficits.
- Argentina returned to the IMF in June 2018, securing a $50 billion standby arrangement, the largest in the Fund’s history, after the peso’s collapse forced the central bank to raise rates to 40%.
- Turkey’s crisis is driven by policy orthodoxy erosion: President Erdogan’s public opposition to rate hikes and his characterisation of interest rates as “the mother of all evil” have shattered investor confidence in central bank independence.
- The broader EM selloff reflects a familiar pattern: when US yields rise and the dollar strengthens, capital flows reverse out of emerging markets, exposing countries that financed current account deficits with foreign borrowing during the easy-money years.
- Contagion risk is real but selective: countries with solid fundamentals (India, Indonesia, Mexico) have sold off in sympathy with Turkey and Argentina, but the fundamental drivers of crisis are idiosyncratic rather than systemic, suggesting differentiation will eventually reassert itself.
EM Under Pressure: Turkey, Argentina, and the 2018 Dollar Squeeze
The first half of 2018 has been brutal for emerging markets. After a stellar 2017 in which the MSCI Emerging Markets Index returned 37.8%, the asset class has given back much of its gains as a combination of rising US yields, a stronger dollar, and escalating trade tensions has reversed the capital flows that sustained the post-crisis EM rally. The damage has been most acute in countries with the weakest fundamentals, and two stand out as the epicentre of the current stress: Turkey and Argentina.
Both countries share a familiar constellation of vulnerabilities. Both run large current account deficits, financed through external borrowing. Both have seen significant increases in dollar-denominated debt during the easy-money era that followed the global financial crisis. Both have governments whose recent policy choices have undermined investor confidence in their institutional frameworks. And both have now become cautionary tales of what happens when the global liquidity tide goes out and the dollar’s gravitational pull reasserts itself.
The Macro Backdrop: Rising US Rates and a Resurgent Dollar
The proximate cause of the EM squeeze is the shift in the global monetary policy landscape. The Federal Reserve, under new chair Jerome Powell, has continued the tightening cycle begun under Janet Yellen. After raising rates in March 2018, the Fed delivered another hike in June, bringing the federal funds rate to 1.75-2.00%, and signalled two more increases before year-end. The 10-year Treasury yield has climbed from 2.40% at the start of the year to over 3.10% in May, its highest level since 2011.
The dollar, after a prolonged weakening trend through 2017, has reversed course sharply. The DXY index, which measures the dollar against a basket of major currencies, has risen roughly 6% from its February low, and the broad trade-weighted dollar index (including EM currencies) has climbed even more. The combination of rising US rates and a stronger dollar is the classic toxic cocktail for emerging markets: it makes dollar-denominated debt more expensive to service, reduces the attractiveness of EM yields relative to US Treasuries, and encourages capital outflows in search of safer, higher-yielding developed market assets.
This dynamic has played out repeatedly throughout history. The 1994 tequila crisis, the 1997-98 Asian financial crisis, the 2013 taper tantrum, and now 2018 all share a common DNA: a shift in US monetary conditions that exposes emerging market vulnerabilities accumulated during the preceding period of loose global liquidity. What differs is which countries prove to be the weakest links.
Turkey: Unorthodox Policy Meets Market Reality
Turkey’s crisis is in many ways self-inflicted. The country has been running a current account deficit of 5-6% of GDP, financed largely through short-term external borrowing and hot money inflows. Corporate sector dollar-denominated debt has ballooned to over 40% of GDP, making Turkish firms acutely vulnerable to currency depreciation. Inflation, which had been drifting higher through 2017, accelerated sharply in 2018, reaching 15.4% in June, well above the central bank’s 5% target.
The orthodox policy response to high inflation and currency pressure is straightforward: raise interest rates aggressively to anchor expectations, restore real yields, and slow credit growth. The Central Bank of the Republic of Turkey (CBRT) did eventually move, raising its policy rate from 8.0% to 17.75% between April and June. But the response was hesitant, grudging, and came only after significant currency damage, reflecting what markets perceived as political pressure against monetary tightening.
President Erdogan has made his unorthodox views on interest rates explicit. In a speech in May, he declared that high interest rates cause inflation rather than cure it, an inversion of mainstream economics that he has repeated on numerous occasions. Ahead of the snap presidential elections in June 2018, Erdogan announced his intention to take a more active role in monetary policy, saying the central bank could not be independent of the political process. These comments were market kryptonite: a senior politician openly challenging central bank independence in a country with an inflation problem is a red flag that no amount of tactical rate hikes can fully offset.
The lira has fallen from roughly 3.80 per dollar at the start of 2018 to 4.70 in late June, a depreciation of nearly 20%. Turkish equity markets, as measured by the Borsa Istanbul 100 Index, have fallen over 20% in dollar terms. Sovereign credit default swap spreads have widened from 170 basis points to over 300, reflecting heightened default risk. The Turkish economy is not yet in crisis in the formal sense, but the trajectory is concerning, and the political environment makes a credible policy response increasingly difficult.
