NN IP: The contrast between Argentina and Turkey

Looking back at the past months, we strongly believe that the combination of adverse exogenous factors explains most of the correction in EM assets. The steady Fed re-pricing since September, the rising oil price since February and the appreciating dollar since mid-April created an environment in which the fundamentally weaker countries were forced into serious policy adjustment.

This, in itself, is a healthy process, if the adjustment quickly reduces macro imbalances and leads to structural improvements in the economy. In the case of Argentina, we think the market pressure has forced the authorities to speed up reforms and correct policy mistakes, such as the monetization of the fiscal deficit that has been the main cause of the structurally high inflation rate. With the assistance of the IMF (politically a very sensitive topic in Argentina since the devaluation of 2001), the Macri government has a good chance of materially strengthening the economy and reducing its vulnerability in the coming years. The main risk is political: will the economic benefits of the current policy adjustment come in time before the 2019 general elections to secure the continuity of reformist policies? For now, we are keeping our positive stance towards Argentine assets and see substantial upside potential after the sharp correction of the past months.

Like Argentina, Turkey has also been forced into policy adjustment. However, Tukey typically only tightened monetary policy when market pressure simply became too painful. The 10 percentage points of policy rate hikes since the end of May can be called dramatic and – in combination with the 25% exchange rate depreciation – will undoubtedly lead to a growth adjustment and some narrowing of Turkey’s current account deficit. But it will not lead to a structural decline in the country’s imbalances. For this, we need to see real reforms that create a better investment climate and boost the confidence of Turkish citizens in their domestic financial system. The latter is key in bringing about a solid growth in bank deposits and thereby reducing the offshore funding of Turkish banks.

The latest news from Turkey, including the appointment of President Erdogan’s son-in-law as the new Finance Minister and the changes in central bank regulation that point to more government interference, suggests that even after the elections a more reformist or economically orthodox policy approach is not in the cards. This means that Turkey remains as vulnerable as it has been recently. With less exogenous pressures the market can recover, but once the environment for EM starts to deteriorate, Turkey is likely to be the number-one problem country again.

Room for recovery

While we think that the risks of continuing Fed re-pricing, a higher oil price and an appreciating dollar remain substantial, we also believe that the correction in EM assets and the policy response in most countries has been large enough to see more balanced risks for the EMD categories over the coming quarters.

The strong recovery in EM debt in the past week, coinciding with a decline in the US dollar index, is encouraging. It shows the sensitivity of the asset class to the dollar, but it also suggests that there is room for a sharp recovery if investors believe that the period of dollar appreciation has ended.

We want to stress that we see the correction of the past months as a selective shake-out due to external headwinds and vulnerabilities in a small number of emerging economies, not because of large fundamental problems in the wide EM universe. The aggregate external financing needs for EM are manageable and Chinese financial system risks have come down a lot in the past years.

The US dollar appreciation has been the main negative factor, together with the oil price and Fed policy normalization. At the same time, the trade protectionism noise created by the Trump administration has affected sentiment towards all EM assets. A full-blown trade war is still not what we expect, which should mean that longer-term EM growth prospects have not changed materially. So far, the Chinese exports that have been hit by new US tariffs account for only 2% of the country’s total exports. In our view, it is premature to draw big negative conclusions for the Chinese export sector, the Chinese economy and EM growth overall.

More important for the medium-term market prospects is what has happened to EM financial conditions. We have seen a clear tightening since April, but because the material impact of the market turmoil has been limited to a handful of vulnerable economies, the overall EM financial conditions score (composed of changes in policy rates, interest rate expectations, money supply growth, fiscal policy and capital flows) is not that negative yet. Indeed, it is only slightly worse than just after the November 2016 election of Trump (see chart). It is remarkable that since mid-May, we have seen only a modest deterioration. It is important to mention in this context that EM credit growth ex-China continues to strengthen. This should prevent a sharp decline in the overall EM growth momentum, which should ultimately help fiscal accounts and overall creditworthiness in the emerging world.