Over the past few days, there has been an almost 20 percent rebound in the Turkish lira from the all-time lows that it plumbed earlier in the week. It would be a mistake to think that this signals the end of the Turkish currency crisis.
More important yet, it would be a mistake for U.S, policymakers to think that a resolution of the Turkish currency crisis would put an end to the emerging market turbulence of the past few weeks.
Even after this week’s strong relief rally, the Turkish lira is down some 40 percent since the start of the year. That is bound to result in a spate of bankruptcies and defaults in Turkey’s corporate sector, which is excessively indebted in U.S. dollar terms.
Those bankruptcies must be expected to have knock-on effects on other heavily indebted emerging market economies.
There is also every reason to think that the Turkish lira’s decline will soon resume since nothing has been done to address the fundamental economic weaknesses that gave rise to its swoon in the first instance.
The Turkish central bank’s independence remains under attack by the country’s president and, despite a pickup in inflation, Turkish interest rates are being kept at artificially low levels.
Meanwhile, the country is engaged in a trade war with the United States, and its external financing needs remain very high as a result of a large external current account deficit and a short-term external debt mountain.
In thinking about whether a resolution of the Turkish lira crisis will put an end to the recent rout in emerging market equities and currencies, an analogy from World War I might be instructive. Most historians would agree that the assassination of Archduke Franz Ferdinand was the trigger and not the underlying cause of the war.
So to, it is all too likely that the Turkish lira crisis has been the trigger and not the underlying cause of the recent emerging market turbulence. Rather, the underlying cause of that turbulence has been the coming to the end of many years of very cheap credit to those economies.
There would seem to be at least two fundamental reasons for thinking that U.S. policymakers should brace themselves for more global economic and financial market turbulence in the months immediately ahead, even were the Turkish economic crisis to be resolved.
The first is that many years of ultra-easy monetary policy by the world’s major central banks has led to a situation where the world economy is characterized by record debt to GDP levels. Compounding matters is the fact that global credit markets have been characterized by both the gross misallocation and the serious mispricing of credit.
With the Trump administration pursuing an expansive fiscal policy at this late stage of the economic cycle, there is every reason to think that the U.S. Federal Reserve will be obliged to keep raising U.S. interest rates.
That in turn is all too likely to lead to a strengthening in the U.S. dollar and to the accentuation of the reversal in emerging market capital flows that has been in evidence over the past few months. Should that indeed occur, one must expect considerable global financial market strains as global credit interest rate spreads widen to more normal levels.
A second reason for expecting that we could be in for an intensification of global market turbulence in the months ahead is that two systemically important and troubled countries face upcoming major challenges of their own before the year is out.
Italy, the eurozone’s third-largest economy, appears to be on a collision course with Europe over the presentation of an expansionary budget by October at the same time that its populist coalition government has made excessive tax cut and spending increase promises to the electorate.
Meanwhile. Brazil, Latin America’s largest economy, is characterized by extreme political uncertainty and unsustainable public finances ahead of its contentious presidential election in October.
The recent emerging market turbulence should prompt Federal Reserve Chairman Jerome Powell to rethink his oft-stated view that the emerging market economies can easily manage to handle the Fed’s proposed course of gradual interest rate hikes.
At the same time, the prospective emerging market turbulence should restrain the Trump administration from being as cavalier as it has been to date in the use of trade restrictions against troubled emerging market economies.
In a troubled global economy, the last thing that the administration should be doing is to pour fuel on an emerging market economic crisis rather than seeking to defuse it.
Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund's Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.