Economic and Fiscal Volatility - Essay Example

Economics Name: Tutor: Subject: Date: Economic and Fiscal Volatility In emerging economies, divergence will remain to be a feature because of factors such as government policy, fluctuating currencies, and commodity prices. Some economies will benefit from such factors while others will not gain anything. It is, therefore, important to analysis to ensure that emerging investments are not only exposed to areas of benefiting but also well funded and governed. This paper discusses how emerging economies can reduce exposure to economic and fiscal volatility. The cause of financial shocks and crises is associated with boom-and-bust cycles in the private capital flows. Since early 2014, the heightened volatility in international financial markets has hit the emerging economies heavily. This economic turmoil for the emerging economies began when the US Federal Reserve Hinting announced that it will begin to reduce quantitative easing in May 2013. Economic analysts received this as a surprise who observed that emerging economies have suffered from trends and policies from advanced economies (Turner, 2014). An emerging market is a country which is experiencing rapid economic and household income growth and industrialization. Turkey is one of the countries which is considered an emerging economy. Turkey recorded a remarkable growth from 2002-2007 with a record of GDP reaching 6.8%. There was strong growth in 2004/2005 which was followed by the slower rate at 2007. This was because of political uncertainties and tightening of monetary policy after the exchange rate-volatility in 2006. The increase was driven by private consumption particularly boom investments. This remarkable growth was also associated with macroeconomic stabilization which was implemented. The country carried out fiscal consolidation which was vital in reducing the burden of public burden and anchoring investment. The borrowing in the public sector was minimized to considerable levels due to strong primary surplus. However, the inflationary target contributed to high interest rate which increased the degree of volatility. Turkey has recorded a remarkable growth of about 6 percent since 2010. This growth is associated with recovery from financial crisis and unemployment issues which have been experienced in the country for the last decade. However, despite this growth in the economy, the country is unable to bridge the gap between the advanced economies due to low national savings and competition challenges. What holds the country from growing into the developed economy are high inflation rates and huge amounts of external deficits (Kara, 2012). In the last decade, emerging economies made substantial efforts to establish resilience against future fiscal volatility shocks. One of the efforts made by these economies was that they were able to accumulate large international reserves either through exports earnings or borrowing. This effort enabled them to cover a high percentage of their external financial requirements. There was a reduction in government external debt in proportion to gross domestic product. The other way in which emerging economies employed to prevent shocks is through the introduction of stringent macro-prudential to prevent vulnerabilities. These efforts, however, have contributed to financial risks and economic crisis in general (Fernández-Villaverde, J., 2011). Turkey, for example, more recently heightened domestic uncertainty and financial market volatility. When countries borrow from abroad due to the advantage of low-interest rate, they expose themselves to exchange-rate risk. In Turkey, the country’s corporate firms are rated with over 90 percent of their debts are dominated by foreign currency (Phillip, 2014). Despite macroeconomic prudential measures put in place, foreign currency risk to the financial institutions is that the risk is not eliminated, but it is only transferred. For example, the banks in Turkey reduce currency mismatches in their balance sheets by offering loans dominated by foreign currency but the risk is only transferred to the borrower thus raising credit risk of the firm. When unstable funding sources and high-level of indebtedness are combined, this can be very dangerous. For example in the case of banks when they are under pressure to remember their own as a result of their funding problems will cause devaluation, and the borrowers will have to pay high interests rates (Turner, 2014). Turkey can avoid volatility in the banking sector by strengthening the banking sector and preserving it. The Government can maintain standards of supervision under level essentials. In addition to supervision the authorities can also extend their macroeconomics prudence. A thorough analysis is also needed to solve the problem of foreign exchange rate. Through the analysis, measures can be identified that reduces the ability of the banks to borrow wholesale foreign exchange. Also, prudent measures should be applied to the foreign exchange lending index. Some economists have recommended that lending measure equivalent to those of direct foreign exchange loans. The rising share of external debt which is subject to foreign currency is mainly held by the private sector. This factor exposes the emerging economies to further vulnerabilities. One of the vulnerabilities is that it limits the governments of the emerging economies to respond to a financial crisis when it occurs. In addition to this, it does not exclude the government totally from absorbing the losses realized through the crisis. Another common feature that faces emerging economies is the willingness of the foreign investors to hold the corporate and the government of the emerging economies with bonds which are dominated by local currency and about 25-60 percent of the bonds being held by non-residents. A report by the World Bank (2013) indicates that more than 30 percent of the bonds in Turkey are held by non-residents. Although this approach helps in reduction of foreign exchange risk, it makes the foreign investors more sensitive to the issue of currency devaluation. Increased frequency of shocks and narrowing of the growth of the current cycle is another characteristic which denies emerging economies time to recover fully and to rebuild. From statistics, the private sector in the emerging economies is at the risk of exchange and interest rate. The government of these economies will be required to step in to resolve this issue so as to