Kontent Review

As I predicted last March: "Today Iceland: Tomorrow Turkey, Hungary, Australia, New Zealand, Spain, U.S."... Soon: the Coming US Hard Landing...
Nouriel Roubini | Jun 24, 2006 Last March the current financial markets turmoil had not started yet and investors were still deluding themselves that easy liquidity would allow them to continue their "poor manager's source of alpha" returns (i.e. the easy returns that even mediocre investors can get from simple carry trades when interest rates are low and money is dirt cheap, to use the appropriately sarcastic expression of Raghu Rajan, the chief economist of the IMF).

At that time, I predicted that the then turmoil in Iceland (then the "canary in the mine") would soon transfer to a much wider set of countries with large current account deficits and at risk of a sudden stop. I cited Turkey, Hungary, Australia, New Zealand, Spain and the U.S. 

I then spared from that infamous list - but not in other presentations (see my India paper) - countries such as the U.K., India and South Africa (that also had large current account deficits) only because their overall fundamentals were, at the margin, better and, in the case of South Africa, they were then  benefitting from high commodity prices.

Then, when the market turmoil in emerging market started in May I repeated and fleshed out in more detail my concerns about countries such as Turkey, Hungary, New Zealand, U.S. and other emerging markets with large current account deficits and other vulnerabilities; I argued that that the beginning of that turmoil was not a temporary phenomenon or blip - as investors were still deluding themselves - but the beginning of a more severe and protracted downturn related to a US and global slowdown in an environment of "stagflation lite".

I was not surprised by the virulence of this turmoil because of two reasons: 1) I had been predicting for months now that Three Ugly Bears (higher inflation leading to higher interest rates and draining cheap liquidity, high oil and commodity prices and a housing bubble bust) would hit the US and global Goldilocks and hurt both G7 and emerging market economies; 2) I had written in 2004 a book with Brad Setser on the financial crises in emerging markets in the last decade and we well knew - based on a decade of crises - that large and unsustainable current account deficits may lead to currency and financial crises. Indeed, with the exception of Russia that did not have a current account deficit in 1997-98, every financial crisis in emerging market economies in the last decade (Mexico, Thailand, Indonesia, Malaysia, Korea, Brazil, Argentina, Ecuador, Turkey, Uruguay, Dominican Republic) had been associated - among several other vulnerabilities - with a large current account deficit that led to a sudden stop when a combination of domestic and external shocks hit the economy.

Next, last month when most market commentary was still suggesting that the vulnerabilities of Central and South Europe were inexistent or very modest at best, I wrote a long paper with my co-author Christian Menegatti arguing that many economies in Central and South Europe (a sample of 14 countries from the Baltics all the way to the Balkans and Turkey) were vulnerable to turmoil and a sudden stop as, unlike emerging Asia and emerging Latin America, they were each and all running large current account deficits and had other significant macro and financial vulnerabilities. When I presented a month ago this paper in Istanbul at a conference on Central and South Europe organized by the Turkish Central Bank my concerns were received with skepticism as the conventional wisdom was still that Central and South Europe had both good fundamentals and the protection of EU (and next EMU) membership or soon-to-be membership.

And to elaborate my concerns about Turkey I wrote another paper earlier this month to analyze and highlight in detail the risks and vulnerabilities of this economy. My even larger concerns about the risks of a crisis in Hungary are fleshed out in detail in a new paper co-authored with Christian Menegatti that is available to RGE Premium Content subscribers.

And, indeed, in the last few months the obvious and predictable - if one had the bother to consider and reflect early on on the risks in the US and global economy of a number of serious economic and financial imbalances - did occur. One by one, countries with large current account deficits were hit by financial turmoil in their equity, currency and bond markets. First Iceland, then Australia, then New Zealand, then the US and the US dollar, then Turkey, then Hungary, then this week New Zealand, South Africa and India whose currencies and markets have been rocked this week by news of surging current account deficits. Each one of them has had serious pressure on its currency and its other asset markets, especially equities but now also bonds.

