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Pre-Interview Article – Turmoil in Emerging Currencies

This week, Room for Discussion will be hosting two guests – Nora Neuteboom, the economist for ABN Amro along with Macro and International Economics Professor Sweder van Wijnbergen from the University of Amsterdam – on a very relevant current issue: Turmoil in Emerging Currencies.


According to IGA Global, developing countries are defined as the ones with low living standards, underdeveloped industrial base, and poor Human Development Index (HDI) score. Generally, those economies are fragile due to the substantial account deficits, high debt-to-GDP ratios and hefty inflation. Adding that political uncertainty, having a volatile currency is almost inevitable in most of the developing nations. Even if ‘fragile’ seems like a negative aspect for a country, according to the macroeconomist Robert Solow, that is, in fact, necessary for developing countries to have a fragile growth-oriented economy, to catch-up with developed ones.


That concept of ‘’fragility” is apparent for those five countries the most: Brazil, India, Indonesia, South Africa and Turkey. That`s why they`re called ‘’The Fragile 5”. It is no surprise that these economies depend heavily on foreign investors to fulfill their growth ambitions. So how vulnerable are they today after the interest rates rose recently? The rupee, India’s currency, sank to an all-time low against the US dollar, losing more than 12% in value since the beginning of the year. the rupiah, Indonesia’s currency, fell to its weakest level since the 1998 Asian financial crisis, losing 10.5% of its value against the dollar since the start of this year. For Brazilian Real, 27% and for South African Rand, 24%. Turkish Lira is no different with 17%. Argentinian Peso, Russian Ruble, all faced considerable deteriorations in value compared to USD.


This contagion has global reasons as much as country-specific ones apart from rising USD itself. But what is the story? How exactly does this depreciation occur?

To begin this story, going back to the wake of the 2008 Financial Crisis is a must. The wounded world economy needed to take a deep breath after such a harsh crisis. In other words, post-crisis shocks and the diminishing demand had to be eliminated by expanded money supply. Therefore Quantitative Easing Programs, triggered by the US Federal Reserve (FED), were introduced one by one by major players in the World economy. Bond-buying programs were slowed down, interest rates declined, sparking the 2008-2015 global Monetary Easing period.


Not only developed economies, but developing economies skyrocketed after the easing period started. GDP of Argetina increased from -4.5% to 4% in one year. With the momentum of cheap money, China started an extensive GDP growth trend triggered by the investment spree that will potentially last at least until they overtake the US as the biggest economy in the world. Turkey, Brazil, India all faced substantial growth rates and made use of this easing era by investing in various sectors.


Imagine you are an American investor in 2010. In your country, interest rates have been dragged down to 0.75% after the crisis. You know that In Turkey, the interest rates were down as well but as much as it could be, to %8.75. With 8.5% inflation, an average Turkish person would get a real rate of 0.25%. But an American who would invest in Turkey but spend in USA (2010 inflation 2.7%) would get a real rate of around 6% (8.75%-2.7%). In addition, you will be investing in an unsaturated market with a lot of incentives and opportunities. Where would you invest in? In your own country or in Turkey? Most of the foreign investors answered this as “Turkey”. But this was not the case only for Turkey, but for all developing countries. In that reasoning, developing economies attracted billions of dollars of foreign investment through cheap loans from developed economies’ banks to be invested in high-interest rated countries. Isn`t that one of the basic principles of finance? Money flows where it has the highest return rate.


For foreign investors to remain in a country in the long term, they need more than high return margins. They seek political stability, a dependable legal system, honest government and protected property rights. Having the economic recovery wind at their back, rulers of developing countries reinforced their authority. Narendra Modi, Recep Tayyip Erdogan, Xi Jinping, Nicolas Maduro, all have shifted explicitly from democratic to authoritarian practices. As a result, all the parameters for democratic developing countries have begun ceasing to exist one by one, making foreign investors run away.


There is also one other reason why foreign investors started leaving away to their homelands: Monetary Tightening Period started as of 2015, right after central banks of major economies began jacking up the interest rates again. The Tightening Period was inevitable mainly because of the inflationary pressures due to economic overheating and rapid growth or to cope with the risk under political uncertainty. In other words, as Jannet Jellen put it, ‘‘that was enough of the Recovery Period’‘.

So again, the time has come for testing the fragility of developing economies. Foreign money, flowing back to developed economies with high interest rates and less political uncertainty has hindered the liquidity of developing economies, resulting in hiking demand to foreign currencies. This high demand for foreign currencies has dragged down the value of local currencies. As the value of local currencies have slumped, inflation has increased. As inflation increased, costs of materials in those economies also increased, lowering down profit margins and consequently, GDP. Adding unforeseeable currency rates to low profit margins, more and more foreign investors have scarpered. Hence, the dynamics of those economies have become inadequate to refinance the foreign debt (which even grew after the depreciation of local currencies compared to major ones). So here we come back to the beginning: again high inflation, substantial foreign debt and a budget deficit that is even higher than before….


So how to break the loop in that case? There are two options for a country coming to that point again: Restructure the whole economy to be based on production so that you are not dependent on foreign investors (e.g. China), or IMF, which means having an economy captivated by a controversial institution at the end. Even if the choice seems clear, restructuring the economy on production does not often become the case, especially for non-democratic developing economies, since it is more profitable and efficient to form channels of corruption in construction sector or in mining.


If there is one lesson to be derived for developing economies after that article, it is that countries should benefit Monetary Easing periods by investing in sectors generating high value like technology and manufacturing. Because if they miss the ‘’cheap money train’’, when the time comes in which their vulnerability will be tested, they will inevitably get into the loop of high inflation, substantial foreign debt, budget deficit and finally, turmoil in currencies. Let`s see what Nora Neuteboom and Sweder van Wijnbergen have to say about this interesting issue!

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