Argentina: The IMF Return
Argentina’s crisis has arrived with greater speed and severity. When President Mauricio Macri took office in December 2015, he inherited an economy emerging from years of populist mismanagement under his predecessor Cristina Fernandez de Kirchner. Macri pursued a gradualist reform strategy: removing capital controls, unifying the exchange rate, settling with holdout creditors from the 2001 default, and returning Argentina to international capital markets. The approach was politically palatable but financially precarious, as it relied on continued access to foreign financing to fund a fiscal deficit while structural reforms were phased in.
For a time, the strategy worked. Argentina issued a 100-year bond in June 2017, an extraordinary symbol of investor confidence that would later become an equally extraordinary symbol of how quickly sentiment can turn. By April 2018, however, cracks were appearing. A drought had hit the agricultural sector, reducing export earnings. A new tax on non-residents holding Argentine short-term debt (LEBACs) triggered capital flight. Inflation was proving stickier than expected, and real interest rates were inadequate to defend the currency.
The peso’s collapse began in earnest in late April. By early May, it had fallen from 20 to over 25 per dollar, and the central bank was forced into emergency action, raising rates from 27.25% to 40% in three successive hikes over eight days. When those measures proved insufficient, Macri made the decision that no Argentine president wants to make: on 8 May, he announced that Argentina would seek assistance from the International Monetary Fund. After weeks of negotiations, the IMF approved a $50 billion standby arrangement on 20 June, the largest in the Fund’s history.
The return to the IMF carries heavy political symbolism for Argentina. The country’s 2001 sovereign default, preceded by an IMF programme that failed to arrest the crisis, left deep scars in the national psyche. Many Argentines blame the IMF for the austerity measures that accompanied the 1990s convertibility regime and the subsequent collapse. By seeking IMF support, Macri has staked his political future on the credibility of a programme that will require fiscal discipline precisely when voters are becoming restless about the pace of economic reform.
| Metric | Turkey | Argentina |
|---|---|---|
| Currency YTD vs USD | -19% (to 4.70 TRY) | -34% (to 28 ARS) |
| Policy Rate (June) | 17.75% (from 8.00%) | 40.00% (from 27.25%) |
| CPI Inflation (Jun) | 15.4% YoY | 29.5% YoY |
| Current Account (% GDP) | -5.6% | -4.8% |
| External Debt (% GDP) | 53% (high dollar share) | 37% (rising) |
| Sovereign CDS (5y) | 305 bps | 425 bps |
| IMF Support | None sought | $50bn standby (20 Jun) |
| Central Bank Credibility | Undermined by political pressure | Independent but recently formed |
The Broader EM Picture: Contagion or Differentiation?
The critical question for investors is whether the stresses in Turkey and Argentina represent idiosyncratic failures or the leading edge of a broader EM crisis. The answer so far is nuanced: there has been meaningful contagion, but it has been selective rather than systemic. Countries with weaker external positions, such as South Africa and Indonesia, have seen their currencies weaken and their bond yields rise, while countries with stronger fundamentals, such as Russia (benefiting from oil prices) and Taiwan (benefiting from tech exports), have been relatively insulated.
Brazil sits in an interesting middle position. The Brazilian real has fallen roughly 15% against the dollar in 2018, reflecting concerns about the October presidential election and the trajectory of pension reform. Yet Brazil’s external position is much stronger than Turkey’s or Argentina’s: the current account deficit is a modest 0.7% of GDP, foreign exchange reserves stand at $380 billion, and the corporate sector has significantly reduced its dollar exposure since the 2015 commodity crisis. The Brazilian central bank has been able to defend the currency with targeted interventions without resorting to the dramatic rate hikes seen in Turkey and Argentina.
The contagion dynamics matter because they determine whether the current stress is buying opportunity or the beginning of a broader deleveraging. In episodes of pure contagion, where investors indiscriminately sell EM regardless of fundamentals, the eventual recovery can deliver outsized returns as differentiation reasserts itself. In episodes of broad-based EM crisis, where multiple countries face simultaneous balance of payments pressures, the losses can be devastating and prolonged. The current episode appears closer to the former than the latter, though the trajectory of US monetary policy remains the critical variable.
What the Market Is Underappreciating
Two points are being underappreciated in the current discussion. First, the structural improvements in EM since the 1990s are real and durable. Many countries now operate floating exchange rates, hold substantial foreign exchange reserves, and have largely local-currency sovereign debt markets. These changes reduce the severity of balance of payments crises and give policymakers more tools to manage adjustment. The current episode, while painful, is a far cry from the synchronised EM crises of 1997-98, when fixed exchange rates and dollar-denominated sovereign debt meant that currency depreciation automatically triggered sovereign default.