We of course know that current account deficits may be a necessary but not sufficient condition for currency and financial pressure; a whole balance sheet approach to risks and vulnerabiliteis is necessary to assess whether an external imbalance is positive or negative and whether it is sustainable over time. But the predictable response of wishful thinking investors and policy makers in good times is always to down play these current account and other vulnerabilities: every time we are told that this is a good current account deficit driven by high growth, strong investment and high productivity. And every time we are told that a real appreciation of the domestic currency does not represent a fundamental overvaluation or misalignment as the fundamental real exchange rate has appreciated because of a strong and growing economy. This is the kind of non-sense that one hears over and over again until the moment the proverbial "shit hits the fan". And those who warn about such external and financial vulnerabilities are ignored until it is too late.

The knee jerk reaction of many folks at the Istanbul conference on Central and South Europe was to down play my concerns about a region with large current account deficits, fixed exchange rates in most countries, currency mismatches, maturity mismatches given large stocks of short term external debt  relative to forex reserves, large external financing needs, weak banking systems and, in several countries, large fiscal deficits. This was the deadly receipe of vulnerabilities that led to financial crises in Asia and Latin America.

But guess, what? The last couple of weeks have been a disaster for Turkey, Hungary and, now increasingly, other countries in that Central and South Europe region as financial "contagion" is now spreading to the region. To cite a couple of reports this week from Goldman Sachs and Citigroup to their clients:

" The global risk reduction began in May with an unwinding of major macro trades held by hedge funds. By early June, many hedge funds appear to have flattened out their risk, and some asset classes showed signs of stabilisation. But over the last two weeks, the contagion has spread to central and eastern Europe, as a new class of investors – real-money convergence funds – has been forced to liquidate positions in the face of redemptions by investors. While differentiation is likely to remain an important theme, even emerging markets with strong fundamentals are likely to continue to suffer portfolio outflows and asset price weakness. " (Goldman Sachs)

"Is the sell-off taking place in emerging market assets driven by technicals or fundamentals? That is the question investors are asking themselves as they once again observe the flicker of red on trading screens as the week draws to a close. The answer to that question has important investment consequences: A “technical” sell-off implies that the brave can probably make money by buying now, while “fundamental” problems may be considerably more complicated. A month ago, many CEEMEA [Central and East Europe, Middle East and Africa] investors would have stridently answered that fundamentals in the region are sound. However, today — with currencies weakening, economists scrambling to raise inflation forecasts, and central banks hiking rates (we count eight hikes in emerging market economies in the past few weeks) — it is becoming more difficult to shrug off concerns over the impact of a changing backdrop.

Although CEEMEA’s [Central and East Europe, Middle East and Africa] economies are clearly in a stronger position than in the past, there is no doubt that financial market volatility has begun to contaminate domestic economic conditions in a number of CEEMEA’s key markets: South Africa, Turkey, and Hungary are all facing higher inflation and interest rates than they were a month ago. Here, however, all markets are not created equal — just as the rand and lira have diverged from the ruble and real, so too do we find differing vulnerabilities of those economies to a prolonged period of capital flight. Above all, markets are punishing current account deficit countries and are likely to continue to do so; in deference to this we downgrade South Africa to Neutral (from Overweight) and upgrade the less-exposed Poland to Overweight (from Neutral).

Just how much farther this vicious process continues is in large part driven by the “technical” side of the equation. How much capital might investors still pull out of these markets and when might buying return? Reviewing funds flows data this week, we find the answer less than reassuring: Although emerging markets funds have seen $15b of outflows since May 10, this represents just under half of the inflows seen in the prior five months, and 25% of the prior three years. With cash levels relatively low, this selling looks like it could well continue." (Citigroup)

Or, as reported by th FT today under the appropriate headline "Emerging Market Deficit Currencies Renew Slide":

"Emerging market currencies dependent on foreign capital flows to balance their books suffered further sharp falls this week. The South African rand, Turkish lira and Hungarian forint, as well as the New Zealand dollar and Icelandic krona, took a fearful beating in a sign that the market is sharpening its focus. Emerging markets have suffered from a wave of sell-offs this year, the most severe biting from May 10. However, while previous episodes hit all emerging currencies fairly uniformly, now there are clear signs of a developing “pecking order”, in the words of Citigroup.

