Sunday, 3 February 2019

US Drivers of Emerging-Market Volatility

The US Federal Reserve turned ´dovish´ recently, somewhat surprisingly. Does that mean that emerging markets (EM) will cheer? Or won´t we have other EM currency crahes in 2019, like in Turkey and Argentina last Summer? The last OECD Economic Outlook (November 2018) stated recently that „Argentina and Turkey have been experiencing severe financial turmoil. Rising tensions in these economies, in the context of US monetary policy normalisation and idiosyncratic domestic factors, led to a sudden change in market sentiment toward semerging-market economies and triggered capital outflows.“[1]

EM cyclical fortunes do depend on US monetary policy, largely via three channels: global interest rates, the dollar, and global output. China, so far the global ´growth machine´, has become another cyclical determinant for emerging-market (EM) output, but so far mainly through trade, raw materials and, until a decade ago, ´unlimited supply of labour´. However, in historical perspective, the monetary shocks emanating from the US Federal Reserve Board (the Fed) have been comparatively minor in 2018 (Figure 1). With the Fed's recent dovish shift, the hunt for yield could be back; flows to EM should be picking up sharply.

Fig.1:  US Fed Funds Rate (blue) and US Dollar Index (red) 1974-2019

·       To be sure, the world´s single most important interest rate – the Fed funds rate – did com back from the zero lower bound in 2018 in recent quarters. However, in historical perspective, we are a long shot off the levels reached in the early 1980s when the disinflationary Volcker shock led to the Latin American, African and Korean debt crises. Even compared to the period thereafter, the recent rise looks almost ´peanuts´.
·       The trade-weighted dollar index has recorded annual percentages changes of maximum +/- 15 % ever since the 1985 "Plaza Accord" when G7 finance ministers reached an agreement about managing the fluctuating value of the US dollar. The recent dollar surge in 2013 in the wake of Bernanke´s paper tantrum caused quite a bit of (short-lived) havoc in EM markets and raw material prices. With corporate balance-sheet assymetries typical of EM, dollar volatility can be fatal[2].

Figure 2: A Tale of Two Currency Crashes 2018
- Currency index, 1/1/2018 = 100 -

The Turkish lira and the Argentine peso both crashed in 2018 (Figure 2), which immediately let to contagion in some emerging countries, notably those who run deficits on the current account and have a high dollar share in private and public debt. That EM contagion remained comparatively limited and short lived, may be attributable to market interpretation that the Turkey and Argentina crises were home-made to a large extent. Note that the Turkish lira has recovered quite well since August while the Argentine peso has stayed knocked down in 2018.

That Argentina and Turkey crashed was predictable. Both countries were expanding their current account deficits into a period of rising G-3 interest rates. Both currency crashes rather are variants of 1st generation currency crises as  external budget constraints and solid FDI funding were ignored for too long:
·       Argentina: In Argentina, unlike Turkey, the big foreign currency borrower is the government. Her twin deficits – fiscal and external – have been widening from zero in 2010 to roughly 6% in 2018. While these number do not sound outlandish – and nor is public debt as a percentage of GDP – Argentina´s debt rests on a very narrow export base. Since the early 2000s, exports (and services)  have come back towards 10% of GDP, from more than 20% in the 2000s. During the 2010s, “exports of bonds” have been gradually replacing exports of goods and services[3]. Toxic.
·       Turkey: In order to maintain his rule via a strong economy, Erdogan used pro-cyclical monetary and fiscal policies to fuel overall economic demand, after the global financial crisis in 2009 and then again after the military coup in mid-2016. In addition to generous money supply and high deficits in the state budget, public loan guarantees for private companies fueled output. Infrastructure investment was booming but increasingly debt-financed. Although private banks and companies in particular have incurred increasing foreign currency debt, the private debt often represents state contingent liabilities[4].

Figure 3: The Global ´Drumpf´ Effect

Beyond ´US monetary policy normalisation and idiosyncratic domestic factors´ listed by the last OECD Economic Outlook, we must look for another determinant that has recently caused, is currently causing and will cause EM financial volatility: global economic policy uncertainty. The Global Economic Policy Uncertainty Index has reached extreme levels never measured since its creation. While Euro fragility and the return of military tensions have certainly added to global uncertainty, the shocks to the world economy caused by US President Trump's isolationism, his obsession with containing China (the EM growth machine) and his willingness to impose sanctions all over the world have driven the index to levels displayed in Figure 3. Let´s call it the global ´Drumpf´effect. This is the central source of EM market volatiliy for the foreseeable future, despite the US Fed having turned dovish.

