As interest rates rise, the stress increases on emerging markets, with tighter money producing higher risk premiums and decreased funds availability. At some point, one or other of the major Third World borrowers will spin into financial crisis, producing a “domino” effect on other indebted countries. In 1982, the first “domino” was Mexico; this time around, it may be Turkey.
Some countries are more affected by higher interest rates than others. Very poor countries are not particularly affected, because much of their foreign funding arrives in concessionary form, and being independent of the market is unlikely to dry up in periods of tightening liquidity. Haiti and Congo will remain desperately poor, but higher interest rates (unless accompanied by a major world recession) are unlikely to affect them much.
Wealthy countries will have vulnerable sectors, such as real estate, may suffer a crisis in their corporate sector if they have undertaken a high volume of leveraged acquisitions, and will find their state budget deficits increase with funding costs. However their finance availability will remain satisfactory unless a real liquidity crisis such as that of 1974 occurs. Germany, Britain and the United States will all continue to be able to obtain financing, and are unlikely to suffer beyond a recession and scattered banking or corporate crises.
Countries that have financed their growth primarily internally, or with foreign direct investment, may find their growth rates reduced, but if they have a solid cost advantage in a particular economic sector, it’s likely that foreign direct investment to take advantage of that cost differential will continue. Thus China and India are unlikely to be severely affected by moderately tighter liquidity, although a crisis in the Chinese banking sector is certainly a possibility.
Countries that fund their growth primarily through private sector international debt, and have thereby acquired a high level of foreign borrowings, are the most likely to be in trouble. However as well as the beginnings of world monetary tightening, the last few years have seen a huge increase in commodity prices. Thus countries whose primary sources of foreign exchange are oil or mining are likely to remain solvent, since the positive effects of increased commodity revenues are unlikely yet to have been fully absorbed unless their governments are truly appalling. Chile, Russia and Mexico will not be the first countries to experience difficulties, although if further increases in interest rates combine with a world economic slowdown and a decline in commodity prices, they could be in very bad trouble indeed later on.
Of the countries with more than $100 billion of external debt in 2005 (a rough borderline above which default becomes “serious” for the international financial system) that leaves four potential deadbeats: Brazil, Indonesia, Poland and Turkey.
Brazil, with $211 billion of external debt in 2005 and an external debt/GDP ratio of 34%, must find default tempting, even though with exports of $115 billion and imports of $78 billion in 2005 its national cash flow was pretty satisfactory. Its neighbor, Argentina, blew off the international banking system in 2001-02, refused to negotiate properly with its foreign creditors, and as a result got a reduction of almost half in its foreign debt (more than three quarters in its private foreign debt) a line of credit from the International Monetary Fund, a forced absence after its default of less than six months from the international bond markets and an economic growth rate in the last three years of 7% per annum.
However, two reasons suggest that Brazil will not be first to default. First, its debt/GDP ratio is lower than the other three countries and has declined somewhat in the last few years, as has its very high level of domestic interest rates, suggesting that the Brazilian economy is moving away from crisis rather than towards it. Second, its center-left President Luis Inacio (Lula) da Silva, who faces re-election in October, has been brought up short by the nationalization by Bolivian President Evo Morales of Petrobras’ oil and gas concessions in Bolivia.
It appeared when Lula was first elected in 2002 that Brazil’s high debt levels and exorbitant interest rates might tempt him to follow the anti-market policies of Venezuela’s Hugo Chavez, or the default policies of Argentina. However the modest economic recovery that has followed four years of relatively austere policy, and the lumping by Chavez’ Bolivian protégé of Brazilian interests in with those of the fiendish international capitalists appear to have suggested to Lula and his supporters that economic success can better be attained through cooperation with the international market rather than autarkic confrontation of it. If conditions become very difficult, and a more general international default occurs, Brazil will probably follow other countries into default (particularly if as in Argentina the defaulters suffer few adverse consequences.) However it’s unlikely that Brazil will be the first domino.
Indonesia has a pro-market center-right government under President Bambang Yudhoyono; its external debt of $140.6 billion represents 54% of GDP. Growth in 2005 was 5.4%, considerably faster than Brazil’s, and has been moderately aided by the rise in oil prices, which together with other commodity exports have given Indonesia, like Brazil, a substantial trade surplus.
While Indonesia is less than half as rich as Brazil, in terms of GDP per capita, its wealth is better distributed, with far less inequality. Further, its status as a very large and moderate Muslim country makes it extremely important to the foreign policy of the United States and the West in general. Because it is politically important, populous and impoverished, it is potentially a large recipient of Western aid and IMF/World Bank funding. Moreover, Indonesia used a period of recovery to repay the IMF’s previous loans in 2004, thus freeing its credit lines for a future emergency. This combination of factors, together with political management that is at least better than has been seen for a decade, makes Indonesia an unlikely first domino, although if oil and commodity prices collapse in a world recession its position could worsen quickly.
While Poland is much richer than Indonesia and its international debt at $123.4 billion is a slightly lower 50% of GDP, its position is in some ways more precarious, even though its foreign trade position is also satisfactory, with exports and imports in balance. Prime Minister Kazimierz Marcinkiewicz leads an inexperienced and very weak coalition that includes a number of anti-market factions, excludes the economically liberal Civic Democrats and has only a small majority. Poland’s economic growth was 3.2% in 2005, lower than Indonesia’s, but that figure’s better than it looks because Poland unlike Indonesia and Brazil has almost no population growth.
