US must take care in Turkey crisis

US must take care in Turkey crisis

The US holds the upper hand in the dispute with Turkey because the latter’s current account deficit has to be funded by international investors. The US president can spook these into reducing their positions in Turkey, which would deliver an economic shock. But since the Asian crisis of 1997, there has been a sea-change in the way countries respond to economic shocks, which could mean the US ends up losing the dispute in the long term.

Economics and politics are tightly intertwined in this issue. If one looks at Turkey in a detached fashion, the large and persistent current account deficit is what hits the eye. It has hovered around 5 per cent of GDP since 2010.

Just as a person has to borrow from somebody else when they spend more than they earn, countries have to find money from abroad when they run current account deficits. This is what makes Turkey vulnerable.

Before the Asian crisis, the world’s richer countries tended to lend their savings to the poorer ones because returns were higher than at home. This can be a healthy practice, because countries that are not yet rich can lack the savings needed to build up the infrastructure required to become rich. It can mean foreigners end up owning large parts of an economy, as the British did in Argentina in the 19th century, for example.

But perhaps it is better that the infrastructure be owned by foreigners than not be built at all.

However, the flows of capital in the 1970s and 1980s were often badly managed at both ends. Western banks often made the investments simply because they had more money than they knew what to do with, such as they had when the OPEC countries deposited their oil wealth with them. And there were instances of corruption and wasting of funds in the recipient countries.

When investors lost confidence in a country, they would race each other to be the first out, which would send the country into turmoil. This processis known as the “sudden stop”, where the foreign lifeline is cut off Traditionally, the International Monetary Fund would administer a dose of its “economic medicine”, to the afflicted country, which normally involved the cutting of public spending and the selling of public assets.

Investors would then have a complete change of heart about the country, and would go back in, often to buy the same assets at very attractive prices. The country would very often return to a position of current-account deficit.

That is how things used to be. When several Asian economies racked up large current account deficits in the late 1990s, it looked as if it would be business as usual. Thailand, Indonesia and South Korea were the worst affected, but the whole region felt the  tremors.

The foreign capital, which had previously rushed in, came rushing out. As the IMF cut to the bone, that capital waited to go back in, but it is still waiting.

The psychological shock felt by the countries involved was such that they effectively vowed they would never again put themselves at the mercy of the international capital markets.

They set themselves on a path of making sure that they exported more than they imported. To do this, they fixed their currencies at an exchange rate that made their exports attractive and imports expensive.This modus operandi became widespread in the region —not just in the four worst-affected countries.

It worked for them, and countries from the region have tended to run large trade surpluses against the US ever since. This transformed many of them from being borrowers, at the mercy of the markets, to lenders.Collectively, they are such big lenders that they are causing havoc in the world economy. As mentioned in this column before, it might well have been the “savings glut” from these countries that forced its way into the US subprime market and caused the global financial crisis in 2007.

In the intervening years, they have been joined by other countries, which reacted to crisis by knuckling down and making themselves super-competitive —often turning a current account deficit into a current account surplus.

Germany did so in the first few years of this century when faced with the prospect of competing with the cheap labour of many of the other eurozone countries. Germany’s current account surplus is now an outrageous 7.8 per cent of GDP.

Perhaps Turkey will make some changes that would make international investors more comfortable and the crisis will pass. For example, the central bank has sometimes given the impression that it accepts President Erdogan’s view that high interest rates are the cause of high inflation rather than the cure for it. Higher interest rates would help to rein in inflation, which is approaching 16 per cent a year.

And perhaps the country needs to cut back on the construction of large infrastructure projects, which might be seen as vanity projects rather than something the economy definitely needs.

However, the US should not discount the possibility than Turkey suffers a sharp economic shock, and returns from the experience as a slimmed-down super competitor with a determination to run a current account surplus.After all, by running a current-account deficit, Turkey is supporting world demand rather than detracting from it. Fewer and fewer countries are supporting world demand by doing so. From a purely economic viewpoint, it is bizarre to see the US attacking a country that does.

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