The Global Economic Policy Uncertainty Index[5] has thus reached extreme levels never measured since its creation. The index is a GDP-weighted average of national indices for 16 countries that account for two-thirds of global output. Each national index reflects the relative frequency of own-country newspaper articles that contain a trio of terms pertaining to the economy, uncertainty and policy-related matters: uncertainty about who will make economic policy decisions, what economic policy actions will be undertaken and when, and the economic effects of policy actions (or inaction)—including uncertainties related to the economic ramifications of “noneconomic” policy matters, for example, military actions.

In order to measure various possible drivers of emerging-market volatility, Figure 4 compares the indicators for the US dollar index, the Federal Funds rate and global economic policy uncertainty index with their long-term average. For each price driver, the distance between the current data point and the ten-year average was plotted. In order to be able to compare the distances, they were compared with the respective standard deviation. Thus, the measurements are standardized with the fluctuation of the respective time series. In statistics, the measure is called the "Z score".

Figure 4: US Drivers of EM Volatility (z-scores), 2007-18

Figure 4 shows the index of economic policy uncertainty at a level of fluctuation triple its long-term average at the end of 2018. Although the Fed Fund rates has recently started to rise, its standardized fluctuation is pretty much at long-term average, while the strong US dollar has lifted its z-score to almost double its long-term average. In sum, emerging markets need currently worry much more about policies of the Trump administration than about the US Federal Reserve, as far as global factors are concerned. 

[2] V. Bruno and H.S. Shin (2018), “Currency depreciation and emerging market corporate distress”, BIS Working Papers No 753.
[3] B. W. Setser (2018), “Argentina: Sustainable, Yes, with Adjustment. But Sustainable with A High Probability?”, Council on Foreign Relations, 21.5.2018.
[4] See my “Erdogan's macro populism is far from over”, ShiftingWealth, 30. 8.2018. In contrast to other observers who saw Erdogan´s imminent demise in August last year, I pointed to ´heterodox´ alternatives to IMF funds and capital controls as lifeguards for the continuation of Erdogan´s populist rule.
[5] For a detailed presentation of the methodology, refer to Scott R. Baker, Nicholas Bloom and Steven J. Davis (2016), “Measuring Economic Policy Uncertainty,” Quarterly Journal of Economics, Volume 131, Issue 4, and Steven J. Davis (2016),“An Index of Global Economic Policy Uncertainty”, University of Chicago Booth School of Business. 

Thursday, 29 November 2018

New Currents for Shifting Wealth

The 2019 OECD Perspectives on Global Development (PGD) have been released in Incheon, Korea.  Since its inception in 2010, the OECD Development Centre’s PGD series has investigated the increasing economic weight of developing countries in the world economy, a phenomenon referred to as “shifting wealth”. The 2010 PGD report "Shifting Wealth" had argued that the center of economic gravity in the world was shifting to Asia, changing the course of development for lower- and middle- income countries. That has proved correct.

The global macroeconomic effects emanating from shifting wealth run deep throughout the developing world and crucially determine how poor countries deal with reducing poverty. Consequently, shifting wealth has redefined development strategies and partners for poor countries. It has changed output linkages between emerging and developing countries, wages and terms of trade, and not least the geography of development finance.

With appropriate strategies, low-income developing countries could grow faster, lifted by the weighty fast-growing emerging countries. The initial opening of the China and India has hurt some middle- and high- income countries in the short term and at specific manufacturing locations. However, the sustained growth of these two emerging economic giants feeds global growth. Thus, it improves the long-term prospects of both low- and middle-income countries.

This sixth edition of the series, Rethinking Development Strategies, picks up on the shifting wealth theme by examining the rise of emerging countries and the implications for international relations. It pays particular attention to China’s evolving role. The second chapter (drafted by Michael Stemmer & myself) contains three main messages:
 Since the 1990s, shifting wealth has evolved in three distinct phases: an opening up phase (1990-2000), a phase of pervasive convergence (2001-08), and a post global financial crisis (GFC) phase (2009-present).
 Although shifting wealth has slowed down since the GFC, largely due to China’s domestic economic transformation, economic convergence continues.
 This continuation is buoyed by growth in India, new low-cost labour manufacturing hubs and strong South-South linkages between developing economies. To be sure, these South-South linkages are largely China driven.

