Emerging Market Bonds
The year 2018 was a difficult one for many of the countries classified as emerging markets. The Fed’s policy of continuous interest rate hikes combined with a sudden emergence of new geopolitical risks has caused many investors to pull their capital out of the region. Turkey was the center of attention back in August when the Turkish lira lost 50% of its value against the USD in a matter of days. The situation posed a significant risk of potentially escalating into a domino effect that could’ve resulted in US capital being pulled out of other peripheral countries as well.
Since then the moderation of US inflation and the pressure President Trump put on the Fed has drastically changed the dollar’s expected interest rate trajectory. As the growth of the US base interest rate decreases so does the capital drain capacity of the US bond market, causing the US dollar to mildly decline as well as almost immediately strengthening the currencies of emerging markets. The one to benefit the most from this outcome was likely the Ankaran government.
Turkey has been a key element in the panic surrounding emerging markets and the lira’s weakening forced the Central Bank of Turkey to gradually raise its own base interest rates to 24%. In the end this series of measures did accomplish its intended goal of halting the lira’s descent, however, the Turkish economy had already suffered a severe blow by the time it did. The 20% inflation rate has drastically reduced Turkey’s retail trade and the country’s GDP was also bound to decline over 2019 according to the World Bank’s forecasts at the time.
Turkey’s outlook has drastically improved since then, in large part due to the changes in US interest rate policy. One of the root causes for their problems was their exposure to the USD. Given the unpredictability of the lira, over the past several decades Turkey has been issuing its treasury notes denominated in US dollars to make them more attractive to US banks and investors. That policy made the country extremely sensitive to the effects of US monetary policy and the consequences of that vulnerability were felts strongly when large a large sum of US dollars flowed out of the country last year. This has left Turkey’s dollar reserves depleted, raising real concerns over their ability to repay outstanding dollar claims. One of the things that helped them through this potential crisis was Qatar’s openness to provide them with US dollars by means of a currency swap deal.
Erdogan’s cabinet has made it clear that they intend to reduce their exposure to the US dollar to avoid incidents like the one in August 2018 in the future. They did so by negotiating another credit swap deal, this time with the European Central Bank (ECB). Turkey’s treasury has previously been releasing long term dollar based bonds at a 7.68% interest. According to their stats 40% of its buyers were American, 27% were Turkish and 20% were from the United Kingdom. The European Union surprisingly only accounts for a mere 8% of their buyers. The ECB has offered to exchange Turkey’s entire stock of bonds for 4.9% interest rate euro denominated ones. Although he transaction theoretically resulted in the EU exposing itself to the dollar, their reserves are sizable enough to handle it. Meanwhile Turkey was be able to repay its bonds in euros. Since the EU is Turkey’s most notable trade partner, this arrangement is significantly more beneficial to them than having to repay the bonds in US dollars. This move by the ECB not only gives Turkey some breathing room, but also shields them from their vulnerability to the Fed’s interest rate policy. Although this only a small measure, it could help the ECB gain popularity and influence in other emerging markets.
Forecasts by international financial organizations suggest that 19 out of 24 peripheral countries will be forced to raise their base interest in 2019 even if the Fed doesn’t. If they fail to do so, the lack of interest rate differential compared to US rates would render them unable to provide their economies with sufficient resources to function. That risk makes the EU’s 0% base interest rate much more attractive to these countries, giving it a competitive edge over the dollar due to the interest rate differences. The ECB’s main difficulty is the fact that don’t have a unified bond market with each member country issuing it’s own bonds of varying interest rates. This fact makes euros unsuitable for countries to keep their reserves in, since the risk isn’t uniform and diverges across countries.
The same forecasts say that Turkey, India, China and Nigeria could potentially decrease their base interest rates while Malaysia may stay at its current interest rate level. They also point out that in 2018 the number of dollar denominated bonds declined by 4.3%, the largest decrease since 2006, showcasing how many of these countries successfully decreased their exposure to the USD.
The bonds market is an unusual angle for gaining influence in peripheral countries and the USA has been losing ground on that front in 2018 primarily due to the Fed’s interest rate policy. Even so the USD still continues to be a powerful enough force on the global financial markets for the Fed’s decisions to affect countries on other continents. Turkey’s a good example of how on one hand changes in US monetary policy could potentially bring distant countries to the brink of collapse while on the other hand it also illustrates that for the USA to retain it’s global leading role the Fed will have to work together with The White House.