Why Turkey and Argentina do not pose a contagion risk to other emerging markets

Concerns are clearly building once more around Turkey and Argentina, which are again experiencing a bout of currency volatility. The chart below highlights the turbulence seen in the Argentinian peso and the Turkish lira this year, particularly when compared to the JP Morgan Emerging Markets Currency Index, an index of major emerging markets (EM) currencies.

With economic growth seemingly faltering and fears of an eventual US recession, investors may be feeling more jittery than usual about the possibility of contagion to the rest of EM.

We, however, think any such concerns are overblown. Turkey and Argentina are not the symptom of a wider problem in EM; they face some rather unique problems in both the economic and political spheres. Sentiment aside, we see no reason for investors to extrapolate market performance in these two troubled economies to the rest of the asset class.

Trying times for Argentina and Turkey’s currencies

Source: Thomson Datastream, Schroders Economics Group. 26 April 2019

Macroeconomics is important…

The two countries' woes have some similarities. Fundamentally, inflation is a big concern in both economies and one which the respective central banks have been struggling to stay on top of. Inflation in Argentina climbed to 54.7% and in Turkey it was 19.7% in March. These levels are far above the EM average and have been climbing at a time when inflation in the rest of EM has been flat or falling.

What is also apparent though is that nowhere else in EM has this problem. Inflation is well under control thanks to a mix of global and domestic factors everywhere else, and so investors would be hard pressed to find even an echo of Turkish or Argentinian policy concerns in this space.

Inflation is a big, but unique problem for the troublesome two

Source: Thomson Datastream, Schroders Economics Group. 26 April 2019

Another challenge for Turkey is that it has very little firepower left to defend its currency. Foreign currency reserves are very low relative to most metrics of adequate reserves.

There are a number of ways to assess this; whether the country has enough reserves to finance a few months of imports, or to self finance maturing hard currency debt (debt denominated in the currency of a country that is viewed as historically politically and economically stable, such as the US dollar or Japanese yen) for example. Turkey looks objectively terrible on all of them (and stated reserves may in any case be inflated by the use of short-term borrowing!).

…but so is policy credibility

Expectations play a crucial role in macroeconomic models and in financial markets. If policymakers are not trusted to take the necessary measures in the future, even if they are doing the right thing now, consumers, firms and investors will take fright.

The belief that central banks are unwilling or unable to deal with inflation, for example, will lead households to move their money out of the currency to prevent losing the value of their savings. Firms will price in the expectation of further large increases in costs, perpetuating the cycle. Investors will demand a greater return to compensate for the risk that their investments will be eroded by inflation.

In both Turkey and Argentina, there is reason to fear for the path of policy. In Turkey this is a familiar story by now; President Erdogan is vehemently opposed to more conventional monetary policy and to that end has leant on the central bank on repeated occasions. That the central bank has been stepping away from a previous commitment to tighter interest rate policy, despite the pressure on the currency, served as affirmation of this perception.

The appointment of his son-in-law as finance minister also did nothing to assuage market fears, particularly after lacklustre PowerPoint presentations, most recently at the IMF meetings. There is little sign so far that policy will take the right direction in Turkey.

In Argentina this is something of a new tune, at least under the current president. President Macri was elected on an economically traditional reform agenda, initially cheered by markets.

However, the turnaround has taken longer than expected, and the electorate have begun to tire of promises of jam tomorrow. Former President Cristina Fernández de Kirchner has begun to climb in the polls, with elections due this October. The return of Kirchner, and populist policy, seems an increasingly real threat.

Political challenges for Turkey and Argentina then are clearly significant, if not insurmountable. The good news for the rest of EM though is that this is very clearly country specific risk, and there is little reason for it to lead to contagion beyond the hit to general EM investor sentiment.

It does however point to a need for investors to monitor political developments, and for policymakers to maintain credibility; both in talking the talk and walking the walk.