Currencies backed by weak fundamentals are struggling, while those with a sound backdrop are holding steady. “The last six weeks are likely to mark the end of an era in which the markets were ready to overlook unsustainable policies, large external deficits and precarious political outlooks in a global search for higher yield,” said Thomas Stolper, global markets economist at Goldman Sachs.

External deficits were very much to the fore this week, with South Africa revealing that its current account deficit jumped to 6.4 per cent of GDP in the first quarter of the year, while New Zealand – not an emerging market but with many of the same characteristics – saying its deficit had surged to 9.3 per cent of GDP. Both currencies fell sharply, with the rand slumping 7.9 per cent to a 33-month low of R7.415 to the dollar, capping a 16.9 per cent slide so far this year, and the kiwi falling 1.7 per cent to $0.6058, down 11.1 per cent so far this year. The contagion spread to other deficit nations, with the Turkish lira (current account 6.3 per cent of GDP) tumbling 7.2 per cent to a three-year low of TL1.7075 to the dollar, cementing a 26.3 per cent fall this year amid an ongoing inflation scare, despite intervention to prop up the currency.  The Icelandic krona (deficit 16.5 per cent) fell 1.8 per cent to IKr76.19 to the dollar, down 20.5 per cent since January 1, and the Hungarian forint (7.2 per cent) fell 2.7 per cent to an all-time low of Ft280.80 to the euro, with Goldman reporting that Central and Eastern European-focused convergence funds have been forced to liquidate positions in the face of redemptions by investors.

However, in sharp contrast, currencies backed by strong fundamentals, such as the Brazilian real, Mexican peso, South Korean won, Thai baht and Singapore dollar all held firm. Sterling was the weakest major currency, slipping 1.7 per cent to $1.8204 to the dollar, 0.8 per cent to £0.6879 to the euro and 0.7 per cent to Y211.55 against the yen, following the death of David Walton, the sole agitator for higher rates at the Bank of England.

But the dollar continued its rebound, bouncing to two-month highs as it rose 0.9 per cent to Y116.22 against the yen, 0.9 per cent to $1.2525 to the euro and 1.3 per cent to SFr1.2464 against the Swiss franc. The dollar was a beneficiary of the emerging market chaos, as US-based hedge funds continued to repatriate funds. The greenback was also aided by ever-rising US rate expectations. Rumours yesterday that Ben Bernanke, the chairman of the Federal Reserve, has asked bond dealers what the reaction would be to a half-point rate hike this Thursday led the futures market to price in a 12 per cent probability that the Fed will, indeed, hike by 50 rather than 25 basis points. A total of 50 points of tightening to 5.5 per cent by the August meeting is now 80 per cent priced in. However, with the US nursing a current account deficit of 6.4 per cent of GDP, some saw warning signs in this week’s sell-off. “We believe it is somewhat bizarre that whilst the market chooses to sell the rand and kiwi because of their currrent account deficits, it chooses to buy the US dollar,” said David Bloom, currency analyst at HSBC. “What one must realise, longer term, is that these currencies are flags, signals for how the dollar will trade once the economy softens and the market stops looking for ever higher rates.”

So, what about the US dollar? The last quotation from David Bloom from HSBC is exactly on the mark. It is indeed bizarre and weird that the US dollar has been recently strenghtening while investors are dumping the currencies of countries with large current account deficits as the US deficit is much larger both in absolute and relative terms. Indeed, the US dollar started to sharply fall in April when the force of gravity of a larger current account deficit stopped being controlled by anti-gravitational forces such as increasing interest rate and GDP growth differentials between the US and Europe/Japan. Since then, the inevitable fall of the dollar has temporarily stopped and has partly reversed for a few reasons: the Fed has signalled that it is not done with tightening while the BoJ was posponing the moment it will drop its ZIRP; and the turmoil in emerging market economies and increased global risk aversion has led investor to seek the relief of safe haven assets such as US Treasuries. But the US stagflationary slowdown together with a still growing current account deficit will soon sink the US dollar. The US and it currency will be the proverbial "last shoe to drop" for all the usual reasons that give the US the "extraordinary privilege" of sustained external financing and reserve status. But since, the size of the US and its imbalances is not that of a small emerging market "shoe" but rather a massive boulder eventually driven down the mountain by fundamental gravitational forces, once this boulder starts rolling down the avalanche will get real nasty for the US and all the world.