The main message for the G20 meeting this weekend in Buenos Aires therefore is: 
A US-driven trade war against China will harm the economic prospects not just of China, but even more so in poorer countries.

Sunday, 30 September 2018

Dollar Dominance, BRICS & Shifting Wealth

Not least as a result of Shifting Wealth - the shift of the centre of gravity of the world economy towards Asia - the BRICS countries are seeking to replace the dollar as the leading currency with the Chinese yuan[1]. The shocks to the world economy caused by US President Trump's isolationism and willingness to impose sanctions can accelerate the rise of the yuan as a lead currency. (Meanwhile, the US are going insane under President Trump, as predicted by the Simpsons already in 2000!).

There is still a lot of plumbing to be done before the dollar dominance can be diminished. This work is in full swing with the establishment of new institutions outside the financial system dominated by the West, the establishment of new transport, energy and digital connections in the context of the Chinese Silk Road Initiative and the disintegration of global trade into regional trading blocks.

BRICS countries and dollar dominance

The five BRICS states form an association with different interests and strengths. If one topic unites these five, it is their rejection of the US-dominated monetary system. Thus the 10th BRICS Summit in Johannesburg in July 2018 once again ended with a call against the dominance of the US dollar. Since the Xiamen Summit in 2017, five selected emerging markets (BRICS Plus[2]) have been invited to promote the de-dollarisation of the global economy.

Since their first summit meeting in 2009 in Ekaterinburg, Russia, the BRICS states have been calling for the US dollar to be replaced as the international reserve currency. In the same year, under the fresh impression of the implosion of the global financial system in the wake of the Lehman bankruptcy, the UN Commission on the Reform of the International Monetary and Financial System headed by Joseph Stiglitz made the demand to replace the US dollar as an international reserve currency, possibly with the basket of Special Drawing Rights (SDR) of the International Monetary Fund. However, Special Drawing Rights are a form of art money that is not traded on foreign exchange markets. They do not fulfil all the functions of money: although SDRs can function as part of a country's official foreign exchange reserves, they cannot be used either to intervene in foreign exchange markets or as an anchor currency. So it's hardly surprising that the political impetus for the SDR as the reserve currency has silted up, even though the SDR basket has become more representative since the Chinese yuan joined in 2016.

The euro could be a serious candidate to reduce dollar dominance as a reserve currency if the institutional conditions were created[3]. In order to be attractive for global transactions, especially for reserve holdings, the euro should be stable in value and crisis-proof. But the reforms of the euro's financial architecture to date have not succeeded in establishing this confidence. Germany's restrictive fiscal policy is also curtailing the supply of risk-free Eurobunds; these would be the obvious alternative to US government bonds, the hitherto dominant form of official reserve holdings. After all, the mercantilist German economic model, which is pinned on external competitiveness, is standing in the way of the internationalisation of the euro because of the Triffin dilemma[4], just as it did in the past for the Deutsche Mark.

A Hundred Years of Dollar Dominance

Ever since the replacement of the British pound as the global reserve currency after the First World War the US dollar has dominated the world economy - for a century now.  The USA had already overtaken Great Britain as the largest economy at the end of the 19th century, and politically it dominated in the wake of the First World War. Today still, the dollar is enthroned in the bel étage of the international monetary system:

1. A large part of international trade, which far exceeds the share of the USA in world trade, is invoiced and settled in dollars. This is also due to the fact that the prices for most raw materials are quoted in dollars. The role of the dollar as the dominant invoicing currency in international trade and its widespread use as a transaction currency has so far been consolidated by network effects.  The global share of the dollar in international payments is now 40 percent, followed by the euro with 35 percent. By contrast, the yuan share has stagnated at just below two percent since 2016 due to devaluation pressure and the implementation of state controls to prevent capital outflows.
2. Network effects are less significant in terms of use as a reserve currency, in which not only liquidity aspects but also diversification arguments play a decisive role. Nevertheless, the dollar remains the dominant reserve currency. At the end of the first quarter of 2018, it accounted for 62.5 percent of the world's allocated official foreign exchange reserves. The euro was in second place at 20.4 percent. The yuan stands at only 1.4 percent[5].
3. The majority of bank financing outside the USA takes place in dollars: According to location-based statistics from the Bank for International Settlements, 62 percent of banks' foreign currency liabilities are denominated in dollars. Similarly, the corporate financing of non-American companies through bank loans and bonds is more denominated in dollars than in other hard currencies[6].

