When Financial Markets

Misread Politics
CAMBRIDGE When Turkeys Justice and Development Party (AKP) defied pundits
and pollsters by regaining a parliamentary majority in the countrys general election
on November 1, financial markets cheered. The next day, the Istanbul stock
exchange rose by more than 5%, and the Turkish lira rallied.
Never mind that one would be hard pressed to find anyone in business or financial
circles these days with a nice thing to say about Recep Tayyip Erdoan or the AKP
that he led before ascending to the presidency in 2014. And make no mistake:
Though Turkeys president is supposed to be above party politics, Erdoan remains
very much at the helm.
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Indeed, it was Erdoans divide-and-rule strategy fueling religious populism and
nationalist sentiment, and inflaming ethnic tension with the Kurds that carried the
AKP to victory. Arguably, it was the only strategy that could work. After all, his
regime has alienated liberals with its attacks on the media; business leaders with its
expropriation of companies affiliated with his erstwhile allies in the so-called Glen
movement; and the West with its confrontational language and inconsistent stance
on the Islamic State.
And yet financial markets, evidently placing a premium on stability, hailed the
outcome. A majority AKP government, investors apparently believed, would be
much better than the likely alternative: a period of political uncertainty, followed by
a weak and indecisive coalition or minority administration. But, in this case, there
was not much wisdom in crowds.
It is true that the AKP had a few good years after first coming to power in late 2002.
But the partys room for mischief was constrained by the European Union and the
International Monetary Fund abroad and secularists at home. Once those limits were
removed, Erdoans governments embraced economic populism and authoritarian
politics. Investors apparent optimism following the AKPs victory recalls Einsteins

definition of insanity: doing the same thing over and over and expecting a different
outcome.
Turkey certainly isnt the only case where financial markets have misread a
countrys politics. Consider Brazil, whose currency, the real, has been hammered
since mid-2014 much worse than most other emerging-market currencies largely
because of a major corruption scandal unfolding there. Prosecutors have revealed a
wide-ranging kickback scheme centered on the state-owned oil company Petrobras
and involving executives, parliamentarians, and government officials. So it may
seem natural that financial markets have been spooked.
Yet the most important outcome of the scandal has been to highlight the
remarkable strength, not weakness, of Brazils legal and democratic institutions.
The prosecutor and judge on the case have been allowed to do their job, despite the
natural impulse of President Dilma Rousseffs government to quash the
investigation. And, from all appearances, the probe has been following proper
judicial procedures and has not been used to advance the oppositions political
agenda.
Beyond the judiciary, a slew of institutions, including the federal police and the
finance ministry, have taken part and worked in synch. Leading businessmen and
politicians have been jailed, among them the former treasurer of the ruling Workers
Party.
Financial markets are supposed to be forward-looking, and many economists believe
that they allocate resources in a way that reflects all available information. But an
accurate comparison of Brazils experience with that of other emerging-market
economies, where corruption is no less a problem, would, if anything, lead to an
upgrade of Brazils standing among investors.
Going back to Turkey, leaked recordings of telephone conversations have directly
implicated Erdoan and his family, along with several government ministers, in a
hugely lucrative corruption ring involving trade with Iran and construction deals. It is
an open secret that government procurement is being used to enrich politicians and
their business cronies. From all indications, corruption reaches higher and is more
widespread than in Brazil.
But today it is the police officers who led the corruption probe against Erdoan who
are in jail. Some of the media outlets that supported the probe have been closed
down and taken over by the government.
The AKP argues that the police officers are adherents of the Glen movement and
that the investigation was politically motivated, aiming to unseat Erdoan. Both
claims are most likely true. But neither justifies the blatant lawlessness with which
the AKP government has clamped down on the corruption allegations. The upshot is
that Turkeys institutions, unlike Brazils, are being captured and corrupted to an
extent that will hamper economic growth and development for years to come.
Nor is Turkey the only country where large-scale corruption is left unchecked. In
Malaysia, Prime Minister Najib Razak has been at the center of a major political

scandal since nearly $700 million in unaccounted funds was found in his bank
accounts. Billions of dollars are said to be missing from the government investment
fund 1MDB, which Najib controlled. Najib has promised a full reckoning, but he has
sacked Malaysias attorney general, who was investigating 1MDB.
In Latin America, Argentina and Mexico both rank among the bottom half of
countries in controlling corruption and maintaining transparency much lower than
Brazil. The dramatic abduction and gruesome killing in 2014 of 43 students north of
Mexico City is only the latest example of collusion among the countrys criminal
gangs, police, and politicians.
We know from painful experience that financial markets short-term focus and herd
behavior often lead them to neglect significant economic fundamentals. We should
not be surprised that the same characteristics can distort markets judgment of
countries governance and political prospects.