avoid a general meltdown of the economy. For Turkish banks, without governmental intervention, the banking sector in the country will collapse. This happened in the Latin America where all losses were taken by the government, and this was accompanied by slow growth rate and high levels of unemployment and other social costs. Turkey’s low domestic savings and challenges related to competitiveness are becoming the major limiting factors for investments and exports. Due to this, the economic growth is expected to slow by about three percent and the consequences of slow economic growth is that it will limit inflation and deteriorate the deficit current account. Slow economic growth rate also translates to Turkey being left in the middle. That is its convergence with the advanced economies would be very low. The emerging economies are faced with a risk of low inflow of capital due to fiscal volatility. External capital inflow helps the developing economies to support debt-based consumptions and to fund their banks. Turkey’s can suffer from the costly adjustment of the actual economy because of the abrupt fluctuations in cash flows. The country’s external, gross financing needs of 25 percent have experienced the shifts. Due to this reason, leverage has increased in the private sector, and this interferes with the shock withstanding (Aysan et al., 2014). When the imbalances increase then, it will become very expensive for Turkey to make adjustments. In 2014, IMF visited Turkey, and the team agreed that they will increase their financial surveillance especially anything to do with cash inflows giving specific attention to the risks of contagion (Kopits, M.G., 2013). A tighter fiscal stance will help in reducing the pressure on monetary policy and external imbalances that are experienced in Turkey. Structural balance in the country has been deteriorating for the past years. Tighter fiscal stance will help in achieving the inflation targets because of minimal pressure from the monetary policy. The monetary policy provided a flexible exchange rate regime and control of monetary aggregates which were set to achieve the targeted inflation level. This policy has not been successful in achieving inflation targets because of its pressure. Tight fiscal stance will encourage private sector investment and improve the competitiveness of Turkey. The stance will also react to shocks and thus increase the GDP in future. When the stance is formulated, it should be ensured that it is consistent with inflation which is focused to reduce to five percent (Kopits, 2013). The emerging economies should learn from the recent crisis because there is none which is near to the tip. Turkey being of them should be in the forefront to understand that international financial flows move up quickly, and they are unpredictable, but the good thing is that there are warning signs. Turkey’s economic growth is limited by dependence on consumption, slow export growth and large investment needs against the large external deficit. This indicated that there are imbalances in the economy, and this issue could be addressed if structural changes are put in place and also the implementation of a strong macroeconomic policy mix (Bergman and Hutchison, 2014). A general recommendation to deal with the issue of volatility is that there is a need for establishing a framework for debt resolution. This will provide a procedure in which the countries are facing a debt crisis. Regional reserve funds should also be established. For example, in Turkey, national reserves which are in line with international standards can be established. This is the work of the central bank of Turkey to ensure that the reserves are in line with the international reserves. Lastly, policymakers should identify stronger control measures on rowdy cash flows (Gamage, 2010). In conclusion, economic turmoil for the emerging economies and divergence will continue to be a feature because of factors such as government policy, fluctuating currencies and commodity prices. In the last decade, emerging economies made substantial efforts to establish resilience against future fiscal volatility shocks. One of the efforts made by these economies was that they were able to accumulate large international reserves either through exports earnings or borrowing. This effort enabled them to cover a high percentage of their external financial requirements. There was a reduction in government external debt in proportion to gross domestic product. The other way in which emerging economies employed to prevent shocks is through the introduction of stringent macro-prudential to prevent vulnerabilities. Turkey is one of the countries which is considered an emerging economy. Turkey has recorded a remarkable growth of about 6 percent since 2010. This growth is associated with recovery from financial crisis and unemployment issues which have been experienced in the country for the last decade. However, despite this growth in economy, the country is unable to bridge the gap between the advanced economies due to low national savings and competition challenges References Aysan, A.F., Fendoglu, S. and Kilinc, M., 2014. Managing short-term capital flows in new central banking: unconventional monetary policy framework in Turkey. Eurasian Economic Review, 4(1), pp.45-69. Bergman, M. and Hutchison, M., 2014. Fiscal Rules and Government Efficiency in Reducing Procyclicality in Emerging and Developing Economies. University of Copenhagen, Denmark and University of California, Santa Cruz. Fernández-Villaverde, J., Guerrón-Quintana, P.A., Kuester, K. and Rubio-Ramírez, J., 2011. Fiscal volatility shocks and economic activity (No. w17317). National Bureau of Economic Research. Gamage, D., 2010. Preventing State Budget Crises: Managing the Fiscal Volatility Problem. California Law Review, 98(3), pp.749-812. Kara, A.H., 2012. Turkish experience with implicit inflation targeting. Central Bank Review, 8(1), pp.1-16. Kopits, M.G., 2013. Rules-based fiscal policy in emerging markets. International Monetary Fund. Phillips M., 2014. Will the emerging market rout get even worse? Watch corporate bonds. Quartz. 30 January. Available at http://qz.com/172509/will-the-emerging-market-rout-get-even-worse-watch-corporate-bonds/ (accessed 23 April 2016). Turner P., 2014. The global long-term interest rate, financial risks and policy choices in EMEs. BIS Working Papers No 441. Bank for International Settlements. Available at www.bis.org (accessed 23 April 2016). Read More