Turkey’s Hot-Money Problem

NEW YORK – The ongoing financial volatility in emerging economies is fueling debate about whether the so-called “Fragile Five” – Brazil, India, Indonesia, South Africa, and Turkey – should be viewed as victims of advanced countries’ monetary policies or victims of their own excessive integration into global financial markets. To answer that question requires examining their different policy responses to monetary expansion – and the different levels of risk that these responses have created.

Although all of the Fragile Five – identified based on their twin fiscal and current-account deficits, which make them particularly vulnerable to capital-flow volatility – have adopted some macroprudential measures since the global financial crisis, the mix of such policies, and their outcomes, has varied substantially. Whereas Brazil, India, and Indonesia have responded to surging inflows with new capital-account regulations, South Africa and Turkey have allowed capital to flow freely across their borders.

Consider Turkey’s response, which has been characterized by an unwavering commitment to capital-account openness. Though political developments in Turkey have been attracting the most attention lately, the country’s current crisis is rooted in economic weaknesses, reflected in declining investor confidence and the sharp depreciation of the lira’s exchange rate. This instability has raised fears of emerging-market contagion, with South Africa especially susceptible, owing to its capital-account openness.

In lieu of capital-flow restrictions, Turkey’s monetary authorities began to cut overnight borrowing rates in November 2010, in order to reduce the profitability of the carry trade (purchases of foreign-currency assets to take advantage of a higher interest rate). The hope was that longer-term capital flows would finance the widening current-account deficit, which exceeded 8% of GDP at the time, mitigating the risk of a sudden stop in external financing.