The world held its breath on September 18th. Would Ben Bernanke taper? Investors around the globe breathed a sigh of relief when he postponed slowing down the Fed’s bond buying programme. The “hot money” honeymoon continues.
This sense of padded comfort is misleading. The flow of hot money is aimed not at long-term investments but at short-term profits. It will, at some point, cool down, and the emerging market economies must anticipate this and adjust accordingly. Economies, which have developed dependencies on U.S. inflows to fund their consumption and investment, now face painful transitions. The wake-up call came in May when rumours circulated that the Fed would taper its bond-buying programme in the fall. What was the result? A global emerging markets sell-off ensued, currencies took a hit and current account deficits were gravely exposed.
Let us focus on Turkey and Brazil, which seem to be among those most exposed by this tapering scare. It is worth looking into why this is the case and what steps the countries’ respective governments can take to ease the impact.
According to The Economist, is most vulnerable to a freeze in foreign capital inflows. Turkey’s addiction to hot money is a problem. As long as interest rates are low in the United States, investors will continue to chase high-yield Turkish bonds and assets. But these are short-term investments and can easily be withdrawn. How should Turkey tackle this problem of being at the mercy of the whims of foreign capital?
1) Save money. By the end of 2010, Turkey was growing at a rate of 9.2% and even though the good times were rolling, the savings account remained closed. The ruling AKP party continued to spend lavishly on welfare schemes and infrastructure projects. This had a huge impact on widening its debt, deepening its deficit and devaluing its currency.
2) Diversify financing. An alternative way of raising money could be to open up the local convertible bond market. Despite legal and regulatory hurdles, it seems that those pursuing this goal may soon make headway. Convertible bonds are beneficial for both corporate bond issuers and investors. The investor can opt to convert into taking new shares in the issuer’s company, and the issuer can, as a result, shrug off debt payments. This interchangeable dynamic between bonds and stocks in a convertible security provides the flexibility needed in an uncertain market. Sceptics, however, are unsure investors will opt to take shares and will rather settle for traditional bond investments due to the world’s weak equity market. However, strong IPO openings this year have suggested otherwise.
3) Cool off the economy. Ruchir Sharma, head of emerging markets at Morgan Stanley, rightly compared Turkey to a sports car. When it revs its engine, it “takes off.” The problem is that it has overheated. A stream of foreign-financed credit to a relatively young population is a recipe for consumer binging. Domestic consumption must be reined in by steadying interest levels to tackle rising household debt and kick the public out of the cheap consumer credit high.
What about Brazil?
In 2009, The Economist published an illustration of the Cristo Redentor taking off. Four years later, they showed it crashing down. Is the symbolism exaggerated? Perhaps. But its underlying message it not wholly inaccurate. With the global commodity craze coming to an end, Brazil’s economy is becoming seriously exposed. Three main factors need to be addressed.
1) Brazil’s spending patterns are uneven and illogical. This needs fixing. Brazil spends 11.3% of GDP on public pensions, despite having a very young population, whilst only 1.5% goes to infrastructure investment. This needs readjusting if sustainable growth is to be achieved.
2) Brazil needs to also find new ways to attract private investment in its blighted infrastructure. President Dima Roussef has recently passed a bill which re-authorizes the auctioning of port projects to foreign companies. This is a promising step.
3) More needs to be done to level the playing field for foreign investors. The bankruptcy code for foreign creditors, for example, is opaque and invites state intervention to protect local companies. While this code does not fully remove collateral for foreign creditors, the recovery plans can include payment alternatives, where secured creditors receive an amount lower than the collateral value. More needs to be done to review the loopholes in this law and create an environment where foreign creditors get a fair deal.
The worst case scenario for Turkey and Brazil is that they become victims of a crisis akin to the Asian financial crisis. The question is, can Turkey and Brazil survive this downturn? It will be challenging. But both countries have a strong sense of national pride, an assertive middle class and a huge reservoir of human capital to tap into.