The Currency Crossroads: Global Investors, Exchange Rates, and Turkey's Balance Sheet Mismatches
How Currency Mismatches and Global Financial Conditions Shape Portfolio Decisions in a Volatile World
While diving into a working paper from the Bank for International Settlements titled "Which Exchange Rate Matters to Global Investors?" by Kristy Jansen, Hyun Song Shin, and Goetz von Peter, I was reminded of a truth I often reflect on the most complex ideas are often the most necessary to simplify. In a world where global finance feels like a maze of shifting currencies and volatile markets, there’s a wisdom in making sense of it all—for those who want to learn, and for those who need to know.
So, I invite you to start this journey with me. We'll explore these intricate dynamics, shedding light on how global investors, emerging markets, and currency mismatches all intertwine, making sense of an ever-changing world. Because, as with any great story, understanding begins with exploration.
The paper explores the distinction between the reference currency of investors and the dollar’s role as a global risk factor, shedding light on how these factors shape portfolio allocation in response to exchange rates. The authors begin by asking, 'How do exchange rates affect the portfolio decisions and risk-taking behavior of global investors?'
Although the answer may vary, a common response, particularly regarding assets issued by emerging market economies (EMEs), relates to the currency mismatch EMEs face when borrowing in a major currency like the USD. When EME currencies depreciate against the dollar, borrowers encounter increased debt burdens, prompting foreign investors to reduce their exposure due to heightened credit risk.
Previous research has shown that foreign portfolio investors generally do not hedge currency risk when investing in local currency bonds, except for those denominated in major currencies. As a result, investors themselves face a currency mismatch and respond to fluctuations in FX rates. This conflates the role of the reference exchange rate (the currency in which investors measure gains and losses) with that of the USD as a global risk factor, where a strong USD limits risk-taking through the financial channel of FX rates (Bruno and Shin, 2015; Avdjiev et al., 2019; Georgiadis et al., 2024). This is due to the dominant position of the USD in global finance and trade invoicing.
The authors focus on euro-based investors, proposing that shifting the reference currency away from the dollar and toward the euro allows for new insights. By doing so, they separate the investor’s reference currency (in this case, the euro) from the influence of global financial conditions tied to the USD. Meanwhile, the borrower’s local currency is neither the euro nor the dollar, offering the flexibility to identify various effects related to exchange rates.
Their empirical findings highlight systematic and distinct responses of EUR-based investors to three types of FX rate.
Additionally, investors tend to sell more local currency bonds from sovereigns that experience depreciation against the euro, particularly those where the currency mismatch impacts them the most. The key takeaway from their findings is that currency mismatches on the lender’s side play a significant role in shaping international portfolio allocation. Up to this point, we have mostly examined currency mismatches from the perspective of EUR-based investors and emerging market economies.
Sialm and Zhu (2024) found that U.S. international fixed-income mutual funds hedge only 18% of their currency risk, while Dutch pension funds hedge only a small fraction of their exposures to non-major currencies. The burden of currency risk falls primarily on the lender's balance sheet. When a country’s currency depreciates, its debt burden in foreign currency increases, potentially elevating credit risk on FX bonds; however, this depreciation does not affect the servicing of local currency debt.
The findings reveal that investors tend to sell local currency bonds when the currency depreciates against the euro. Investors are primarily concerned with the currency mismatch on their own balance sheets, meaning the relevant exchange rate for them is that of the bond they hold, rather than the issuer country’s currency. A depreciation specific to a country prompts the sale of its local currency bonds, whereas a general appreciation of the euro leads to the sale of all local currency bonds. Moreover, tighter global financial conditions result in reduced bond holdings across all currencies, including the euro.
Another key insight from the article is that investors prefer to hold assets in their own currency to avoid currency mismatches on their balance sheets. This behavior has significant implications for emerging markets and small open economies. Investors exposed to currency risk may sell bonds at the first sign of depreciation, regardless of the underlying credit risk. To retain investor interest in local currency bonds, borrowers often have to offer a substantial yield premium over U.S. Treasuries, largely to compensate for currency risk (Du and Schreger, 2016). Consequently, countries borrowing in their own currency still face risks similar to those associated with foreign currency debt (Lane and Shambaugh, 2010).
Additionally, Maggiori (2020) demonstrates that investors exhibit a strong preference for holding bonds in their own currency, which results in corporations rarely borrowing abroad in their domestic currency, instead opting to issue bonds in USD or the currency of foreign investors. Following this introduction to currency mismatches and their impact on borrowers' balance sheets, for the next section we will dive into the Turkey's foreign currency balance sheet mismatch problem, with a focus on exposure and interconnectedness.
