The currency crisis in Turkey has the potential to spread to other emerging markets, and the resulting contagion could drag down economic growth.
On its face, the spat between the U.S. government and Turkey over a detained pastor seems like a narrowly focused political conflict. However, the fight has quickly erupted into an economic crisis for Turkey, and the fallout could be felt around the world. At a time when the oil market faces significant supply outages, the economic headwinds contribute to the uncertainty, potentially upending oil demand this year and next.
The Turkish lira crisis
The Trump administration announced a doubling of steel and aluminum tariffs on Turkey on August 10, which caused the Turkish currency, the lira, to plunge. Turkey announced a series of retaliatory tariffs on U.S. cars, alcohol, tobacco and other products a few days later, with President Recep Tayyip Erdogan promising to fight back against what his administration has dubbed an “economic coup.”
The currency trouble is the result of a combination of factors that are both unique to Turkey and the consequence of a broader deterioration in the macro environment. Turkey’s debt-fueled spending binge over the past decade has created the conditions for a sudden shift in investor sentiment. The tariff dispute was only the spark in a crisis that has been building for quite some time.
Just this week, as the Turkish lira crisis exploded, Argentina’s central bank had to hike interest rates by another 5 percentage points, and Argentina now has some of the highest interest rates in the world. The peso has lost more than half of its value this year.
However, the plunging lira is also occurring against a darkening backdrop for emerging market currencies more broadly. The U.S. Federal Reserve has increased interest rates several times over the past year, and has outlined several more rate hikes this year and in 2019. The rate tightening represents the end of a 10-year campaign to keep interest rates near zero following the global financial crisis. Higher interest rates are pushing up the value of the dollar, which has put pressure on emerging market currencies.
Currency troubles are brewing around the world. Argentina suffered a sharp drop in the peso earlier this year, forcing the central bank to enact painful interest rate hikes. Ultimately, the Argentine government had to turn to the IMF for a bailout. Just this week, as the Turkish lira crisis exploded, Argentina’s central bank had to hike interest rates by another 5 percentage points, and Argentina now has some of the highest interest rates in the world. The peso has lost more than half of its value this year.
Brazil is another country that has been rocked by the stronger dollar. The country’s currency, the real, lost ground to the dollar earlier this year at a time when global oil prices were rising. The result was a steep increase in fuel prices, sparking nationwide protests from truckers and oil worker, temporarily crippling the country’s economy.
The end result could be serious downside risk to the oil market as oil becomes prohibitively expensive to millions of people.
The volatility in so many emerging market currencies, when viewed in isolation, may seem like unrelated events. But the U.S. Federal Reserve and the end of the ten-year near-zero interest rate environment is playing a role in destabilizing a whole host of economies. That has been true for much of 2018. The sudden meltdown in the Turkish lira, which can be attributed both to problems unique to Turkey and to outside forces including the strength of the dollar, could potentially amount to a spark in a broader emerging market selloff. The end result could be serious downside risk to the oil market as oil becomes prohibitively expensive to millions of people.
Turkey was not immune to these forces, and the lira has depreciated over the course of 2018. The darkening economic clouds and the growing pressure from the strengthening dollar left the lira dangerously exposed. The U.S. tariffs on Turkey seems to have pushed it over the edge.
The problem for Turkey is that the central bank lacks independence and, due to political pressure, is likely unable to raise interest rates high enough to offset the currency turmoil. “The economy needs drastic measures at the moment. But the central bank will never really do that one shot hike that would show the markets that they are serious,” Nafez Zouk, economist at Oxford Economics, said in an interview with the Financial Times.
Oil market vulnerable to financial contagion
The currency turmoil is not confined to the realm of monetary policy. The fallout has instant ramifications for the oil market. Because oil is priced in U.S. dollars, a strengthening greenback makes oil much more expensive in local currency. In 1998, the financial crisis in Asia was partly the result of higher interest rates and a stronger U.S. dollar, which led to a plunge in oil demand growth. One could draw some parallels to the current predicament.
