Reversal of Capital Flows to Emerging Markets Poses Risks

With super low interest rates available in the U.S. and the rest of the developed world, investors may be tempted to chase the juicy yields available on emerging market (EM) debt.

The World Bank estimates that in 2009, 104 of 129 developing countries will have current account surpluses inadequate to cover private debt coming due. For these countries, total financing needs are expected to amount to more than US$1.4 trillion during the year. External financing needs are expected to exceed private sources of financing (equity flows and private debt disbursements) in 98 of the 104 countries, implying a financing gap in 98 countries of about US$268 bn. Should bank rollover rates be lower than expected, or should capital flight significantly increase, this figure could rise to almost US$700 bn. Well over US$1 trillion in EM corporate debt and US$2½-3 trillion in total EM debt matures in 2009, the majority of which reflects claims of major international banks extended cross-border or through their affiliates and branches located in emerging markets.

The outlook for the flow of portfolio investments is even less encouraging. Redemptions of US$41.2 bn out of EM equity funds in 2008 have fully reversed the record US$40.8 bn inflow of 2007. About half of the EM fund purchases that have occurred since 2003 have now been withdrawn. According to the Institute for International Finance (IIF), net private capital flows to emerging markets are estimated to have declined to US$467 bn in 2008, half of their 2007 level. A further sharp decline to US$165 bn is forecast for 2009, with just over three-quarters of the decline due to deterioration in net flows from commercial banks. Moreover, net lending of international banks to emerging countries (excluding Gulf countries) is expected to fall to US$135 bn in 2009 from US$401 bn in 2007 and US$245 bn in 2008.

Expect capital controls, defaults and social unrest caused by austerity measures dictated by the multi-lateral organizations supplying financial rescue packages.

Where is the Turkish Lira Headed?

This has been a wild week for the Turkish Lira, which has seen wild swings in the order of 6% or more in either direction. It is true that the markets' current worries about the foreign-funded FX lending in Central and Eastern Europe and the related exposure of Western European banks does not apply to Turkey. The country's banking system is solid with no exposure to the toxic assets plaguing the banks in the US and Europe. The Turkish banks have the lowest loan-to-deposit ratio and the smallest external indebtedness as a percent of the GDP in Eastern Europe. The slowdown that is currently setting in is directly related to shrinking export markets in Europe, Turkey's main trading partner.

The cause of the extraordinary volatility has been blamed on the external fear factors such as the recent events surrounding GM, GE and Citibank and the decision of a couple of foreign banks to liquidate their Turkish assets. The ensuing Central Bank decision to start foreign exchange auctions have had a calming effect on the Lira.

I beleve we are entering a critical period for the Turkish Lira that spans the end of March-early April. Turkey is slated to have local elections on March 29, where the governing AKP Party is expected to win most municipalities. These approaching elections have acted as a brake on the government's willingness to conclude a $20-30 billion new stand-by agreement with the IMF. The lack of an IMF agreement coupled with agressive interest rate cuts by the Central Bank has decresed the attractiveness of Lire denominated assets.

Turkey is a member of the G-20 that will be meeting on April 2. This will be followed by the NATO summit on April 3-4 and President Obama's visit to Turkey. The latter event is important because it will highlight Turkey's status as a regional power and an energy corridor for the West.

The optimistic scenario to which I subscribe would be for the AKP to get a renewed mandate in the local elections and have the political will to sign an agreement with the IMF around the time of the April summits. Syncronizing the IMF agreement with the Obama visit and the announcement of further political (Kurds, new constitution) and economic reforms to give new impetus to the EU accession talks would have a very good chance of stabilizing the Lira in a much lower band than we have observes this week.