Turkey teaches new generation of investors some old (and painful) lessons

“The collapse of the Turkish lira and the threat of contagion across emerging and also developed stock and bond markets look to be catching many investors off guard but this is just an example of what the economist J.K. Galbraith once termed ‘the extreme brevity of financial memory, because we have been here before,” says Russ Mould, AJ Bell Investment Director.

“The current Turkish situation bears all of the hallmarks of the Asian and Russian economic crises of 1997-98, which finally spilled over into the West and led to a short, sharp bear market in developed market share prices, while Turkey last got into serious trouble in 2000-01 when the lira collapsed.

“That crisis followed a period of rip-roaring growth funded by a rising budget deficit and rampant overseas borrowing that left the economy overheating – which all sounds very familiar today, given Turkey’s $200 billion-plus of overseas debt, inflation in the high-teens and a current account deficit that represents nearly 6% of GDP.

“When the smash came in 2000, the Turkish lira halved in value and GDP plunged while unemployment and inflation soared. This all happened under the supervision of the International Monetary Fund (IMF), which offered more than $20 billion in financial assistance between 1999 and 2003, in return for a package of interest rate hikes and fiscal austerity.

“This economic disaster paved the way for the 2002 general election victory of the newly-created Justice and Development (AKP) Party under Recep Tayyip Erdogan, so no investor should be surprised by how Mr Erdogan is now responding.

“His rise to power was at least partly fuelled by public discontent with the IMF’s version of economic orthodoxy, so it is no wonder he is determined not to follow the path of higher interest rates and lower government spending now.

“Given that he also called interest rates ‘the mother of all evil’ in a speech last May, raising the question of whether he wanted to pay interest and repay overseas loans, let alone could do so, all it needed was some unexpected development to puncture confidence in Turkish assets and prompt capital flight. After all, ‘capital will always go where it’s welcome and stay where it’s well treated’, as one-time Citigroup chairman Walter Wriston once said, and it may well be that Turkey now no longer fits that bill.

“Turkey has five options to try and solve its debt problems

  • Jack up interest rates to stem capital flight and persuade money to stay – after 2000-2002 this seems unlikely
  • Devalue its currency to lower interest bills on lira-priced debt, slow imports and help exports to tackle the current account deficit – but this makes servicing dollar-priced debt more expensive and so hardly helps and it will hit the economic growth that Mr Erdogan needs and craves
  • Find a fresh source of funds. The IMF is unlikely to be considered as an option and Pakistan has just spurned an IMF package in exchange for Chinese assistance. Mr Erdogan could turn to China or Russia.
  • Default on the debt. This remains a possibility although it would lock Turkey out of financial markets for some time to come (not that Mr Erdogan may care
  • Capital controls, a concept already being floated by legendary emerging market fund manager Mark Mobius. Turkey would simply shut up shop and prevent foreigners from withdrawing their cash.

“Turkey has not given any indication of its preferred options but the last three are the only ones that may prove politically palatable.

“Malaysia went down the path of capital controls in 1998 with horrible results for financial markets. The Malaysian stock market plunged and those investors who found themselves with assets stranded in ringgit on the Kuala Lumpur exchanges looked to sell assets in other emerging markets, to avoid the risk of similar moves in other emerging markets and also raise liquidity to protect themselves (and in the case of emerging market funds to meet redemptions from their own nervous investors).

“This shows how even smaller economies and stock markets such as Malaysia can have a potentially huge impact on global financial prices, through contagion. It took around a year for the ripple effect to reach its maximum, as the FTSE All-World stumbled in the second half of 1998.

Source: Thomson Reuters Datastream

“The UK was hard hit, too. The FTSE All-Share fell by 24% between June and October 1998 as investors fretted over the prospects for global growth and the damage done to financial markets and institutions by losses in Asia and then Russia, which defaulted in August 1998 prompting in turn the collapse of the Long Term Capital Management hedge fund.

Bear markets in the FTSE All-Share since inception in 1962

Start Finish Duration (days) Start Finish Decline
1 31-Jan-69 27-May-70 481 181 114 (37.0%)
2 15-Aug-72 06-Jan-75 874 226 62 (72.6%)
3 06-Jun-75 08-Aug-75 63 154 122 (20.8%)
4 03-May-76 20-Oct-76 170 172 116 (32.6%)
5 07-May-79 15-Nov-79 192 284 220 (22.5%)
6 17-Aug-81 28-Sep-81 42 339 266 (21.5%)
7 16-Jul-87 10-Nov-87 117 1,239 785 (36.6%)
8 08-Jun-98 08-Oct-98 122 2,868 2,178 (24.1%)
9 31-Dec-99 12-Mar-03 1167 3,242 1,593 (50.9%)
10 25-Jun-07 03-Mar-09 617 3,479 1,789 (48.6%)
Source: Thomson Reuters Datastream

“It remains to be seen whether Turkey leads to a similar rout this time around but there is a risk that the lessons of 1997-98 in Asia and Russia and 2001-02 have been forgotten in London, New York and other major financial hubs – but not Istanbul, where the memories of IMF-enforced austerity are still very fresh.”

These articles are for information purposes only and are not a personal recommendation or advice