Learning From Meltdown Of Turkish Currency

Posted: Nov 13, 2018 10:42 AM
Learning From Meltdown Of Turkish Currency

I've written about the severe loss of value for investors in the Turkish equity markets here.

And I've written about the role that lack of financial resiliency and the presence of high political fragility have played in the loss here.

Now, let's look at the currency side of things. There are a few scenarios which tend to cause currency crises. One of the most vulnerable situations for a country is when it has done a lot of borrowing in a currency other than its own. This creates an uncontrollable risk problem should the currency that they have borrowed in (usually the dollar) go up in value.

When Donald Trump won the presidential election in November of 2016, my mind immediately turned to the effects of a strong dollar. I wrote a longish article at the time arguing that, despite fact that the immediate emerging market sell-off was believed to be due to fears of protectionism, the data did not support that idea, because the nations which sold off the most were not necessarily the ones slated for a change in trade policy, and the ones which were slated to have their trade agreements torn up were not necessarily the ones performing badly.

There's a part of that article which I wrote but did not publish. It made the article too long. It focused on the issue of emerging market countries which borrowed in dollars. That issue has become a major one in the case of Turkey this year, so I decided to pull it off the hard-drive and publish it now.

Here's what I said about the sell-off in certain emerging market countries in late 2016:

"Since the total returns of other countries are generally calculated in a way which also includes the appreciation/decline in their currencies in addition to the return on the index in its own domestic currency terms: then a strong dollar will automatically tend to detract from the overall return of stock indices in countries which are denominated in the currencies which the dollar strengthened against.

But that is not the only effect of a strong dollar on EM. The underperformance of the EM currencies is not large enough to explain the underperformance of the indices on a total return basis. In other words, investors lost money in EM in the stock markets on top of the losses in the currency markets.

There must be something else going on. There is, and it also involves a strong dollar, but in a most indirect way. Many emerging market countries have been borrowing money in dollars rather than in their own currencies (for more on this just Google 'Yankee Bonds'). These countries have noted that interest rates for the dollar have been extremely low. Why pay sky-high Peso interest rates when you can pay financially suppressed dollar interest rates? Well, one reason not to do that is that you pay a price for that lower rate: you add currency risk to your financial outlook. If you borrow dollars and have to pay interest in dollars and eventually have to repay the principle in dollars, then you are running a risk that the dollar will go up in value. You'll have to pay back dollars which are worth more than the dollars you originally borrowed. If you are transacting business in, say, the Mexican Peso or the Brazilian Real and those currencies plunge in value next to the dollar, you'll have to take your Peso or Real denominated profits and use those devalued currencies to buy expensive dollars to make your debt service payments. If your currency declines in value ten percent in relation to the dollar, then you've basically increased your Yankee Bond debt by a tenth. Ouch.

So the Yankee Bond hypothesis makes sense on the surface, but does it hold up to the data? It certainly held up to the first data test we applied to it: Latin America significantly underperformed emerging Asia, and Latin America has many more Yankee Bonds. Emerging Asia learned its lesson during the 'Asian Contagion' of the late '90s and since then has been very careful about its debt levels and particularly to its exposure in the area of foreign exchange. It lived through a strong dollar patch (barely) and it did not want to go through all of that again. Latin America has yet to learn such a lesson.

We decided to run a series of analyses which look at correlations between individual countries' dollar denominated debt (we didn't include the US in this: because US debt is, of course, almost entirely denominated in dollars, but so are its other economic activities). We found that for emerging markets, there was a negative correlation between USD debt as percentage of GDP or as percentage of total foreign reserves and performance of the country total return. In other words: the more USD debt they had, the more they under-performed the rest of the EM world.

…Dollar liability exposure is a significant factor in explaining an individual country's underperformance. But clearly it is not the only factor. For example, Chile's returns have been significantly higher than one would expect given very high levels of Dollar liability exposure, but copper export is a major source of revenues for Chile and copper has appreciated in value significantly since Trump's election. In other words: part of Chile's performance is caused by appreciating copper prices. For another example, Russia was the single best performer in the two weeks following the election, but expert opinion finds Russia much more likely to be freed from financial sanctions under a Trump administration, given his Russo-phile sympathies in contrast to Clinton's 'blame Russia first' tendencies. In other words, Russia's appreciation appears to be much more driven by shifting diplomatic winds in its favor than by any other factor."

That analysis, written in early December of 201, anticipates the problem that we've seen with Turkey. As the dollar surged…

…Turkey was forced to pay back dollar denominated debt at higher value. Same for Brazil, which I mentioned in Dec. 2016, which was also a very weak performer earlier this year (though that also involved a certain amount of political risk).

The foreign currency debt risk is substantial, but since it involves a fairly obscure and technical aspect of finance, it only seems to get attention after it has imposed pain on investors when the damage is already done. How to estimate the risk which comes from this needs a good deal more research, and is a topic too large to deal with in this article. Keep watching this space for more on currency risks, such as in emerging markets.