As I read the article, my thoughts turned to the hardships faced by my ancestors. Their struggles, carved into history, are mirrored in the economic complexities we see today. With the wisdom I have gathered from years of study, I feel compelled to delve deeper into academic research, seeking to bridge past experiences with present knowledge. One such effort is my focus on a recent working paper, Foreign Currency Balance Sheets in Türkiye: Exposure and Interconnectedness, authored by Alex Pienkowski and published in August 2023.
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Balance sheet mismatches have long been a source of vulnerability for Türkiye. As Sahay (2015) pointed out, financial deepening, along with increasing integration into global capital markets, has rendered emerging market balance sheets far more intricate over the past few decades. Through the lens of this research, I aim to enhance our understanding of these vulnerabilities, not just as abstract financial concepts, but as realities that echo through history and impact us today.
While this can bring benefits -access to global saving, information sharing, diversification risk – it also brings dangers, especially if not well managed. In the contrast of this argument, Allen (2002) suggested that balance sheet mismatches, in maturity, currency, and capital structure, can quickly spill-over into other sectors, potentially triggering an external balance of payments crisis which we had similar experience recently. Their analysis was only focused on one thing one thing only as FX mismatches in Türkiye. They started with analyzing each sector’s FX balance sheets starting from households (by far the largest positive FX position, mainly in the form of FX deposits in banks, but also FX loans to NFCs) and finished with central bank (Since March 2020, the central bank has had a negative net FX position, mostly in the form of FX deposits from the banking system).
Türkiye has a large negative net FX position relative to the RoW. Each of these sectoral balance sheets can be combined to construct an economy-wide net FX position. As of end-2022, this stood at minus $150bn (14% of GDP). Only the central bank has more assets than liabilities, with all other sectors acting as net FX debtors to the RoW. However, this is viewed, this large negative FX position leaves Türkiye vulnerable to adverse balance sheet effects from exchange rate shocks.
Turkey’s stock market has posted big gains in recent years, with the BIST 100 more than doubling in dollar terms since the start of 2022, as local investors turned equities to protect their savings against inflation, which peaked above 85% in late 2022.
Tunc Yildirim, head of institutional equity sales at UNLU&CO, mentioned that local investors' appetite for equities has waned due to "fatigue" and the increasing availability of alternative savings options offering moderate returns. The international investors entering the Turkish markets have mostly been hedge funds and emerging markets specialists, who typically act more swiftly than mainstream asset managers. These funds have achieved substantial gains but are now beginning to exit the market just as local investor interest is fading. According to central bank data, foreign investors have withdrawn approximately $2.4 billion since early May.
Analysts have highlighted that the future of the Turkish market will largely depend on whether policymakers maintain their commitment to tight economic policies, despite growing political pressure on Erdoğan's government due to the program's impact on households and businesses. Over the past year, foreign investors have cautiously re-entered Turkey’s market, and rating agencies have improved their outlook on the country’s creditworthiness. However, analysts point out that recent inflows have been primarily driven by hedge funds and other short-term investors attracted by high interest rates. Large institutional investment firms have generally remained wary of Turkey’s markets, concerned about a sudden shift in policy, which has occurred multiple times in the past. Additionally, significant foreign direct investment announcements have been scarce, as corporate leaders are hesitant to commit to long-term projects in Turkey due to economic uncertainties and broader issues, such as concerns about the rule of law and the independence of the judiciary.
In an increasingly globalized financial landscape, understanding the interplay between exchange rates and investment decisions is critical for both global and local investors. Turkey’s experience with currency mismatches and volatile market conditions highlights the importance of managing risks tied to foreign debt and fluctuating currencies. As we've seen, a stronger U.S. dollar can tighten global financial conditions, while local currencies like the Turkish lira face pressures that can impact both borrowers and investors. For emerging markets, maintaining investor confidence often requires offering higher yields to compensate for these risks. Ultimately, successfully navigating these challenges requires a deep understanding of both local market dynamics and broader global financial forces.
Related Resources;
Pienkowski, A. (2023). Foreign Currency Balance Sheets in Türkiye: Exposure and Interconnectedness. IMF Working Papers, 2023
Jansen, Kristy A.E. and Shin, Hyun Song and von Peter, Goetz, Which Exchange Rate Matters to Global Investors? (November 26, 2023)