The risks behind using the exchange rate to fight inflation

Capital Economics warns that Turkey and Argentina's reliance on exchange rate anchors to combat inflation, while initially effective, historically leads to overvalued real exchange rates, widening current account deficits, and increased foreign currency borrowing, setting the stage for future currency crises. The brokerage's analysis suggests both nations will likely experience slower disinflation and weaker growth than anticipated, with Argentina facing higher vulnerability due to an already significantly overvalued peso and escalating foreign currency credit, further compounded by persistent political risks.

Analysis

Based on a historical analysis of emerging markets, Capital Economics highlights significant medium-term risks associated with Turkey and Argentina's current strategy of using an exchange rate anchor to combat inflation. This policy, while effective in delivering an initial drop in inflation, historically leads to a severely overvalued real exchange rate—with a median appreciation of 50% within six years in past cases—eroding export competitiveness and widening current account deficits. This dynamic sets the stage for potential balance of payments crises, as previously observed in Mexico (1994) and Russia (1998). For Turkey and Argentina, this precedent suggests disinflation will be slower and economic growth weaker than market expectations. Argentina is positioned as particularly vulnerable, with its real exchange rate already deemed significantly overvalued, whereas Turkey's starting point from a weaker currency provides a slightly better buffer. A compounding risk is the rise in foreign currency-denominated credit, which has increased to 35% of total lending in Turkey and 19% in Argentina, creating balance sheet mismatches that could amplify the negative economic impact of a sharp currency depreciation. The long-term success of these stabilization programs is further jeopardized by high political risk, given both countries' history of abandoning macroeconomic orthodoxy.

Key Decisions for Investors

• Investors should consider hedging or reducing exposure to the Turkish lira and especially the more vulnerable Argentine peso, given the high risk of large devaluations stemming from overvalued real exchange rates and widening current account deficits.
• A cautious stance on Turkish and Argentinian sovereign debt and domestic equities is warranted, as slower-than-anticipated growth and the looming threat of a balance of payments crisis could negatively impact asset valuations.
• Closely monitor the rising share of foreign currency lending in both banking systems, as this trend signals increasing vulnerability to a potential currency shock that could impact financial stability and economic growth.
• Factor in the high degree of political risk, as the historical tendency for policy reversals in both nations presents a significant threat to the long-term sustainability of their economic stabilization efforts.