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September 13, 2018

One interest rate hike won't stop emerging market pain

Emerging markets beware: In this climate, even a major interest rate hike can fail to impress worried investors.

The Turkish central bank stepped up Thursday after months of inaction and increased interest rates to 24% from 17.75%. The move produced an immediate reaction from the embattled Turkish lira, which strengthened as much as 5% against the US dollar.

But the lira, which has lost over 35% of its value so far this year, soon gave up most of its gains.

The rate hike is the latest example of an emerging market taking emergency action to protect its currency, but failing to convince investors that there was no need to seek out safer harbors.

"Today's actions don't look like they can sustain a decent recovery in the lira," said Kathleen Brooks, research director at Capital Index. "This is a sign that individual central banks can't really impact anything."

Emerging markets such as South Africa, Pakistan, Russia and Sri Lanka, but especially Argentina and Turkey, have been battered this year by investors who have pulled out of developing economies and directed their money to the United States, where interest rates are rising.

Economists are worried that the trouble could spread, infecting other vulnerable markets or even Wall Street.

Yet there appear to be few solutions, especially as economic powerhouses such as the United States and China fight a trade war. Not even an IMF bailout and interest rates of 60% have stemmed the bleeding in Argentina.

Brooks said that the dynamic is unlikely to change until investors become much more confident.

"We need to see a calm down in rhetoric about trade war," she said. "That's when emerging markets will start to recover."

The situation in Turkey has been made more difficult by the economic policies of President Recep Tayyip Erdogan, who caused the lira to weaken on Thursday by describing interest rates as "tools of exploitation."

Investors have worried about the president's influence over the central bank, which has been criticized for its slow response to the currency slide.

"Any sign that [Erdogan] will try to reassert his influence over monetary policy decisions could quickly cause market sentiment to deteriorate... there is clearly a lot of political pressure on the central bank," said Jason Tuvey, senior emerging markets economist at Capital Economics.

Meanwhile, other economies in Europe are likely to feel the effects of an economic slowdown in Turkey caused in part by inflation that has spiked to 18%.

"Trading partners will still have to contend with a likely significant drop in their exports to Turkey," said Holger Schmieding, chief economist at Berenberg Bank.

Schmieding estimated that a 25% fall in eurozone exports to Turkey would shave roughly 0.1 percentage point off the region's annual economic growth.

"People in Turkey aren't going to buy a BMW if it's costing 40% more ... you need a stable currency to have stable trade," said Brooks.

-- Gul Tuysuz contributed reporting.

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