Back on the 3rd of May I pointed out that yet another feature of economics 101 was not working these days. Here was my response to interest-rate rises from the central bank of Argentina or BCRA.
This is perhaps the most common response and in my view it is the most flawed. The problem is twofold. Firstly you can end up chasing you own tail like a dog. What I mean by this is that markets can expect more interest-rate rises each time the currency falls and usually that is exactly what it does next. Why is this? Well if anticipating a 27,25%% return on your money is not doing the job is 30.25% going to do it?
Since then the BCRA has indeed ended up chasing its own tail like a dog, as interest-rates are now an eye watering 60%. But the sequence of rises has been accompanied by further currency falls, as back then an exchange rate to the US Dollar of 21/22 ( it was a volatile day) has been replaced by 39.4. To my mind this has been influenced by the second factor I looked at back in May.
Next comes the way that markets discount this in terms of forward exchange rates which now will factor in the higher interest-rate by lowering the forward price of the Peso. So against the US Dollar it will be of the order of 28% lower in a year’s time so the expected return in each currency is equal. This should not matter but human psychology and nature intervene and it turns out often to matter and helps the currency lower which of course is exactly the wrong result.
Right now the forward price of the Argentine Peso will be heavily discounted by the 60% interest-rate. At least the Argentines got some welcome good news on the rugby front on Saturday when they beat Australia. Although they currently seem unable to avoid bad news for long.
The Argentine peso has lost more than half its value, but U2 frontman Bono is advocating for the economic well-being of the Argentine people ( Bloomberg ).
As you can imagine the announcement below on the 3rd of this month from the Turkish central bank or CBRT made me mull the thoughts above.
monetary stance will be adjusted at the September Monetary Policy Committee Meeting in view of the latest developments.
On the day itself ( last Thursday) the water got very muddy for a while as President Erdogan again made a case for low interest-rates. He apparently has a theory that high interest-rates create high inflation. But the CBRT is not a believer in that.
The Monetary Policy Committee (the Committee) has decided to increase the policy rate (one week repo auction rate) from 17.75 percent to 24 percent.
The consensus was that this was a good idea as highlighted by the economist Timothy Ash.
Turkey – huge move by the CBRT, doing 625bps, taking the base rate to 24%. Respect. Difficult decision set against huge political pressure, but the right should set a floor, and gives the lira and Turkish assets, banks etc a chance.
I have more than a few doubts about that. The simplest is what calculations bring you to a 6.25% rise, or was it plucked out of thin air? Added to that is the concept of a floor and giving the currency and banks a chance. Really? The words of Newt from the film Aliens comes to mind.
It wont make any difference
Initially the Turkish Lira did respond with a bounce. It rallied to around 6.1 versus the US Dollar on the day and then pushed higher to 6.01 on Friday. In response I tweeted this.
In the case of Argentina the half-life of the currency rally was 24 hours at best….
So as I checked the situation this morning I had a wry smile as I noted the Lira had weakened to 6.26 versus the US Dollar. I also note that the coverage in the Financial Times had someone who agrees with me albeit perhaps by a different route.
But Cristian Maggio, EM strategist at TD Securities, said the central bank did not go far enough, because inflation was likely to rise beyond 20 per cent, and “higher inflation will require even higher rates”.
On the day some speculators will have got their fingers singed as the comments from President Erdogan sent the currency weaker at first, so following that the CBRT move whip sawed them. If that was a tactical plan it succeeded, but that is very different to calling this a strategic success.
Another issue is that the currency may well be even more volatile looking forwards. This is because holding a short position versus the US Dollar has a negative carry of 22% or so and against the Euro has one of 24% or so. Thus there will be a tendency to hold the Turkish Lira for the carry and then to jump out ahead of any possible bad news. The problem with that is not everyone can jump out at once! Any falls will lead to a mass exodus or panic and we know from the experience of past carry trades that the subsequent moves are often large ones.
Brad Setser has crunched the numbers on this.
Turkey has about $180 billion external debt coming due, according to the latest central bank data. And most of that is denominated in foreign currency. The Central Bank of Turkey’s foreign exchange reserves are now just over $75 billion, and the banks may have about $25 billion (or a bit less now) in foreign exchange of their own. I left out Turkey’s gold reserves, in part because they are in large part borrowed from the banks and unlikely to be usable.
The total external debt is now a bit over US $450 billion. Very little of that is the government itself although the state banks are responsible for some of it. The problem is thus one for the private-sector and the banks.
How this plays out is very hard to forecast as we do not know how many companies will not be able to pay, and how much of a domino effect that would have on other companies. Also we can be sure that both the government and CBRT will be looking to support such firms, but we can also be sure that they do not have the firepower to support all of them! This is another factor making things very volatile.
The domestic economy
There are a lot of factors at play here but let me open by linking this to the foreign debt. If we look back we would also be adding a current account deficit to the problems above but this is getting much smaller and may soon disappear. From the third of this month.
There should be a boost for exports which will help some but so far the main player has been a fall in imports which were 22.4% lower in the merchandise trade figures above. So a real squeeze is being applied to the economy which the GDP figures will initially record as a boost, as imports are a subtraction from GDP. So they will throw a curve ball as the situation declines.
Added to that is this which was before the latest interest-rate rise.
Switching to a year on year basis the impact so far of this new credit crunch is around three-quarters of the 2008/09 one. The new higher official interest-rate seems set to put this under further pressure as the banks tend to borrow short ( which is now much more expensive) and lend long ( which will remain relatively cheap for a while).
A major problem in this sort of scenario was explained by Carole King some years ago.
But it’s too late, baby, now it’s too late
Though we really did try to make it
Something inside has died and I can’t hide
And I just can’t fake it, Oh no no no no no
Regular readers will be aware that it is in my opinion as important when you move interest-rates as what you do. Sadly that particular boat sailed some time ago for Turkey ( and Argentina) and macho style responses that are too late may only compound the problem. Or as the CBRT release puts it.
slowdown in domestic demand accelerates
It must be a very grim time for workers and consumers in Turkey so let me end by wishing them all the best in what are hard times as well as a little humour for hard times.