Second, the private sector dollar debt build-up in EM since 2010 represents a new and poorly understood channel of vulnerability. While sovereigns have de-dollarised their liabilities, corporates have gone in the opposite direction: global EM non-financial corporate dollar debt stands at roughly $3.7 trillion, much of it issued during the low-rate years when it seemed virtually free. A stronger dollar and higher US rates transform this debt from a cheap source of financing into an expensive liability, with balance sheet effects that propagate through the real economy via investment cuts, employment reductions, and potential defaults. This channel is not captured in the sovereign vulnerability metrics that analysts traditionally focus on.
The Policy Dilemma for EM Central Banks
EM central banks facing currency pressure confront a difficult trade-off. Raising interest rates to defend the currency restores confidence and slows capital outflows, but at the cost of slowing domestic growth, increasing debt service burdens, and potentially triggering political backlash. Allowing the currency to depreciate absorbs the external shock more smoothly but risks an inflation spiral, balance sheet damage to dollar borrowers, and loss of confidence in the monetary framework.
The right choice depends on country-specific factors: the extent of dollar-denominated liabilities, the credibility of the inflation-targeting framework, the degree of pass-through from currency depreciation to domestic prices, and the political sustainability of tighter policy. Turkey and Argentina illustrate the extreme ends of the spectrum. Argentina, despite its much larger currency depreciation, has pursued orthodox policy and secured international support, preserving market confidence in its institutional framework even as the real economy suffers. Turkey, by contrast, has undermined its own institutional credibility by making central bank independence a political issue, and is now experiencing a confidence crisis that monetary policy alone cannot resolve.
The lesson for EM policymakers more broadly is stark: in a world of rising US rates and a stronger dollar, the premium on credibility is enormous. Countries that maintain disciplined fiscal and monetary policies, transparent institutional frameworks, and sustainable external balances will weather the storm. Countries that erode these foundations through populist rhetoric, political interference, or procyclical fiscal policy will find themselves on the wrong side of capital flows when the tide turns.
Investor Implications: Navigating EM Stress
For EM investors, the current episode offers several practical lessons. First, external vulnerability metrics matter far more than GDP growth forecasts when the global liquidity environment shifts. Current account deficits, short-term external debt, foreign exchange reserves adequacy, and corporate dollar leverage are the first screens that should drive country allocation in a rising-rate environment. Countries scoring poorly on these metrics, regardless of their growth prospects, should be underweighted.
Second, the distinction between hard currency and local currency EM debt has become critical. Hard currency sovereign debt has been relatively resilient, reflecting the fact that many EM sovereigns have improved their external positions. Local currency debt has been hammered as currency depreciation compounds mark-to-market losses on bond holdings. Investors with a structural long EM position should consider hedging currency exposure during periods of dollar strength, or tilting toward hard currency credit to avoid the double hit.
Third, the corporate dollar debt theme deserves specific attention. EM corporate credit has underperformed sovereign credit in 2018, reflecting the balance sheet risks embedded in the accumulated dollar liabilities. Within EM corporate, selectivity matters enormously: exporters with natural dollar hedges are much less vulnerable than domestically-focused companies whose revenues are in local currency but whose debt is in dollars. This analysis is not yet fully reflected in spreads, creating both risks for the unprepared and opportunities for careful credit pickers.
Finally, the episode reinforces the importance of being positioned for the scenario in which the Fed pauses or reverses. EM assets remain highly sensitive to the US rate path, and any signal that the Fed is reconsidering its tightening trajectory would trigger a sharp reversal in the dollar and a powerful rally in EM. Investors underweight EM on fundamentals should be mindful that the next catalyst for outperformance is as likely to come from Washington as from the EM countries themselves.
Conclusion
The EM stress of 2018 is a reminder that the rules of the global financial system are ultimately written in Washington. When US rates rise and the dollar strengthens, capital flows reverse and the vulnerabilities that accumulated during the easy-money years are exposed ruthlessly. Turkey and Argentina, for very different reasons and through very different channels, now find themselves on the wrong side of this dynamic. Whether the current episode remains contained to the weakest links or spreads into a broader EM crisis will depend primarily on the trajectory of US monetary policy and the evolution of the dollar. For now, the damage is severe but localised, institutional frameworks in most EMs remain intact, and differentiation based on fundamentals is still operating. The investors who navigate this period most successfully will be those who respect the old adage that the dollar is everyone’s currency, but emerging market vulnerabilities are always someone else’s problem, until they are not.
Sources: IMF Press Release on Argentina Standby Arrangement, June 2018; Central Bank of the Republic of Turkey; Banco Central de la Republica Argentina; Bloomberg Market Data; Bank for International Settlements, Global Liquidity Indicators; Federal Reserve FOMC Materials, 2018.
Related Reading: For how Fed tightening ultimately culminated in the late-2018 market crash, see Q4 2018 Selloff: When Fed Tightening Met Trade War Fears. The dovish reversal that eventually relieved EM pressure is analysed in The Powell Pivot: How the Fed Blinked and Markets Roared Back. The early Powell-era tightening that set the stage is covered in The Fed Under New Leadership: Jerome Powell’s First Moves. The broader trade war backdrop is examined in Trade War 1.0: Trump Fires the First Tariff Salvo Against China.
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