Poland’s great advantage is that it has rich friends through its membership of the EU. These give it strength in two ways. First, they have lots of money, and can provide soft loans if Poland gets into trouble. Second, subtler but more important, they are in the process of integrating Poland into the European pool of labor and capital, in which Polish labor will be both skilled and very cheap. Hence, absent really appalling political management (which is not quite impossible) Poland is likely to get richer quite quickly, attract substantial foreign investment from elsewhere in the EU, and survive any short term crisis without too much difficulty.
Turkey’s debt of $161.8 billion in 2005 was 48% of GDP, close to the levels of Poland and Indonesia, while its 2005 growth rate was 5.6%, the best of the four (Friday it reported a 6.4% growth rate in the first quarter of 2006.) However unlike the other three countries Turkey ran a substantial trade deficit in 2005; its exports were $72.5 billion compared to imports of $101.2 billion. (Capital inflows attracted by Turkey’s potential entry into the EU strengthened the Turkish lira unduly following the 2002 crisis, preventing Turkey from repairing its balance of payments as had Brazil after its similar crisis in 1998.) Thus Turkey’s structural cash flow position is substantially negative, making it especially vulnerable to a credit squeeze.
Wednesday the Turkish central bank raised short term interest rates by 2% to 22.25%, necessary to obtain external funding in a currency that has lost 20% of its value since March, but severely contractionary for an economy whose inflation rate has only just risen to 10%.The Istanbul Stock Exchange, which had risen by 64% in 2005 on hopes for Turkey’s entry into the EU, has dropped back to close Friday at around its December 2004 level.
Unlike Poland, Brazil and Indonesia, Turkey is currently short of rich friends. After the financial crisis and currency collapse of 2002, Turkey underwent an election which removed the entire political class from power and replaced it with a moderate Islamist government under Reccip Erdogan. The Erdogan government surprised the United States by refusing permission at the last moment for U.S. troops to cross Turkey to reach Iraq (its own supporters were split, while the previous government, now the opposition, was heavily opposed.) As Erdogan has also shown signs of reversing some of Turkey’s traditional secular social policies, relations with the United States have been correct since 2003, but less cordial than was historically normal.
Then in October 2005 Turkey opened accession talks with the EU, only to run into difficulty over the subject of Cyprus, the Greek part of which had entered the EU in 2004, leaving the island’s Turkish community isolated. EU Enlargement Commissioner Olli Rehn warned June 15 of a possible “train crash” if Turkey did not open its ports and airports to Cyprus, and Erdogan responded the following day “If the talks halt, let them halt.” Within the corridors of Brussels, according to the Economist Friday, there was considerable discussion of the EU’s “absorption capacity” – thinly disguised code for concern that Turkey was too large, too culturally different and too poor to let in any time soon.
Turkey has thus alienated at least partially both its potential rich sugar daddies, the United States and the EU, while its need for additional funding is considerably greater than that of the other three countries in this group, and its economic growth is about to be brought to a screaming halt by punishing increases in interest rates. Add the advent of an election season, with Erdogan facing bitter parliamentary and military opposition in 2007, and you have a recipe for default that is not certain, but is considerably closer than in the other three potential “dominoes.” If world monetary conditions continue their gradual tightening, a crisis in late 2006 or early 2007 seems likely. Needless to say, a Turkish default would render the position of the other “dominoes” and of the world financial system as a whole much more precarious.
Turkey’s real problem is that for several decades its military and economic policies have been incompatible with the country’s ethnic, geographic and cultural position. Militarily, Turkey is a long standing member of NATO, and is proud of its close alliance with the United States. This has caused political problems as NATO’s chief enemies have become not the Soviet juggernaut against which Turkey was in the front line, but Islamic terrorists for which Turkey as a predominantly Moslem country naturally has considerable a priori sympathy.
Turkey has since 1963 attempted to join the European Union, a club with which it has little economically in common, which contains its local antagonists, Greece and Cyprus, and which is overwhelmingly composed of members of a different and potentially hostile religion. (If the difference between Orthodox Christianity and Catholicism could cause a highly unpleasant civil war in the 1990s, it is by no means paranoid to suppose that the Moslem/Christian divide can be equally dangerous in the 21st century.) The people of the EU (as distinct from the political elites) oppose Turkey’s membership, for perfectly good economic and cultural reasons, even if they are bombarded by the media with propaganda telling them to feel guilty about doing so.
Turkey needs to rethink its strategy. It is not a weak and unreliable U.S. ally and an impoverished second class European; it is a proud and capable country with a fine military and cultural tradition of its own, and an economic potential equal to that of the East Asian wonder-economies. Militarily, it should be neutral between the United States and the Middle East, while strongly opposed to the cruelty of terrorism. Economically, it should stop being a second class European and become a first class Asian, finding its destiny through free trade agreements with both the EU and the United States, and seeking to attract foreign investment from Japan, Korea and other East Asian countries. Such a policy can bring it rapid economic growth and lead the Turkish people to a better future, with a secure and comfortable position in the world.
Turkey needs political leadership, to reorient its policies and demonstrate that a better future awaits through such a reorientation. Erdogan, lacking ties to previous Turkish political failure, had an opportunity to provide such leadership in 2003, but has so far failed to do so, wasting political capital on an application to join the EU that is almost certainly doomed and that must be deeply damaging to the Turkish psyche. Maybe a debt crisis can provide the impetus for fundamental change; it is to be hoped so, for the crisis itself will be very painful indeed.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.