Thursday, February 11, 2010

Weekly Forbes column: The World’s best-concealed debt migraine

Below is the unedited version of my column for this week. You can read the final version at the Forbes website. As usual, the unedited and final versions are a lot different. The editors always do a very tedious job over there, but they really topped it this time around, so I'd recommend you to read the final version; this rough draft is for my archiving purposes only. Feel free to comment or rate the article over there; remember that bad ratings are even more appreciated than good ones, provided they come with an explanation on why you don't like the article.

As for the column, I don't have extra comments for now, but hopefully, I'll get some comments so that I will be able to discuss this important issue further.

The Mediterranean fiscal soap opera is going on unabated although markets have sighed in relief for now, as hopes of a Greek bailout by the EU have risen.

Portugal is struggling with a political crisis over a regional finance bill to put its fiscal books into order. Spain has taken an entirely different route by accusing economists, including Nobel-winner Paul Krugman, and the media of unfair finger-pointing, while at the same time mounting a PR campaign.

All this melee is helping other countries with fiscal problems of their own, as they have completely been shut off the investors’ radar. A case-in-point is Turkey, which has not only been able to shove its debt problems under the carpet, but also managed to shine as a bastion of fiscal responsibility by rating agencies and economists alike.

Just the mere mention of ratings agencies hints, based on their past performance, that something is amiss here. After all, it was possible to make a fortune in 2007 and 2008 simply by doing the opposite of what they were saying, as hedge fund manager John Paulson can confirm. But the Turkey proponents seem to have the numbers on their side.

In fact, a simple comparison with the troubled Mediterranean trio would probably make you wonder what I’ve been smoking. After all, at 45% of GDP, Turkish public debt looks rather reasonable when compared to Greece’s 113%, Portugal’s 77% or even Spain’s 54%.

But simple cross country comparisons, which ignore the vastly different circumstances in each country, can be very misleading. For one thing, it’s not the level of the debt that is worrying, but its rate of increase. The chart below, courtesy of Turkey Data Monitor, illustrates the sharp rise of domestic debt over the past year.

To make matters worse, at around two years, the maturity of the debt is still short, as can be seen in the same chart. The improving macroeconomic conditions and Turkish Treasury’s deft debt management have been increasing maturity slowly but steadily, and Turkey managed to issue its first-ever ten-year domestic bonds two weeks ago. But even the maturity of newly-issued debt is still around three years.

Finally, the absorptive capacity of financial markets makes a big difference. Of course, who owns the debt is crucial. For example, the US, with its large domestic market and safe haven status of its bonds, will not have much problem borrowing, at least so long as the Chinese have hordes of reserves that they need to stack. But there is no fixed formula: Spain in on red alert precisely because almost all of the country’s over-a-trillion euros of debt is held by non-residents.

Then, it should help Turkey that non-residents hold only about 15% of its domestic debt. But, around 60% of the government debt is held by domestic banks, which bought bonds relentlessly last year, positioning to take advantage of the Central Bank’s great easing cycle, where the policy rate decreased from 16.75% in November 2008 to 6.50% in November 2009.

In essence, the banks were able record record-profits due to their banking on rate cuts last year, but now they don’t have much more appetite for government bonds, as the Central Bank has been on hold for the past three months and the next direction for the policy rate is likely to be up rather than down.

A good comparison could be made with Japan, where banks and insurance companies also hold around 60% of government debt. But there, both households and corporations are increasing their savings and with the weak economy, there isn’t much demand for credit. As a result, the banks have plenty of cash to go around, and not much other place to park them other than government bonds.

In contrast, private savings are likely to stay low in Turkey as demand is expected to pick this year, so banks will not be getting a fresh stack of cash. In addition, all the firms in search for credit would have to compete with government bonds for the banks’ scarce cash. This would not only create upward pressure on rates, but the resulting crowding out of private lending would slow down economic recovery.

These issues can remain under the carpet for some time, as investors remain bullish on emerging markets. After all, all emerging markets are equal in good times, but some become more equal than others during bouts of risk aversion.

When that decoupling materializes, the hunting season will be open for bond vigilantes, and the spotlight will be on savings-oriented economies with high growth and trade surpluses such as much of Asia and Russia, as Pimco’s Bill Gross argues in a recent report. Turkey could easily fall behind then due to its rising current account deficit and political risks.

Obviously, Turkey’s debt problems are much smaller in scale and scope than those of the Mediterranean trio. A sudden death, as Greece is likely to face without a bailout, is out of the question. Even a slow death from rising rates is not very likely, either.

It would rather be a long migraine, for the banks, holders of Turkish debt and firms alike…


Anonymous said...

I am so impressed by your analysis...You are the only economist who can see this...But on the other hand you work for Hürriyet...Don't worry your boss will not have to pay the tax and penalty levied upon him...Then you can change your "opinion" Good luck.

Emre Deliveli said...

Given the comments I received at the Forbes web site, I should be thankful for your kind remarks, and I am.

But really, I do not see myself working for Hurriyet, Forbes, or anyone else for that matter- one of the beauties of being freelance is that I neither get hired nor fired...

Also, I am proud to say that there has never been any pressure on me from Hurriyet (or the government or anyone else for that matter) for what I've written and there is a simple reason for that:

Obviously, you can argue that there has been no reason to pressure me to being more pro-government, given the troubles between my "boss" and the government. But if they become best buddies, and she tells me she does not like my "opinion", I can tell you right away that I will not change my opinion. She can then tell me she does not want me to write for the Daily News anymore, and that's about it. I will luckily find another freelance post at another English daily and together with Forbes and teaching and some consulting, I will still bring home the bacon.

Besides, I am not really pro or anti government. I am just trying to look at things from an economist's objective lens. If the AKP brings back fiscal responsibility, I'll be the first columnist to congratulate them.

Anyway, thanks for your comments, which are never required but always appreciated...