What To Do About Debt

GENEVA Over the last few months, a great deal of attention has been devoted to
financial-market volatility. But as frightening as the ups and downs of stock prices can
be, they are mere froth on the waves compared to the real threat to the global economy:
the enormous tsunami of debt bearing down on households, businesses, banks, and
governments. If the US Federal Reserve follows through on raising interest rates at the
end of this year, as has been suggested, the global economy and especially emerging
markets could be in serious trouble.
Global debt has grown some $57 trillion since the collapse of Lehman Brothers in 2008,
reaching a back-breaking $199 trillion in 2014, more than 2.5 times global
GDP, according to the McKinsey Global Institute. Servicing these debts will most likely
become increasingly difficult over the coming years, especially if growth continues to
stagnate, interest rates begin to rise, export opportunities remain subdued, and the
collapse in commodity prices persists.

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Much of the concern about debt has been focused on the potential for defaults in the
eurozone. But heavily indebted companies in emerging markets may be an even
greater danger. Corporate debt in the developing world is estimated to have reached
more than $18 trillion dollars, with as much as $2 trillion of it in foreign currencies. The
risk is that as in Latin America in the 1980s and Asia in the 1990s private-sector
defaults will infect public-sector balance sheets.
That possibility is, if anything, greater today than it has been in the past. Increasingly
open financial markets allow foreign banks and asset managers to dump debts rapidly,
often for reasons that have little to do with economic fundamentals. When accompanied
by currency depreciation, the results can be brutal as Ukraine is learning the hard
way. In such cases, private losses inevitably become a costly public concern, with
market jitters rapidly spreading across borders as governments bail out creditors in
order to prevent economic collapse.
It is important to note that indebted governments are both more and less vulnerable
than private debtors. Sovereign borrowers cannot seek the protection of bankruptcy
laws to delay and restructure payments; at the same time, their creditors cannot seize
non-commercial public assets in compensation for unpaid debts. When a government is
unable to pay, the only solution is direct negotiations. But the existing system of debt
restructuring is inefficient, fragmented, and unfair.
Sovereign borrowers inability to service their debt tends to be addressed too late and
ineffectively. Governments are reluctant to acknowledge solvency problems for fear of
triggering capital outflows, financial panics, and economic crises. Meanwhile, private
creditors, anxious to avoid a haircut, will often postpone resolution in the hope that the
situation will turn around. When the problem is finally acknowledged, it is usually

already an emergency, and rescue efforts all too often focus on propping up
irresponsible lenders rather than on facilitating economic recovery.
To make matters worse, when a compromise is reached, the burden falls
disproportionately on the debtor, in the form of enforced austerity and structural reforms
that make the residual debt even less sustainable. Furthermore, the recent
strengthening of creditor rights and the growth of bond financing has made sovereigndebt restructuring enormously complex and open to abuse by highly speculative holdout
investors, including so-called vulture funds.
As consensus grows regarding the need for better ways to restructure debt, three
options have emerged. The first would strengthen bond markets legal underpinnings,
by introducing strong collective-action clauses in contracts and clarifying the pari
passu (equal treatment) provision, as well as promoting the use of GDP-indexed or
contingent-convertible bonds. This approach would be voluntary and consensual, but it
would miss large parts of the debt market and do little to support economic recovery or
a return to sustainable growth.
A second approach would focus on building a consensus around soft-law principles to
guide restructuring efforts. The core principles those under discussion include
sovereignty, legitimacy, impartiality, transparency, good faith, and sustainability
principles currently would apply to all debt instruments and could provide greater
coordination than market-based approaches. But, although this effort has the advantage
of familiarity, it would be non-binding, with no guarantee that a critical mass of parties
would adhere to it.
The third option would attempt to resolve this coordination problem through a set of
rules and norms agreed in advance as part of an international debt-workout mechanism
that would be similar to bankruptcy laws at the national level. Its purpose would be to
prevent financial meltdowns in countries facing difficulties servicing their external debt
and to guide their economies back toward sustainable growth.
The mechanism would include provisions allowing for a temporary standstill on all
payments due, whether private or public; an automatic stay on creditor litigation;

temporary exchange-rate and capital controls; the provision of debtor-in-possession and

interim financing for vital current-account transactions; and, eventually, debt
restructuring and relief.
Evidence from Ghana, Greece, Puerto Rico, Ukraine, and many other countries shows
the economic and social damage that unsustainable debts can cause when they are
improperly managed. In September, the United Nations General Assembly adopted a
set of principles to guide sovereign-debt restructuring. This is an important step forward,
but much remains to be done to prevent much from coming undone as the global
economy confronts the looming wall of debt.