The trade-weighted dollar index, which measures dollar strength against emerging market currencies, is close to its highest level since the Federal Reserve compiled in the index beginning in 1995. In other words, the strength of the dollar is becoming a crushing weight on emerging market currencies.
In 1998, the financial crisis in Asia was partly the result of higher interest rates and a stronger U.S. dollar, which led to a plunge in oil demand growth. One could draw some parallels to the current predicament.
In countries that have seen severe currency turmoil, such as in Turkey, Argentina, Brazil, India, Mexico, Russia, South Africa, and Indonesia, to name a few, the sticker shock for gasoline and diesel for consumers is sudden and painful. For example, while Brent crude prices have gained roughly 7 percent this year in U.S. dollars, in India the price effect is twice as large because of the drop of the rupee relative to the dollar. In Turkey, where the lira has crashed, imported oil now costs 60 percent more.
“Turkey’s gotten hit by a double whammy this year: It’s among the most dollarized economies among emerging markets, and it’s one of the most oil and gas dependent,” Brad Setser, an economist at the Council on Foreign Relations, told the Wall Street Journal. “The implication is that it’s much harder to get out from the crisis.”
Turkey’s government is going the other way, announcing a fuel tax increase in recent days, as the hole in the government budget is now a much bigger concern than pump prices.
Not every country is responding in the same way. Indonesia, for instance, is increasing subsidies for gasoline and diesel to shield its population from painful increases in pump prices stemming from the compounding effects of a stronger dollar and higher global crude oil prices. Brazil also moved to regulate fuel prices to tamp down public outrage, rolling back market-based reforms instituted a few years ago. India’s government has tried to avoid a return to fuel subsidies, scrapped three years ago, although next year’s election is raising speculation that price supports might make a return. Turkey’s government is going the other way, announcing a fuel tax increase in recent days, as the hole in the government budget is now a much bigger concern than pump prices.
The deeper risk is if the contagion spreads either because major banks are exposed to souring emerging market assets, or because businesses and even entire governments struggle to pay back the mounting debt denominated in U.S. dollars. Dollar-denominated corporate liabilities in emerging markets has topped $3.7 trillion, or twice as high as in 2010, according to Bloomberg and the Institute for International Finance. “The risk of contagion is pretty high,” Robert Subbaraman, an emerging market economist at Nomura in Singapore, said in an interview with the New York Times.
Some signs of the “cooldown” are already cropping up.
In short, the risks to the oil market are profound. Oil demand growth has already cooled this year, falling from a 1.8-million-barrel-per-day (Mbd) growth rate in the first quarter of 2018 to an estimated 1 Mbd growth rate in each of the second and third quarters, according to the International Energy Agency (IEA). In Europe, oil demand in the second quarter was actually lower than a year earlier, and gasoline demand growth in the U.S. halved from the first to second quarter. The IEA said in its most recent Oil Market Report that “demand growth could cool down later this year and into 2019,” which “might dampen to some extent the impact on prices of any supply pressures.”
Some signs of the “cooldown” are already cropping up. China and India, two countries that play a pivotal role in oil demand growth, saw imports slow significantly in July. Reuters notes that their combined imports for July were roughly 0.5 Mbd below the average level seen in the first six months of the year. “Several Asian economies are already showing signs of weakness, possibly reflecting the impact of trade tensions,” the IEA said in its August OMR.
The International Monetary Fund warned in July that while global GDP growth remained strong, growth was becoming “uneven” in emerging markets, “amid rising oil prices, higher yields in the United States, escalating trade tensions, and market pressures on the currencies of some economies with weaker fundamentals.”
Many analysts still doubt that the the crisis in Turkey will spread and set off a broader emerging market crisis, but such a calamity cannot be ruled out. The result could be oil demand growth that is sharply lower than expected. “If this situation in Turkey doesn’t get resolved reasonably soon there’s a downside risk to our figures for sure,” said Michael Dei-Michei, head of research at JBC Energy, according to the WSJ.