Goldman Assesses EM's "Original Debt Sin," Finds Burnt Turkey

Over the course of what can only be described as a protracted EM FX bloodbath - catalyzed, of course, by slumping commodity prices, the yuan deval, and threat of a Fed hike - one topic that’s been brought up repeatedly is that emerging economies with a large amount of foreign currency debt could find themselves in a decisively tough spot. 

After all, if you’re sitting on a pile of USD-denominated liabilities and the currency you print crashes against the dollar, well then, you’ve got a big problem on your hands. This time around, most analysts point to better developed markets for local currency debt, which has allowed governments to avoid the so called “original sin” of becoming overly reliant of FX debt for funding. 

Now, as we go into December, the market should be probably be asking more questions about what the potential for a soaring dollar means for emerging market balance sheets. As Bloomberg’s Richard Breslow put it last week, “emerging markets are not panicking, despite the Fed talk. The fall in their currencies in the last year and improved fiscal conditions are perceived as allowing them to withstand a Fed hike. Maybe wishful thinking but there you have it.”

Yes maybe. On Sunday, Goldman is out with an interesting take on the “original sin” issue, noting that you have to look at the whole picture (i.e. NIIP) if you want to understand where EM balance sheets really stand. Here’s more:

EM FX has been under pressure in 2015. For example, both the ZAR and the TRY have depreciated by 22% against the Dollar year-to-date.


This is not all bad news...but from a sovereign balance sheet perspective (i.e., credit risk perspective), this development is a concern as many emerging economies have issued significant amounts of foreign currency denominated debt (the ‘original sin’) which rises in local currency terms when FX depreciates. 

Many emerging economies issue debt in foreign currency (the ‘original sin’) to reduce interest rate payments or because the market will not fund them in their own currency. This makes the country’s debt dynamics vulnerable to sharp currency movements and, as a result, incentivizes the local central bank to hold FX reserves. Exhibit 3 illustrates the level of external debt across EMs, divided into FX and local currency.



The large amounts of FX denominated debt, combined with the sharp FX movements, are a dangerous cocktail from a credit perspective. For example, a 10% TRY depreciation against the dollar will lead to a 3.5pp of GDP rise in Turkey’s external debt level (10% x 35% of GDP), all else being equal. Therefore, at first glance, it is no surprise that EM sovereign credit sold off in sync with EM FX over the summer. 


But one also needs to assess the impact on external assets (e.g., FX reserves) when evaluating the credit implications of the sharp FX re-pricing. The asset side of the emerging markets net international investment position (NIIP) is illustrated in Exhibit 4. 



Exhibit 5 illustrates the net external FX position (i.e., external assets minus FX dominated debt), divided into a USD, EUR and ‘other’ component. Within the CEEMEA region, Romania and Turkey are most vulnerable to generic currency weakness, as their net FX position is negative (in sharp contrast to Russia and especially South Africa). 


In the simplest possible terms: Turkey doesn't have enough in the way of external assets that can appreciate in an unfavorable FX environment to offset the pain said environment will have on the country's pile of FX debt.

Just how big of a problem is that for Ankara you ask? Here's Goldman again: 

So how have EM balance sheets been affected by the latest FX adjustment? Exhibit 6 illustrates the estimated change in the net international investment position following the EM FX adjustment in 2015 (for Russia since September 1, 2014). Turkey’s balance sheet (NIIP) has weakened by around 5pp of GDP following the large TRY adjustment, as the rise in the level of FX denominated debt dominated the rise in Turkey’s external assets.



So you can add "balance sheet problem" to Turkey's laundry list of troubling issues and what the above means, in a nutshell, is that if the dollar continues to appreciate against the lira, this is going to get materially worse.

One important thing to note about this particular situation, is that Turkey has been reluctant to hike in order to arrest the lira's decline. In fact, the central bank has on any number of occasions explicitly stated that it will follow the Fed. But when, back in August, Turkey attempted to release a "roadmap" of how its central bank intended to respond to policy normalization by DM central banks, the market wasn't buying it, suggesting that if the Fed hikes, it may not be as simple as simpy saying "oh, ok, we'll hike too." That is, they may find themselves unable to catch up, portending still more lira weakness, exacerbating the problem outlined above.

And for anyone who thinks that a "strong" AKP government is going to give the lira anything that even approximates lasting relief, or that further ECB easing will give the central scope to remain on hold (or even to cut) in the face of a Fed hike, we suggest you take a hard look at exactly what's going on politically and militarily both within Turkey and on its borders. There are huge (and likely intractable) idiosyncratic risk factors here that could send the currency plunging at any time. And then there is of course sheer autocratic incompetence (via Reuters): 

Turkish President Tayyip Erdogan renewed his call for lower interest rates on Sunday, saying they were too high to encourage investment and entrepreneurship, an argument likely to unnerve investors already worried about central bank independence.


Long a champion of populist economics, Erdogan has repeatedly called for lower rates to spur growth, equating higher financing costs with treason.


Economists say Turkey's central bank needs to hike rates to rein in inflation. Its refusal to do so has sparked worries about political interference in monetary policy, helping send the lira currency to a series of record lows this year.