For the past several months, Turkey’s woes have grabbed the headlines. A combination of political, economic, and trade news has decimated its capital markets and caused a general flight of foreign capital and a corresponding plunge in the value of its currency, the lira. Fewer headlines have been written on the broad sell-off among nearly all emerging-market currencies as skittish investors see shadows of earlier crises. But is the comparison apt? Is this a rational response to an unraveling asset class or a case of throwing the baby out with the bathwater? First, some background.
What happened to Turkey?
The current situation in Turkey is the culmination of several different crises for the nation. Over the past several years, it has been one of the fastest-growing economies. However, what enabled this growth were vast amounts of debt issued by the Turkish government and corporations—debt that was denominated in US dollars. Given the small size of the country’s hard-currency reserves, a fall in the value of the lira would make this debt all but impossible to service.
On top of this, the country has had a hard time controlling inflation, with double-digit rates the norm. Historically, Turkey’s central bank has reacted to this elevated inflation by systematically raising its interest rates, a tactic that tends to reduce inflation and attract foreign capital, which keeps the value of the lira stable in the face of inflation. The tipping point was the June reelection of President Recep Tayyip Erdoğan, which resulted in his declaring that he could dictate the actions of the central bank. His announced intention of keeping interest rates low—through a misguided belief that low rates spur growth—reduced demand for the currency on the global stage. This in turn resulted in a lower value for the lira, which then revealed the extent of Turkey’s foreign borrowing, which seemed untenable given the size of its hard-currency reserves. At this point the currency’s crash was all but preordained.
Value of Turkish lira in US dollars, 1/1/2018–8/14/2018
Sources: Parametric, Bloomberg as of 8/14/2018
Will Turkey’s troubles affect other emerging-market currencies?
The situation in Turkey is fairly complex, involving the interaction of a variety of factors, most of which have been boiling along for many years and are fairly specific to Turkey. But what about the other emerging-market currencies? The graph below offers some guidance. In it we map the fall in the value of every emerging-market currency versus the dollar and compare it with that country’s current account deficit (in essence, the amount by which the goods and services it imports exceeds the goods and services it exports).
Currency returns vs. current account balance for all emerging-market countries except Turkey
Sources: Parametric, Bloomberg
Countries running a current account surplus have positive net sales abroad, which should make their currencies stronger, because foreign customers must “buy” the country’s currency to purchase their goods. Similarly, countries with current account deficits have weaker currencies, all else equal. But when we map the July price action of emerging-market currencies, the chart shows that investors are selling nearly all emerging-market currencies indiscriminately, regardless of current account balance.
The bottom line
Volatility—including currency volatility—is an inherent part of investing in emerging markets. Could the events in Turkey lead to a cascade of similar declines across the emerging markets? Perhaps. However, the above graph seems to point to an overreaction among investors, leading them to throw out the broad emerging-market bathwater with the Turkish baby.
The thing to remember is that drivers of major declines in a currency tend to be country specific. This points to the need for emerging-market investors to diversify their country exposure to prevent any sudden calamity in currency from having an outsize impact on portfolio performance.
Potential Parametric solution
Our Emerging Markets Strategy is designed to provide all-cap exposure to countries with the potential to outperform the index, with less volatility. Our investment process is based on mathematical principles of diversification, compounded growth, and volatility capture.
Tim Atwill, PhD, CFA, Head of Investment Strategy (emeritus)
Mr. Atwill leads the Investment Strategy team at Parametric, which is responsible for all aspects of Parametric’s investment strategies. In addition, he holds investment responsibilities for Parametric’s emerging market and international equity strategies, as well as shared responsibility for the firm’s commodity strategy.
The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Parametric and its affiliates disclaim any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Parametric are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Parametric strategy. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results. All investments are subject to the risk of loss.