turkey and the carry trade -- 2/2/21
Today's selection -- from The Rise of Carry by Jamie Lee, Kevin Coldiron, and Tim Lee. A major economic phenomenon of recent decades has been the growth of the “carry trade,” whereby an investor borrows in a currency with low interest rates (such as dollars) and then lends or buys debt in a currency with high interest rates (such as Turkish lira), pocketing the difference. This encourages a large flow of money into these countries with high interest rates, helping to encourage rapid growth in borrowing by the private sector in that economy -- a boom. That inflow of money also has the effect of strengthening the currency of that borrowing currency, causing or exacerbating a trade deficit/current account deficit. But the boom leads to overbuilding and overcapacity, and the stronger currency leads to a loss of competitiveness, which leads to an inevitable withdrawal of money by investors from that economy and a crash in the currency and decimation of that economy. Carry trade investors, if they avoid these periodic and inevitable crashes, do well. If not …
"[In Turkey], continuous rapid credit growth, a large real estate bubble, and high inflation, would have long since found itself in a crisis similar to the 1997-1998 Asian crisis. But year after year yield-seeking capital continued to flow into the country, and the economy consequently kept going -- and the bubble kept growing. Turkey, more visibly than any other single part of the global economic picture, was testament to the power and size of the global bubble in carry that developed out of the 2007-2009 global financial crisis.
"A lesson of Turkey's experience is how the global carry bubble masks the development of serious underlying economic problems, preventing analysts using standard macroeconomic metric from foreseeing crisis until the moment it impacts. For instance, standard indicators of economic health such as the ratio of foreign debt to GDP are seriously distorted by the carry bubble. The carry bubble means huge flows of capital into the higher interest rate county – such as Turkey over many years up until about 2016 – which tend to drive up the exchange rate for the currency, rendering the currency more and more overvalued. As already noted, the comparatively firm trend of the currency exchange rate only helps to attract more capital, because carry traders stand to benefit from both a large interest rate differential and, potentially, currency appreciation if the trend continues.
"Sustained very high interest rates -- which underpin the country's status as a carry recipient -- must be associated with high inflation. For example, over the whole period from the end of 2002 until the beginning of the climax of the global financial crisis in August 2008, Turkey’s consumer price index (IMF measure) increased by 83 percent. The US consumer price index rose by 20 percent over the same period. This is a big difference, and not-withstanding that sometimes rapidly growing developing economies can have higher rates of consumer price inflation without suffering loss of trade competitiveness, one would assume that such a big differential in inflation would be offset by at least some currency depreciation – in the context of the need to maintain trade competitiveness. Yet over the same period, Turkey’s currency, the lira, appreciated, and not by a little – by about 35 percent, a substantial currency appreciation.
"However one looks at this, it represents a huge loss of competitiveness. But it seemed sustainable for a time because persistent capital inflows driven by the carry trade encouraged domestic credit growth and supported the currency. Because of the credit bubble and high inflation, Turkey's GDP was growing rapidly. Translated into dollars the growth appeared even stronger because the lira was going up against the dollar as well.
"At the end of 2002, annual GDP for Turkey was about US$240 billion. By the third quarter of 2008, when the lira was still close to its peak, GDP was over US$800 billion, a more than threefold increase in a few short years. Of course that level was not sustainable, and as the lira subsequently began to weaken sharply in the foreign exchange markets, the dollar value of GDP fell back. But the effect was to make Turkish macro statistics look much better than they really were in an underlying sense. The dollar value of GDP is the denominator in simple measures of debt sustainability, such as foreign debt as a ratio to GDP or current account deficit as a percentage of GDP. When the dollar value of GDP is so much higher, it makes these ratios look better – until the currency collapses in the carry cash, and then they suddenly look very much worse. But by then it is too late for any investor who has taken these kinds of indicators too seriously.
"Turkey’s balance of payments on current account deteriorated sharply over the 2002-2008 period, from being roughly in balance to being in large deficit by about 5.5 percent of GDP. But it would have been much worse without the exaggerated increase in dollar GDP, thereby storing up problems for later. Turkey’s foreign debt ratios tell a similar story. The huge increase in dollar GDP made Turkeys external debt – to – GDP ratio look reasonably respectable in 2008, at under 40 percent of GDP, and much lower than the close-to-60 percent ratio that had been associated with the Turkish financial crises of 1994 and 2001. But, tellingly, a recalculation that substituted a fair value estimate for the Turkish lira rather than the actual exchange rate – thereby significantly reducing the measure of dollar GDP at over 70 percent in 2008, higher than the previous crisis levels. As the following years saw several bouts of severe lira weakness in the foreign exchange markets, the actual foreign debt ratio, measured at current exchange rates, inevitably moved toward the 60 percent level.
"In 2018 the Turkish lira finally suffered the inevitable severe carry crash. Turkish corporates that had borrowed dollars excessively were left insolvent. The full story of Turkey will play out over many years. But it will stand as an admonishment to policy makers for ignoring the widespread consequences of the rise of carry, even more so for actively encouraging the rise and globalization of carry."