The lead currency functions (means of payment, holding reserves and financing vehicles) are interlinked in multiple configurations[7]. The high proportion of internationally traded goods invoiced in dollars drives the demand for secure dollar claims. Risk-free investments in US dollars generally pay lower exchange rate adjusted returns than risk-free investments in most other currencies. The violation of the uncovered interest parity in turn favors the dollar as a cheap funding currency. This feedback loop applies in particular to the export firms of emerging markets. Because of this violation, taking out dollar loans is generally cheaper than taking out loans in local currency. This increases the incentive for the company to settle its exports in dollars, because it can thus plan its future dollar sales more reliably. This, in turn, enables the company to borrow in cheaper dollars with lower exchange rate risks.

The USA, as the issuer of the global lead currency, enjoys the ´extraordinary privilege´[8], to import foreign capital by providing international dollar liquidity while non-Americans mostly hold their dollar investments in low-interest US government bonds. Some of these capital imports are channelled by the US into high-yield foreign investments, which generates considerable interest gains for the United States. Nonetheless, the rest of the world has also benefited from the dollar's status as a reserve currency. The depth and liquidity of the US financial markets and the economic weight of the US economy make the dollar attractive not just as a transaction and reserve currency. Countries with less liquid financial markets, in particular, are benefiting from the dollar as the reserve currency, partly due to favorable refinancing conditions on the US bond markets. In addition, the dollar has exhibited low inflation rates and relatively high external stability in recent decades.

The Dollar Discomfort of Emerging Markets

So what do the BRICS have to object to the dollar as the lead currency?

1. A most immediate response is provided by the currency crises in Argentina and Turkey, which were only recently the preferred borrowers of foreign banks and global bond markets. Now, in 2018, they have to swallow a rapid collapse in the external value of their currencies; they are paying heavy fines on the ´original sin´[9] typical of emerging markets. As many emerging markets have quite illiquid and narrow financial markets, the violation of the uncovered interest rate parity tempts them to borrow in foreign currency. If the dollar borrowing is made by companies or banks that do not have corresponding dollar revenues, currency mismatches arise in corporate balance sheets. These balance sheet mismatches are a time bomb for private actors, but equally for public budgets via contingent liabilities for public bailouts.
2. Another current concern relates to the United States' ability to impose sanctions. Any transaction conducted in US dollars or through a US bank automatically results in trading partners being subject to US jurisdiction. The US is currently waging an economic war against a tenth of the world's countries with a cumulative population of almost 2 billion people and a GDP of more than 15 trillion dollars. These include Russia, Iran, Venezuela, Cuba, Sudan, Zimbabwe, Myanmar, the Democratic Republic of the Congo, North Korea, but also countries such as China, Pakistan and Turkey, targets of other economic sanctions. The resulting trade war similarly weakens the attractiveness of the dollar in international trade and financial transactions. Countries like Iran welcome the possibility of circumventing US sanctions by exporting goods to China that can be settled in yuan. In July 2018, SWIFT's RMB tracker[10] quoted a 9.9 percent increase in the value of yuan payments for July 2018 compared to June 2018, while transactions in all other currencies  declined by 2.5 percent that month[11].
3. From a wealth perspective, emerging markets are worried about the danger of a depreciation of the US dollar. China (including Kong Kong) and the twelve largest emerging markets recently held official foreign exchange reserves of 6.7 trillion dollars, almost 60 percent of the world's official reserves. Often motivated by their vulnerability to sudden stops (of capital inflows), the demand for foreign exchange reserves is forcing developing countries to transfer resources to the countries that issue these reserve currencies - a case of "reverse aid", particularly benefiting the US. Major emerging economies, often net creditors to the rest of the world and with substantial holdings of US sovereign debt, fear a deliberate devaluation strategy by the US that would devalue their vast currency reserves by hundreds of billions of dollars. China's net foreign wealth has risen steadily over the past three decades, to half of its rapidly growing gross domestic product (GDP). Due to their notorious consumption surplus, the US extended their net debt position to 40 percent of GDP over the same period (Fig. 1)[12]. 

