What economic theory gets wrong about Turkey and other emerging economies

Turkey’s got a dollar problem—and so do a lot of other emerging markets.
Turkey’s got a dollar problem—and so do a lot of other emerging markets.
Image: Reuters/Umit Bektas
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Classic economic theory holds that when the value of a country’s currency falls, its economy should expand. So relax, Turkey. The lira’s 40% plunge against the dollar since the beginning of this year? It should be a sign of impending growth.

But regardless of what the economic textbooks might predict, the history books foretell a much grimmer future for Turkey and its ilk. In the 1990s alone, sharp currency drops in Asia, Latin America, and Russia set off a rash of banking crises and economic slumps. This is why investors are panicking about Turkey right now—and feeling growing unease about South Africa, Colombia, Indonesia, Lebanon, and a slew of other countries. (Argentina, whose peso has lost nearly as much against the dollar as Turkey’s lira this year, is already in deep enough trouble that it asked for International Monetary Fund help.)

Turkey, Argentina, South Africa, and Indonesia have little in common. They vary in population size, economic structure, banking systems, and political institutions. So why are these and other emerging market countries suddenly all in trouble?

The reason has to do with what they do share: monetary systems that increasingly run on speculative financial inflows, much of which are in dollars. At the end of 2017, emerging markets as a whole had racked up $3.7 trillion in corporate debt borrowed in US dollars, according to a fascinating working paper (pdf) by economists at the Bank for International Settlements. That’s roughly double what they owed in 2008.

Other things have changed too. Increasingly, emerging market companies are getting their dollars through bonds, not bank loans. While lending drove the increase in dollar credit in the run-up to the global financial crisis, since 2011, emerging market issuance of dollar bonds has grown at a much faster clip. The outstanding stock of dollar bond credit has been rising at a rate of about 17% annually since late 2016, according to BIS data.

Offshore bond issuance is defined as outstanding US dollar-denominated bonds issued offshore (ie outside the country listed in the panel title) by non-banks with the nationality listed in the panel title.
Offshore bond issuance is defined as outstanding US dollar-denominated bonds issued offshore (ie outside the country listed in the panel title) by non-banks with the nationality listed in the panel title.
Image: Dealogic; Euroclear; Thomson Reuters; TRAX; BIS calculations.

This has been a boon not just for emerging market corporations, but also for their local economies. As borrowers converted their new dollars into local currency bank deposits or loans to other entities, they effectively created new money in their home economies—easing overall credit conditions in the process.

But there’s a catch: When this cycle of easy prosperity reverses, it can rapidly spin out of control.

If a country’s supply of new dollars stops, or even just slows, domestic monetary conditions tighten. As global investors dump bonds, yields start rising and the currency’s value drops. Things snowball from there. Depreciation makes the dollar debts owed by corporations, particularly those operating in the local currency, much more expensive to pay back. As local corporations start hoarding dollars in order to cover their debts, they drive down their native currency’s value even more. Meanwhile, to arrest the currency’s fall, the central bank faces pressure to raise rates—which makes borrowing pricier still. What began as a financial shock begins hitting the real economy. Investment plummets, and defaults and unemployment rise. Demand seizes up. The prices of stocks, real estate, and other assets plunge far below their fair value. Banking crises erupt. Though there are a few exceptions, once this cycle sets in, it typically takes years, even decades, for economies to wrest themselves free of it.

So what’s behind the current panic? Since the global financial crisis, super-low yields in advanced economies like the US, Europe, and Japan pushed investors into ever-riskier, higher-yielding assets. But the tide of easy money is starting to turn, as the Federal Reserve has gradually begun tightening. Still, the Fed’s moves have been fairly gentle, and have so far been offset by continued easing by the central banks of the euro zone and Japan. The sensitivity we’re seeing in Turkey and Argentina doesn’t bode well for the other dollar-dependent economies around the globe.

No one should find any of this surprising. For the last two centuries, this boom-and-bust pattern of emerging market investment has played out over and over, argues Michael Pettis, a finance professor at Peking University, in his book, The Volatility Machine. These investments waves have had little to do with local growth potential—which is why they affect a random smattering of countries. Instead, they’re usually a function of the easiness of money in rich countries, says Pettis, as well as financial innovations that extend the reach of foreign capital.

This helps explain why the economic textbooks are so often wrong about currency depreciations in emerging markets with open financial systems. However much supply and demand curves influence their economic prospects, the way their balance sheets interlock with those of other, richer countries matters much more. With financial globalization deeper than perhaps ever before in history, the the fates of small, poorer countries rests far less on domestic policies or market reforms than on the whims of far away financiers and central bankers.