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.

Enlarge
Source: Bloomberg
1M3M6M
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.

You can access both of our platforms from a single Saxo account.

Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/legal/disclaimer/saxo-disclaimer)