Net foreign assets, 1990 – 2014,, % of GDP

Source: Lane & Milesi-Ferretti (2018).

4. Finally, it also matters when the global economic gravity shift from the USA to China will also be reflected politically[13]. Shifting Wealth is incomplete and possibly endangered in the long run if its economic pillar is not safeguarded by military deterrence and a reduction in dollar dominance. Historically, the global reserve currency came from the leading economy of the time. According to IMF data, China is the largest economy in the world after adjustment for purchasing power; its share of the world product today (2018) is 18.7 percent, while the US share is estimated at 15.1 percent.  Since the USA (and the traditional OECD countries) has lost relative economic weight, the query of the lead currency has been a recurring theme in the context of Shifting Wealth.


The dollar still dominates the bel étage of the international monetary system with dominant positions in global payments, reserves and financing vehicles. In the basement, however, the Chinese are already busy laying the pipelines for a reduction in dollar dominance through the yuan. The establishment of new multilateral financing institutions outside the financial system dominated by the West, new transport, energy and digital connections along the Chinese Belt and Road as well as the disintegration of global world trade into regional trading blocs are the prerequisites for the internationalization of the Chinese currency.

According to Eichengreen's account of historical changes in the international monetary system[14], the sequence of internationalization of a currency is: 1. to promote its use in invoicing and settlement of trade; 2. to promote its use in private financial transactions; 3. to promote its use by central banks and governments as a reserve currency.

According to the latest data (2017) from the WTO, China was the largest exporting nation with over 2.26 trillion dollars and a 12.8 percentage share of world trade. China's imports amounted to 1.84 trillion dollars in 2017, making China the second largest importing country after the USA with a global import share of 10.2 percent. The USA's departure from multilateralism and world trade is promoting the rise of the yuan. Mega-projects focused on the US - the Transpacific Partnership (TPP) and the Transatlantic Trade and Investment Partnership (TTIP) - were suspended. Instead, the Pacific-Asian region is negotiating the China-led trading bloc ´Regional Comprehensive Economic Partnership´ (RCEP), which comprises thirteen countries alongside China, India and Japan and thus more than half of humanity.

Since the end of the yuan´s dollar peg in August 2015, there has been an empirically closer connection (comovement between currencies) between China's bilateral trade links and the respective yuan correlation. Therefore, the RCEP is likely to promote a yuan block in Asia. A rising influence of the Chinese currency has also recently been observed in some Latin American currencies. The growing yuan block will therefore also promote the yuan as a reserve currency in the future for reasons of stability and portfolio theory.

China's Belt-Road Initiative (BRI), with a planned investment volume of over 100 billion dollars, plays a key role in the internationalization of the yuan. The BRI was announced at the Silk Road Summit in Beijing in May 2017 by Xi Jinping, head of state and party leader, to 29 heads of state and government of the participating countries in Asia, Africa and Europe. The use of the yuan is to be promoted by the payment flows (yuan loans) in the countries along the routes accompanying the trading activities. The yuan loans originate, among others, from the Asian Infrastructure Investment Bank (AIIB) founded by China in 2016, which grants BRI infrastructure loans outside the Bretton Woods system dominated by the USA[15].