Japans TPP Transformation

TOKYO On October 5, after years of exhausting and exhaustive haggling, a dozen
Pacific Rim countries finally signed up to the Trans-Pacific Partnership (TPP), an
agreement that promises everything from more trade to a cleaner environment. The
negotiations were such that the hair of Akira Amari, Japans economic and fiscal policy
minister, turned completely grey. His solace, however, is that the TPP will prove to be a
key foundation stone of the Asian Century.
The TPPs origins, pre-dating Amaris involvement, go back to a 2006 trade agreement
among only Singapore, New Zealand, Chile, and Brunei the so-called Pacific 4. The
United States, Australia, Peru, and Vietnam, seeing the prospect of a rules-based
international order in Asia, joined the talks in March 2010, and in an instant the P-4s
small boat became a great ocean liner.

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And then it became a convoy, as Malaysia, Mexico, Canada, and finally in 2013
Japan joined the negotiations. Combined, the TPP economies account for some 40% of
world GDP, outstripping the largest existing free-trade area, the European Union. Once
the TPP enters into effect, its impact on the global economy will undoubtedly be
monumental even without the participation of China, which on a purchasing-powerparity basis is now the worlds biggest economy.
Chinas exclusion was no accident. Its huge and complex economy would have injected
insuperable problems into the talks. In response, China has launched its Silk
Road initiative to create an economic zone that will favor its own priorities. It is also
seeking greater trade cooperation with European countries. One example is President
Xi Jinpings recent visit to the United Kingdom which in essence is also an attempt to
weaken Britains special relationship with the US by creating a cats cradle of trade,
financial, and investment ties with Britain. It is worth noting that Xi had already lured the
UK into supporting against American advice the new, China-led Asian Infrastructure
Investment Bank.
But, as Japanese Prime Minister Shinzo Abes recent call for talks with China on the
issue confirm, the TPP is not off-limits to China or to other Asian economies. South
Korea is warming to the idea of the TPP, as is Indonesia, following President Joko
Widodos recent visit to Washington, DC.
For Japan, the TPP is vital to achieve economic liberalization the third arrow of
Abenomics, the governments program to revitalize the countrys ailing economy. The
legislation to enact the TPP will simply push aside the lobbies and vested interests that
have been so effective in slowing down or diverting piecemeal reforms.
The promise of greater exchange of goods, services, and capital across the Pacific, as
well as the creation of international standards (for example, for intellectual-property
rights), is simply too appealing to ignore. When Japan and other Asian countries weigh
the risk of implementing the TPP against the risk of not participating, the risk of not
participating is overwhelmingly higher.

Japans political challenge will be to sell the TPP to its voters, especially the farm lobby.
The customs duty on beef imports, for example, is currently 38.5%. It will be 27.5% in
the first year after the TPP takes effect, and will then be gradually lowered to 9% in the
agreements 16th year.
That should surely provide more than enough time for Japanese beef ranchers to
prepare themselves for foreign competition (of the 870,000 tons of beef imported
annually, 520,000 tons come from Australia, the US, and New Zealand). And it will
certainly be a boon for consumers, as the price of their beef-noodle soup and sukiyaki
falls dramatically.
Japans ranchers do need time to adjust. Because they deal with animals, shortcuts
cannot be taken, and there are limits to mechanization, particularly in creating the type
of beef that Japanese consumers demand. Whereas ranchers in Australia and the US
have huge herds of cattle, Japanese ranchers raise each individual cow on beer and
massages. As a result, they will never be able to compete on price, and thus will need to
emphasize quality, most likely through much improved branding and marketing.
The same applies to rice. Rumor has it that when the wife of a certain Chinese leader
visited Japan, she bought a delicious variety of Japanese rice by the ton. Taking
advantage of the worldwide sushi boom, Japan needs to emphasize that real sushi
requires Japanese rice, branding it an exclusive product. Skeptics should note that Italy
has already succeeded in this, with top-tier restaurants around the world advertising that
they use genuine Italian pasta.
In fact, regardless of whether or not the TPP is implemented, Japans farmers must
pursue this approach to secure their futures, rather than hoping that protective subsidies
continue ad infinitum. Under the logic of the TPP, the terraced rice fields that make up
Japans beautiful landscape cannot be protected. So why not protect our landscape as
a resource for tourism and even as a way of combating climate change?
But now comes the truly hard part. The TPP has been signed but it will not be
implemented unless and until it is ratified by the legislatures of countries such as the US
and Canada. That process could well be enough to turn Amaris gray hair white.