Brazil and Turkey: 2 canaries in the coal mine

Global economic policymakers taking comfort in the absence of a full-blown emerging market crisis in the wake of the pandemic might want to take careful note of Brazil and Turkey’s present economic and financial market difficulties. 

Despite a tidal wave of global liquidity that has been buoying the economically troubled emerging market economies, both Brazil and Turkey now find themselves in the grips of serious foreign exchange crises. This should be highlighting the real risk that we could have a global emerging market debt crisis even before the world’s major central banks start to normalize their ultra-unorthodox monetary policies.

Even before the COVID-19 pandemic, the emerging market economies had shaky economic fundamentals and record levels of debt in relation to the size of their economies. The pandemic has now further exposed those weaknesses. It has done so by subjecting them to a perfect economic storm of a major supply side shock, low international commodity prices, weak external demand, and a drying up of workers’ remittances from abroad.

Brazil’s President Jair Bolsonaro and his ministers attend a national flag hoisting ceremony in front of Alvorada Palace in Brasilia, Brazil, October 27, 2020. REUTERS/Adriano Machado

The market reaction to the pandemic-induced deterioration in the emerging market’s economic fundamentals led to a very sharp initial selloff in emerging market assets and to a record reversal of capital flows to those countries. However, those trends were quickly reversed by the ultra-aggressive Federal Reserve response to the crisis, which has included a US$ 3 trillion increase in the size of the Fed’s balance sheet. Over the past six months, buoyed by Fed liquidity, emerging market asset prices have almost fully regained their pre-pandemic levels while a considerable amount of capital has flowed back to those economies.

Despite the general calm restored to the emerging economies’ financial markets by the tidal wave of Fed liquidity, investors have not turned a blind eye to the considerable worsening of the economic fundamentals in Brazil and Turkey, two of the largest emerging market economies. This has led to a more than 25 percent depreciation of those two countries’ currencies since the start of the year. Worse yet, the Turkish lira is now showing the clearest of signs of being in free fall.

In the case of Brazil, markets seem to be unsettled not simply by the country’s lack of any coherent plan to contain COVID-19’s spread but also by the fact that the pandemic has put Brazil’s public finances on a clearly unsustainable path. According to the IMF, Brazil’s budget deficit is expected to balloon to almost 17 percent of GDP in 2020 while by yearend its public debt to GDP ratio is expected to exceed 100 percent, which is an unusually high level for an emerging market economy. With Brazil’s long history of trying to inflate its way out of its debt problems, it is little wonder that investors seem to be rapidly losing confidence in its currency for fear of yet another Brazilian inflationary episode.

If markets are losing confidence in the Brazilian currency, they seem to be doing so at an even faster pace in the case of the Turkish lira. Driving this loss of confidence is both the market’s dismay at the politically motivated way in which Turkish economic policy is being run and at President Erdogan’s foreign policy adventures abroad that are managing to antagonize simultaneously Europe, Russia, and the United States. Particular matters of investor concern are President Erdogan’s undermining central bank independence by political interference and his dogged belief, even at a time of a full blown foreign exchange crisis, that higher interest rates are a cause rather than a cure for inflation.

Via REUTERS/Murad Sezer

Now that we are experiencing exchange rate crises in two major emerging market economies, this should be a clear warning to US economic policymakers of the risks that the emerging market economies could pose to the US economic recovery. This would seem to be particularly the case considering that the emerging market economies now constitute around half of the world economy and owe more than US$ 4 trillion in US dollar-denominated debt. It would also be the case at a time that both Europe and the United States seem to be in the grips of a second wave in the pandemic and at a time that the emerging market economies are having to cope with major debt problems during the worst economic recession in the past ninety years. 

In short, now is not the time for policy complacency about the emerging market economies. Rather, it is the time for US economic policymakers to be making serious contingency plans for another emerging market debt crisis.

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Brazil and Turkey: 2 canaries in the coal mine