The weekend gave Turkey and the world's financial markets a much-needed breather after the country’s currency experienced a week of intense weakness and dizzying volatility But it also builds expectations among traders of a decisive policy initiative that, if it proves insufficiently impressive, could lead to even more market disorder and, with that, the potential for wider economic and financial dislocations.
There are seven main issues that traders, investors, governments and central banks should keep in mind.
No. 1. Beyond foreign exchange
Even though the focus these days is on how much the currency moves, Turkey’s predicament extends well beyond the foreign-exchange market. Currencies overshoot quite often, especially in emerging economies, and not just on the way down. Such violent moves are often neither the driver of the underlying turmoil nor the end result. They are best thought of as a highly visible indicator, and one that can also contain important forward-leading signals.
No. 2. Imbalances have been around for a while
By persistently stimulating its economy through credit and, more recently, the budget, Turkey has accumulated twin deficits –-- that is, imbalances in both its public-sector budget and in the current account of the balance of payments. Funded by external borrowing and capital inflows, these have helped boost investment and growth. But the incremental income generated has been insufficient to curb the debt burden.
No. 3. The external environment has turned less hospitable
Although financing needs remain considerable, Turkey is now facing a more challenging external environment. This will not change any time soon. As a result, inflows have become less abundant and more expensive.
When it comes to global liquidity, the world is in the midst of a transition away from a protracted period of loose financial conditions engineered by central banks. Some of the large monthly injections of cash resulting from central banks’ asset purchase programs have either stopped (as in the case of the Federal Reserve) or are tapering (European Central Bank). The short end of the U.S. yield curve has risen as the Fed has hiked rates several times, a policy path that it is unlikely to abandon any time soon with the continuing rise in inflation. And with policy, growth and rate differentials favoring the U.S., the likelihood of a further general strengthening of the dollar is considerable.
This has affected technically more fragile asset classes, especially emerging markets, which have experienced considerable capital outflows. Local- and foreign-currency denominated bonds and, therefore, currencies and risk spreads, have come under pressure.