EM squeezes and the contagion effect

Mahesh Sethuraman

Singapore Sales Trader

Contrasting tales of two classic EM squeezes:

The year has seen two emerging market currency squeezes, one in the Argentine peso (down 47% in the last six months) and the other in the Turkish lira (42% in the same timeframe). What is remarkable about the two routs is that while the fundamental cause of the financial crisis in both countries is similar, their responses have been completely divergent. Argentina followed the conventional response to an EM crisis – raise interest rates, adopt austerity, and seek International Monetary Fund aid. Turkey, meanwhile, is trying the impossible with pretty much no sign of reforms in sight. This underlines two important takeaways; firstly, and as Mohamed El-arian enumerates in his superb piece at FT, the crisis has moved beyond asset prices continuously adjusting to new economic developments into the crisis-of-confidence zone and the severity is further exacerbated by the resultant lack of liquidity. Two, the Turkish crisis could get much worse… even from the current baseline.

Source: Bloomberg
Argentine Peso-29.07-35.12-47.49
Turkish Lira-19.66-30.80-42.60

Monday’s spike in Turkish inflation to 17.9% led the Central Bank of Turkey to hint at an imminent rate hike at its September 13 meeting. While that is a deviation from the central bank’s extant (and dangerous) norm, it is quite likely to be much less than the situation warrants, as Erdogan may not be pleased. A token gesture here and there might provide a temporary blip – Germany offers support, Qatar enters a trade deal, central bank hikes rates, etc. – but until we see real signs of fiscal discipline like inflation-taming rate hikes, perhaps some form of capital control, and ideally reaching out to IMF for aid – the pressure on the lira will not wane.

The contrarian theories, which hold that every past EM crisis eventually proved to be a great buying opportunity for real money investors with holding power and the strategic geographic location of Turkey will ensure US (and other western allies) prop up their support for Turkey – have a lot of merit. But given the current scale of the crisis and the incredibly woeful responses so far, these factors are not substantial enough grounds for a recovery narrative.

Contagion effect:

The fortunes of TRY are barely the headline indicator of the Turkish crisis’ consequences. The contagion effect, while substantial, has so far been contained to specific EM economies and to a small extent on the euro area. The longer Erdogan takes to come out with credible corrective actions, however, the more the contagion will spread into the EM space – and this is just the surface level impact, or the ‘known known’.

What about the known unknowns:

  • If Turkey defaults, what is the scale of the shock to the European banking system (even though only a handful of banks have direct exposure to Turkish credit)? And where would such a shock leave the European Central Bank’s gradual tightening?
  • What will the ramifications of Turkey’s potential default be on other EM currencies with sizeable current deficits? These, after all, are already swelling up as the domestic currencies weaken further on the Fed’s policy normalisation?
  • Will the escalation of crisis lead to a period of sustained USD strength and would that exacerbate the EM crisis far beyond the direct contagion effects?
  • What would the Fed do in the face of sustained USD strength? US asset prices won’t be insulated from an EM crisis if it crosses a certain threshold. Will they slow down the pace of winding down QE?
  • The trade war rhetoric, despite a lot of drama, has been relatively contained so far. But what would President Trump do if the USD appreciation theme sustains closer to the US mid-term elections?
  • Then come the third-order ripple effect of the ‘unknown unknowns’, where Black Swan strategies will likely enjoy their time in the sun.

Day of reckoning?

The escalation of the Turkish crisis will coincide with a dearer USD on Fed normalisation and Trump escalating the US-China trade war. This could set the stage for a sustained spell of contagion risk across EM economies with some spillover impact on the developed economies. The September 13 Central Bank of Turkey meeting could prove to be a day of reckoning for the EM space at large as disproportionate policy tightening (to the scale of inflation) could lead contagion effects to escalate.


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