Trouble in Turkey, Mixed picture in India
Sébastien Galy, Sr. Macro Strategist Nordea Asset Management
Trouble in Turkey
The Turkish economy is barely out of a recession but is being helped by a falling rate of inflation. This is due to a base effect, or in other words, the fact that prices rose so much in the past, courtesy of a run on the Turkish Lira, that they are now rising far more slowly by comparison. As inflation falls, most observers expect the Turkish central bank to ease in order to keep the cost of money, in real terms, even. Another way to look at this is that as price pressure eases so does the need to fight against it. In this environment, the government decided to fire the head of the central bank and replace him with his deputy. There are two plausible reasons for this:1) The government wants to take credit for the cycle of easing 2) The government wants a more aggressive easing cycle than is priced into the market. The Turkish Lira reacted by dropping 2.8% suggesting the market is going for the second reason, which is not necessarily self-evident. Moving forward, the market tentatively will be looking for the government to send a clear signal of its intentions. We expect that the central bank will follow a steady pace of easing leading to further weakness in the Lira and, hence, some imported inflation.
The problem in Turkey is that the private sector accumulated dollar debt hoping that the Turkish Lira would appreciate while borrowing at very low costs. The odds are that they did the same with the Euro. Unfortunately, the central bank’s foreign reserves are relatively small and include 20% of household deposits in commercial banks. This means that the central bank can’t afford much intervention in the currency market.
The path forward will likely be a difficult one for the economy as households and corporates are unnerved by hard currency debt and rising demand for hard currency. Nonetheless, the economy should continue to trough and maintain a steady but slow pace of growth. Its main risk is oil imports. If oil prices spike, the impact on the economy would be difficult to handle and the central bank would need to tighten as economic activity plunges.
Caution is warranted in Turkey particularly on the credit side given the slow pace of economic growth and risk of a weaker Turkish Lira. The odds of an impact on developed economies is limited, though this does matter for Germany.
Mixed picture in India
The Indian economy is slowing down as a function of weaker internal demand. We expect this process to continue as the government has yet to address the problems in the shadow banking sector. They have given the Reserve Bank of India (RBI) a remit to control the sector, but it will take months for them to address the problem and take remedial actions such as additional funding and some deleveraging. The RBI has been known to lower liquidity requirements for banks in the past and is likely to let these higher risk investors have lower risk requirements. The critical exercise will be for the RBI to gain the trust of the investors, and for this it will require months of work on site. As a consequence, the slowdown in consumer demand within rural areas, and some specific sectors such as real estate investments, are likely to continue.
Surprisingly, the Indian government failed to react to this with greater fiscal expansion. The deficit is forecasted to be 3.3% of GDP from 3.4% currently. Concern about the country’s overall debt level may be responsible for the government’s reluctance to expand fiscally. Without support for infrastructure, the government is left to rely on external demand and the middle class. External demand is likely to stay subdued until China troughs, likely within the next three to six months. That leaves a middle-class demand, which remains robust. The election of Narendra Modi likely reassured consumers, which means that demand is likely to be decent although unemployment is relatively high. Nonetheless, there are troubling aspects, such as a low level of productivity in the economy. Overall, it suggests that the economic slowdown could continue by another percentage point. While India remains one of the growing economies in the world, this slowdown should eventually reverse the situation.
With such a difficult environment, earnings expectations are depressed and underestimate the reaction function of the central bank. The equity market is likely to stay expensive as earnings expectations improve and deliver a subdued performance relative to the rest of Asia.
- The shadow banking sector hurt growth
Failures in the banking sector (e.g. Infrastructure Leasing & Financial Services default) deprive access to capital for higher risks clients such as real estate companies and rural households. The Wall Street Journal, for example, reports that car sales in India were down 19% in May. More broadly, financing conditions in the shadow banking sectors worsened considerably leading to fewer and more expensive loans as non-performing loans rose to 6.1%. In reaction to this, the government decided that non-banking finance companies would come under the control of the Reserve Bank of India as would housing finance companies. This unfortunately could take two quarters.
- Heat and lack of rain is an issue
A very weak monsoon season in June is not expected to continue according to India’s Meteorological Department, though it for now impacts farmers and hence GDP growth. Heat waves between March and July have become more intense, frequent and longer (CNN) and could eventually make parts of the densely inhabited India very hard to live in with water shortages. Experts believe heat waves could spread to the whole of India. By the year of 2100, all parts of Asia would not exceed the limits of survivability under a +2.25C scenario, however if no measure against climate change is taken, the Chota Nagpur Plateau and Bangladesh would reach that threshold. Other areas of India would come close to becoming unlivable without Air Conditioning (+35C). India has taken a series of measures against this. It is a signatory to the Paris Accord and pledged to reduce its carbon emissions by 33 – 35% below 2005 levels by 2030 in part by using solar power, though the country would remain reliant on coal.
- Structurally weak trade balance
With a manufacturing and Emerging Market slowdown, a rebound in exports depends in part on Chinese growth rebounding within the next three to six months. This would be a cyclical rebound, while the problem for India is a structural one as it maintains a persistently negative trade balance. Its manufacturing sector seems under-developed (15% of GDP) and fails to take advantage of a rising wave of educated youth. Indeed, only one of India’s top 10 companies is a global brand, Tata Motors. One should note the persistent issue of a heavy dependency on commodity imports, primarily energy, coal and gold.
- Long-term issue: Productivity
One of the key issues for relatively weak consumption and exports is that the Indian economy’s productivity has been relatively low for a while. There is, in essence, hoarding of labor and sectors that are still human intensive at a time when capital rather than humans should increasingly play a role. A large part of the economy is comprised of small companies with little access to innovation (Livemint). Upskilling workers in such small companies is likely a significant issue. Faced with this, households are likely limiting consumption and big-ticket investments. The government has shown willingness, albeit limited, to force new foreign competition and ideas. For example, the government is now allowing 100% FDI (from 49%) in insurance intermediaries in the latest budget as part of steps to liberate Foreign Direct Investments. More importantly, the government says it will open up sectors such as aviation, media, insurance and animation (CNBC) which is deflationary. Local sourcing restrictions will be eased for FDIs in single-brand retail sector.
Patience is warranted with India. It may take another quarter or two for growth to reverse. Till then demand related sectors are likely to still have some difficulties.