[1] Translated version of an invited contribution to debate the dollar dominance in Wirtschaftsdienst.
[2] Argentina, Egypt, Indonesia, Jamaica and Turkey.
[3] S. Dullien (2018), “The German barrier to a global euro”, ECFR, 30th August.
[4] The reserve currency country should continuously provide the world economy with risk-free liquidity through a current account deficit, which may undermine confidence in the reserve currency in the long run.
[5] IMF (2018), Currency Composition of Official Foreign Exchange Reserves (COFER),, 1st quarter 2018.
[6] G. Gopinath & J. Stein (2018), “Banking, Trade, and the Making of a Dominant Currency”, NBER Working Paper No. 24485, April.
[7] G. Gopinath & J. Stein (2018), op.cit.
[8] So already then French finance minister Giscard d´Estaing in 1965.
[9] B. Eichengreen, R. Hausmann, U. Panizza, U (2003), „ Currency Mismatches, Debt Intolerance and Original Sin. Why They Are Not the Same and Why It Matters”, NBER Working Paper  No. 10036, October.
[10] SWIFT is the acronym for the private Brussels-based service provider ´Society for Worldwide Interbank Financial Telecommunication´. RMB stands for Renminbi, the alternative name for the currency of the People's Republic of China.
[11] K. Yeung (2018), “ US-China trade war is helping to boost use of yuan in international transactions”, South China Morning Post, 9th September.
[12] P. Lane, G.-M. Milesi-Ferretti (2018), “The External Wealth of Nations Revisited: International Financial Integration in the Aftermath of the Global Financial Crisis”, in: IMF Economic Review, International Monetary Fund, Vol. 66(1), S. 189-222, March.
[13] Many think that US President Trump is “A Recipe for Disaster”, and the US going insane,  as  predicted in a Simpsons series in 2000 already. See “Simpsons writer says President Trump episode was 'warning to US', The Guardian, 18th March 2016.

[14] B. Eichengreen, “The renminbi as an international currency”, in: Journal of Policy Modeling, 2011, Vol. 33. 5, pp. 723-730.
[15] H. Reisen (2015), “Will the AIIB and the NDB help reform multilateral development banking?”, Global Policy, September,

Thursday, 30 August 2018

Erdogan's macro populism is far from over

China, Ruanda or Singapore show that autocratic regimes can stay in power for a long time - provided that they can be effectively controlled and removed by a "selectorate"[1]. Recep Tayyip Erdogan's "career", however, has more of a role model in the emerging countries of Latin America. Rudi Dornbusch and Sebastian Edwards created the typical phantom image of the macropopulist in 1991, with the four phases he usually goes through[2]:

·         As a rule, populists exploit widespread unease among the population about inadequate economic performance, often as a result of an austerity policy demanded by the IMF. A blatant unequal distribution promotes dissatisfaction, because the poor and middle class usually pay the bill for the fund's stabilisation programmes. At the same time, a successful IMF programme will lead to higher foreign exchange reserves and lower budget deficits. Cash is seductive - the call for expansion is getting louder. The situation described by Dornbusch and Edwards was exactly right when Erdogan first took office in 2003.
·         Growth by stimulating demand (to increase popularity) and redistribution (to ensure proximity to the people) have top priority in the second phase. Erdogan, the underdog from Istanbul's rough neighborhood Kasımpaşa, finds his support especially among the "Dark Turks" - the poor and orthodox Anatolian masses[3].
·         Parallel to the postulate of growth and distribution, the macro populist typically (under)assesses the macroeconomic risks of price inflation, consumptive deficit financing and external imbalances as secondary. If necessary, from the populists' point of view, dampening inflation calls for suppression of corporate profit margins as well as price and rent controls - that is phase three. Macropopulist governments generally avoid massive wage increases being offset by currency devaluation. The artificial undervaluation of imports (and implicitly of tradable agricultural products) puts the unruly urban population at rest, as this increases the purchasing power of their wages.

Beside the last point, the sketch of Dornbusch/Edwards applies to Turkey. So far, the country has been characterised by an open capital account and flexible exchange rates. This can probably be explained by the fact that Erdogan is more committed to rural Anatolia than to the urban area of Istanbul. In contrast to the dictum of Friedrich August von Hayek that capital controls mean the "Road to Serfdom", Turkey went this direction under Erdogan with free movement of capital.

But what about phase four of the phantom image - namely the end of the macro populist regime?

Erdogan´s Achievements

When Erdogan took office in 2003, Turkey was undergoing a reform process led by IMF and Economics Minister Kemal Dervis to overcome the severe financial crisis of 2001. The fruits, for example in the form of a steep rise in per capita income, were harvested primarily by the ruling party AKP led by Erdogan. Outside agriculture in particular, the AKP generated strong employment growth in poor Anatolia. The absolute poverty rate (below $4.30 per capita income) declined steadily. Erdogan's economic achievements were considered a blueprint, especially in the Arab region. Measured in terms of the top half of OECD member countries, Turkey was able to catch up economically. This convergence process slowed just before the failed military coup in 2016, though (Fig. 1).

