Rising political risk in Turkey a reminder of EM vulnerability
On Monday morning, the Turkish lira, one of the most vulnerable emerging market (EM) currencies, fell more than 5 per cent against the US dollar before recovering slightly to finish the day’s trading session down 3.4 per cent - its worst one-day fall since the 2008 global financial crisis.
Turkey has been a focal point for concern for financial markets ever since the US Federal Reserve signalled in May 2013 that it planned to end its programme of quantitative easing (QE). Investors have been particularly concerned about the country’s large current account deficit – still close to 6 per cent of gross domestic product - and the lack of inflation-fighting credibility on the part of Turkey’s central bank.
Yet for much of last year, investors were willing to turn a blind eye to these vulnerabilities, partly because of the complacency generated by heightened expectations that the European Central Bank (ECB) would launch its own QE programme, which it eventually did in March.
However the Justice and Development Party’s loss of its parliamentary majority in a general election on Sunday has knocked sentiment, which had already deteriorated in the run-up to the ballot, with the lira down 18 per cent against the US dollar this year.
The escalation in political risk is making investors a lot more sensitive to Turkey’s economic woes.
This is a reminder that EMs are more vulnerable to political instability than advanced economies, largely because political risk is still deemed to be a more important determinant of both investor sentiment and the creditworthiness of developing economies - even though the economic fundamentals of many EMs are now stronger than those of most advanced economies.
Brazil, which has long suffered from severe fiscal and structural economic problems, saw the yield on its local 10-year bond collapse from more than 17 per cent at the end of 2008 to less than 10 per cent by the end of 2012 partly because of the political stability it enjoyed under its popular former president, Luiz Inacio Lula da Silva. Now that political conditions have deteriorated significantly - Lula’s successor, Dilma Rousseff, has been severely wounded by a high-profile corruption scandal and a collapse in growth - investors are suddenly paying more attention to Brazil’s troubles.
Conversely, countries which have a good “reform story” to tell are better able to mask their economic vulnerabilities - or are at least given the benefit of the doubt by investors. India, which suffers from deep-seated structural and institutional problems, is benefiting from investors’ faith in Narendra Modi, its charismatic prime minister, who has pledged to implement far-reaching reforms despite making only limited progress in his first year in office.
Investors in EMs also prize political stability over political governance - particularly when it is accompanied by buoyant growth. While mainland China is the most prominent example, many investors breathed a sigh of relief when six months of debilitating protests in Thailand culminated in a military coup in May last year.
Yet it would be wrong to claim that politics is the most important determinant of sentiment towards EMs.
The economic fundamentals of many developing economies have improved significantly over the past 15 years or so. Countries like Chile, Poland and even oil-dependent Malaysia – all three of which enjoy upper investment grade credit ratings - are much less affected by political uncertainty because of the strength of their policy regimes.
Just as importantly, the ownership structure of EM debt has changed dramatically over the past decade or so. The bulk of EM local bonds are now held by domestic and foreign institutional investors who have a deeper knowledge of developing economies and are more likely to take a longer-term view.
Not only have the underlying fundamentals of most EMs improved but developing economies benefit from a more mature and committed investor base.
It is also difficult to disentangle the determinants of sentiment towards EMs.
Turkey may be suffering a bout of political turmoil but it is also one of the EMs most at risk from a tightening in US monetary policy because of its heavy dependence on speculative capital inflows to fund its current account deficit.
Political risk clearly matters more in EMs - particularly in the case of countries with weak fundamentals - but it’s just one of several factors shaping sentiment and determining sovereign creditworthiness.
The stronger the fundamentals, the less worrisome the politics – a lesson Turkey would do well to heed.
Nicholas Spiro is managing director of Spiro Sovereign Strategy