All this while the official Bernanke and Fed and US Treasury and CEA view is that the US current account deficit is not a deficit but "a capital account surplus", that this deficit has little or nothing to do with the US but is caused by a "global savings glut" and that US fiscal deficits have no effects on the US current account deficits. At least some wiser minds at the Fed - such as Tim Geithner and several other sensible Fed governors and Fed presidents - recognize and worry about the unsustainability of the US current account deficit and of the US fiscal deficit and have publicly expressed their concerns about it. And, luckily for the US, Tim Geithner very succesfully managed - both at the US Treasury and next the IMF - all the emerging market financial crises of the last decade. So, the knowledge and wisdom and expertize of this "supremo crisis manager" will come handy when the biggest emerging market of all - the US being the biggest net borrower and net debtor ever - will experience its own nasty financial crisis. The 1998 LTCM mess will then look like a minor ripple in the sea compared to the "perfect storm" that could engulf the US and the global economy once the US policy recklessness and blissful ignorance of the risks we are facing triggers an ugly hard landing.

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Turkey’s Risks and Vulnerabilities in the Current Market Turmoil
Nouriel Roubini | Jun 19, 2006 What explains the recent turmoil in Turkey’s financial markets? How much is it due to changes in global or external conditions as opposed to domestic vulnerabilities? Will Turkey weather the current storm or is it at risk of experiencing another serious financial and real economy crisis? These are complex questions that require a detailed analysis that I have done in a new paper that is available here to RGE’s Premium Content subscribers. I will summarize some of the points of this paper in this blog. See also a recent blog by Brad Setser who discusses the turmoil of Turkey in the context of the turmoil broader pressures on a wide range of economies and emerging markets.

As a starting observation, note that one feature of the recent turmoil in global financial markets is that a wide range of emerging markets – both those with greater vulnerabilities (such as current account deficits and other imbalances) and those with lower vulnerabilities (such as current account surpluses) – have been hit. Indeed, common global factors (the risk of global slowdown, the risk of increased inflation leading to tighter monetary policies in the US and other G7 economies, and an increase in the international investors’ risk aversion) have led to a sell-off in currency, equity and bond markets of most emerging market economies. So, is not just Turkey to have been hit by this financial turmoil; most emerging markets have. However, investors have partly discriminated among these various economies based on their individual vulnerabilities. In fact, the country that has had one of the largest falls in its currency value and in its stock market in recent weeks has been Turkey that also has one of the largest current account deficits among these emerging markets and several other significant vulnerabilities.  (see also my recent paper with Christian Menegatti on vulnerabilities in a large sample of 14 Central and South European emerging market economies) 

Indeed, Turkey is not just at risk because of the current account deficit that makes its economy vulnerable to a sudden stop. It is true that, after the 2001 crisis, Turkey has done a lot to reduce its macro and financial vulnerabilities: a primary surplus of over 6%, a sharp reduction of its fiscal deficit, a fall of inflation to single digit levels and a sharp pick-up in economic growth, a clean-up of its crisis-ridden banking system, privatization and opening to FDI, a build-up of foreign reserves, a flexible exchange rate, a successful IMF program,. But significant vulnerabilities - both at the aggregate and sectoral levels - remain: the short maturity of its public debt; still meaningful, if lower, currency mismatches at the aggregate level; a banking system where credit growth and maturity extension were becoming excessive; an increasingly overvalued currency (before the recent sell-off) that worsened the external balance; and now rising political tensions including a partly botched succession of the central bank governorship, rising conflict between the secular “deep state” plus the military and the islamist government, uncertainty about the timing and outcome of the presidential and parliamentary election, now even the specter of political violence; and the negotiations about EU accession going at a slowing pace and encountering a number of difficulties, including a harder stance by some in the EU on the issue of eventual Turkish accession. Also, the early adoption of a formal low inflation target for 2006 (5 to 7% range) while inflation was inertially above the target and currency overvalued has now created a monetary policy dilemma: with the currency sharply down, given the recent turmoil, the creeping increase in inflation has sharply accelerated in May. Thus, an increase in policy rates – the first in years – became now necessary (with a sharp 175bps increase in the policy rate to a 15% level) but this hike risks to lead to a slowdown in growth at the time when the political system expects continued good economic performance. The central bank is now trying to do the right thing, show its independence and tighten as necessary to stem inflationary expectations; but the costs of such tightening on growth may become painful.