Figure 1: Turkey´s Convergence, GDP/cap
- in % of the mean upper half OECD by GDP/cap –

Erdogan´s Failures

China has shown that autocrats need high economic growth for legitimation. In order to maintain his rule and a strong economy, Erdogan used pro-cyclical monetary and fiscal policies to fuel overall economic demand, after the global financial crisis in 2009 and then again after the military coup in mid-2016. In addition to generous money supply and high deficits in the state budget, public loan guarantees for private companies fueled output. Infrastructure investment was booming but increasingly debt-financed (Fig.2). Although private banks and companies in particular have incurred increasing foreign currency debt, they often represent state contingent liabilities.

Figure 2: Investment and Debt, Turkey (% of GDP)

As a result of the increasing legal arbitrariness under Erdogan, the high current account deficit was less and less underpinned by direct investment. The demand stimulated by Erdogan met supply-side capacity bottlenecks, resulting in rising inflation that could not be effectively combated by the government controlled central bank. The erosion of investor confidence increasingly weakened the Turkish lira, which further fueled inflation.

The rising demand for gold from the Turks, who increasingly distrusted the arbitrariness of Erdogan's rule, had the same effect. Since 2017, annual inflation has been in double figures. So it was only a matter of time before Turkey became the victim of a currency crisis, especially since the strong US dollar put a global burden on emerging markets. Emerging economies can be defined not only by their poverty or economic growth - but also by their dependence on the dollar exchange rate through balance-sheet asymmetries and commodity markets.

In the hot summer of 2018 nothing could stop the Turkish lira´s crash (Fig. 3). After his re-election in June, Erdogan had announced that he would have a stronger influence on economic policy in the future; in July he appointed his son-in-law as Minister of Finance. At the same time, the USA and Turkey overdid themselves with punitive tariffs, which further weakened the lira. Finally, the three major rating agencies put Turkey's creditworthiness even deeper into the junk status. When the lira crashed on 13 August, the Turkish currency, although already severely undervalued, was now worth just under 50% less than in June. Erdogan's macro populism had failed.

Figure 3. Turkish Lira/Euro, Summer 2018

Is Erdogan at the End as Many Hope?

For the time being, he does not want to resort to classical austerity measures. Restrictive monetary policy, especially higher interest rates to support the currency and fight inflation, is an abomination for Erdogan. The central bank is on a short leash, and interest rates are "mother and father of all evils" for Erdogan.

Indeed, higher interest rates would at best support the Turkish lira in the short term - in the medium term the largely credit-financed economy and the banks would collapse, which in turn would probably weaken the currency. The IMF could support the Turkish central bank by adding to its rather meagre foreign exchange reserves, in order to secure the refinancing of the Turkish economy's foreign exchange debts. Erdogan doesn't want to hear about that either: "We know very well that those who propose a deal with the IMF are actually proposing to give up our country's political independence," he said. Erdogan does not want to be domesticated from outside.

Erdogan not only has orthodox instruments at his disposal to keep himself at the top until his desired departure in 2025, especially since Turkey has become member of the BRICS Plus grouping since the BRICS summit 2017 in Xiamei..

The Russian Foreign Minister recently visited, and the Qatari ruling family has already promised USD 15 billion. That is only about 10% of the liabilities due next year. But in the area of global development banks (AIIB, NDB) and with China's new Silk Road, powerful resources have opened up outside the multilateral financial system dominated by the West. The "charm" of these new donors to autocrats like Erdogan is that the governance rhetoric about democracy, human rights and the rule of law plays little role. Even Germany, in the hands of Erdogan as a result of Merkel´s  migration deal, wants to help out.

Erdogan could also have recourse to capital controls. Prime Minister Mahathir responded to the speculative attacks of George Soros' Quantum Fund in 1997 with strict capital controls during the so-called Asian crisis, thus saving Malaysia from ruin. However, capital export controls only make sense for Erdogan if Turkey's external deficit is reduced to a level that can be financed by the new donors. However, this should be achieved with a degree of austerity that does not upset Erdogan's position of power.

Alas, Erdogan is far from over.

[1] Helmut Reisen (2018), „Paradigm Lost“, OECD Development Matters, 10. April.
[2] Rudi Dornbusch & Sebastian Edwards (1991), „The Macroeconomics of Populism in Latin America”, NBER, January.
[3] Jan-Werner Müller (2017), What is Populism?, Penguin Books.