Europe will feel the pain of emerging markets

Wolfgang MunchauBy 

So much for “crisis over”. After the US subprime meltdown and the explosion of eurozone sovereign debt yields, we are now confronting a classic emerging market currency crisis with possible repercussions in other parts of the global economy. 

In Turkey, a reversal of capital flows in the second half of last year led to a gradual fall in the exchange rate against the dollar and the euro. When the Turkish lira started to collapse, the central bank responded with steep increases in various official interest rates. 

After a brief rally the currency resumed its decline. Turkey, once hailed as a leading high-growth economy, now has a weak currency and high interest rates. The looming cardiac arrest of the economy comes in a year of local and presidential elections and possibly a general election as well. Fears of political instability are feeding back to the currency markets. 

Currency weakness and inflation fears have also hit Argentina and South Africa. The turbulence is not – or at least not yet – of the scale of the great currency crises of the 1990s. But it is already having a global impact. As always the US is relatively robust to global shocks, up to a point – not so Europe, least of all the eurozone.

Start with the direct effect of the Turkish crisis on Greece and Cyprus. The magnitude is not that great on a global scale, but significant for the two countries. Their main industry – tourism – is competing head-on with Turkey. The Greeks and Cypriots have gone through incredible pains to improve their competitive position through wage and price cuts. The recovery in tourism is one of the few bright spots in their still depressed economies. The devaluation of the Turkish lira has put paid to all of this. Any holiday-maker headed for the eastern Mediterranean will find Turkey a lot cheaper. It is a game Greece and Cyprus cannot win.

The reason is, of course, that they are stuck with a strengthening euro. The euro’s real effective exchange rate – trade-weighted against all other currencies after taking account of inflation – rose 1.7 per cent in December, according to data from Bank for International Settlements. It probably went up further in January. For an economy on the brink of deflation, a currency crisis next door is the last thing that you want to happen. And this is not just a problem for Greece and Cyprus but for the eurozone as a whole. 

For the eurozone as a whole, the main problem is not trade because it has a moderately large trade surplus. Instead, the problem is the impact on the price level. Eurostat, the EU’s statistics office, estimates that core inflation was 0.8 per cent in January. 

I like to focus on core inflation because this is the measure that excludes volatile items such as energy and foods, and tends to be stable. The core rate has been fluctuating in a narrow band around the January level for the past four months. In other words, it has become unpleasantly sticky at a level that is way below the European Central Bank’s inflation target. 

At 0.8 per cent we are not far from outright deflation. A single large shock may be all that is needed. What is happening in Turkey and Argentina may constitute such a shock. And I have not even begun to talk about the possible consequences of shifting economic policy in China. 

Mario Draghi, president of the ECB, promised last month to ease monetary policy if inflation ended lower than expected. That condition is now fulfilled, so I would expect him and his governing council to make good on this promise. 

But another smallish rate cut is not going to be enough. Monetary policy has many direct effects, for example on the stock market, but its effects on the price level takes time. A rate cut of 0.15 percentage points could never make the difference between deflation and price stability. The ECB will have to do a lot more heavy lifting to prevent deflation. I am not sure that we will see a sufficiently forceful response. And it has already left it rather late. 

What is really troubling is that allowing inflation to drop and hold at its current level has already produced a type of deflation. 

As the Belgian economist Paul de Grauwe recently noted, debt deflation can occur even when official inflation rates are positive. It happens when expectations of future inflation rates are lower than they were when the debt contracts were made. 

This is clearly not an intuitive result. It means that when inflation expectations fall permanently, the value of existing debt rises – even if no new debt is incurred. We do not have to get to zero inflation to find ourselves in trouble.

Few lenders and borrowers ever expected core inflation to be sticky at around 0.8 per cent. Debt deflation is dangerous in a world with an unresolved debt crisis. The longer you wait, the worse it gets.

The last thing the global economy needs at the moment is a resurgence of the European debt crisis. It is true that the global economy is going through a weak cyclical recovery. However, it is also true that everybody is vulnerable to shocks elsewhere. 

Copyright The Financial Times Limited 2014.