The paper analyzes in detail both the macro and the financial vulnerabilities of Turkey at the aggregate and sectoral levels. Macro imbalances remain significant with a large current account deficit and a fiscal deficit that, while lower, is still significant; while the current account deterioration was partly driven by investment – some of it housing rather than tradeable goods investment fueled by a credit boom – it was also partly due to an overvalued currency. The financing of these imbalances has also some worrisome features, both at the aggregate level and at the sectoral level of public sector, financial institutions and corporate sector: currency mismatches remain significant (at the government and corporate sectors level) in spite of a process of liability de-dollarization; maturity mismatches are important (in the government and financial sector) and external financing needs remain large relative to foreign reserves; there has been greater reliance on debt rather equity for the financing of the current account even if FDI is rising; and while solvency risk is limited both at the aggregate and sectoral levels, debt ratios are still high (if falling) for the country and the public sector.

Hopefully, given its overall good macro and financial fundamentals, Turkey will weather this storm with limited damage. Certainly a flexible exchange rate help to let the financial steam get off the pot via a currency adjustment as opposed to a fixed exchange rate where the pot has a tight lid that entraps the boiling steam inside the pot, only to have the entire pot explode in a currency crisis once the pressure becomes too much to contain. But the financial conditions are most delicate in a worsening global environment with high oil and commodity prices, the risk of a global slowdown, rising global interest rates and rising international investors’ risk aversion. A country like Turkey that has a large current account deficit and even large external financing needs is highly vulnerable to a sudden stop of international capital flows. If the sudden stop is modest, the country may still be able to finance a current account deficit close to the large expected value for 2006. But if the stop were to be more significant, it would force a current account adjustment that would be painful as it would be associated with a significant slowdown of growth. Also, the fall in asset prices – equity, local currency debt, currency value – has been severe and inflicting sharp losses to foreign investors that had only recently ventured in the Turkish market; a mood of near panic was thus setting in recent weeks among such investors that only lately realized the risks of being stuck in a relatively illiquid range of markets.

Thus, sound policy choices are essential in this period of market turmoil. Maintaining a large primary surplus will be essential, especially as concerns about fiscal slippages may increase as elections become closer; and continuing the reforms required to sustain fiscal discipline over the medium term will be important. Monetary policy should be targeted to contain inflationary expectations and actual inflation trends even if this implies a slowdown in economic growth.  However, strict adherence to the inflation target may be counterproductive; given the current currency shock some increase in the inflation rate above the formal target is inevitable and needs to be partly accommodated; overreacting and trying to achieve the strict inflation target would require over-tightening that would hurt more than help the economy. And the recent adoption of a formal inflation target ended up being a tactical mistake; given the risks of financial and currency shocks the country may be better off with a more informal inflation targeting regime rather than adopting a weakly credible formal inflation target. Forex intervention should be used only to smooth excess currency volatility; systematic one sided intervention would be counter-productive and monetary policy – rather than forex intervention – is a better tool to address financial pressures.  In conclusion, very savvy monetary and fiscal policy making – together with less political noise - will be required to stem the growing financial pressures and avoid more severe market developments that would eventually negatively affect the real economy. The central bank is now showing its independence and tightening as necessary to stem inflationary expectations; but the costs of such tightening on growth could become significant in the near future.  Indeed, it is likely that the growth rate in the next few quarters will slow down by at least 1% given the combined effects of rising short term and long term interest rates and falling equity prices.  And further growth slowdown cannot be ruled out if external/global conditions worsen (as it is likely), political noise increases and financial market turmoil continues.