The ominous facts are well known – the strongest predictors of financial crises are domestic credit booms and external debts (Reinhart and Rogoff 2011). In emerging markets, credit booms are generally preceded by large capital inflows (Reinhart and Reinhart 2010). Many high-growth emerging markets have been receiving capital inflows for the last five years as the developed economies have been attending to their wounds from the Global Financial Crisis. Now the tide is reversing. Emerging markets are experiencing slowdowns in growth and widening current-account deficits.
Should we then expect a new crisis in emerging markets in the wake of the Fed’s decision to pull back from its bond-buying programme? Such ‘tapering’ has the potential to trigger large capital outflows from the emerging markets. Should we expect investors to dump a single country’s assets first – an action that might then spread contagiously to others, as happened during Asian Crisis in the late 1990s? The answer depends on the existing economic and political vulnerabilities in each country. To put it another way: “Have the emerging markets been naughty or nice during the boom years?”
The common narrative has been such that most of the emerging countries have already ‘emerged’. They have solved their problems of high external debt and inflexible exchange rates, put their macro houses in order, and proven themselves by their resilience during the Global Financial Crisis. Indeed, macroeconomic policies have been much better than in the previous decade. But have such countries really ‘emerged’ from weak rule of law, corruption, and political instability? If not, they are still vulnerable to a confidence crisis where political instability can easily trigger a financial crisis.
The case of Turkey
A case in point is Turkey, which might very well be the next ‘sudden stop’. During the last decade, under the AK Party government, Turkey enjoyed political stability and resilient growth that averaged 5% annually. Turkey earned praise from financial markets and economists alike until recently, when it was put on Morgan Stanley’s so-called ‘fragile five’ list together with Brazil, India, Indonesia, and South Africa. All of these countries have experienced a slowdown in growth and other vulnerabilities. Turkey seems to be the most fragile with the biggest current account deficit – this stood at 7.5% of GDP as of November 2013, and is mostly financed by short-term volatile capital flows.
The situation became more alarming with the major corruption scandal that is currently unfolding. Allegedly, several high-level officials, sons of ministers, top businessman, and mayors were involved in extensive graft, in which development projects which acted as a catalyst to Istanbul’s and other urban centres’ growth were shadowed by large bribes. The AK Party (AK means clean and pure in Turkish) has made transparent governance and the fight against corruption their key motto. According to the prime minister, this is the key reason for the political stability and growth that they have provided to the country during the last decade.
The last decade was a political bubble in the sense that no major structural, institutional, or legal reform had occurred (Kalemli-Ozcan 2013). It would not be surprising if there has also been a financial bubble. The prime minister’s initial reaction to the corruption charges did not suggest that there had been any institutional reform in the past decade, especially in judicial and legal institutions. The government sacked 70 top police chiefs and passed a law that restricts prosecutors from conducting probes without approval. Journalists are blocked from accessing the police, and are being asked not to report anything that would compromise the investigation in any way.
Political bubbles are likely to form during periods of political stability and strong government support. Research has shown that, in the past, emerging-economy crises are preceded by a strong increase in government support (Herrera et al. 2013). On average, in emerging markets, government stability increases by