(Bloomberg) -- Turkey’s market mayhem came as no surprise to many emerging-market veterans. What investors may be underestimating, though, is the contagion risk for Brazil, according to Carmen Reinhart, the Cuban-born economist whose warning in May of perils to come proved prescient.
"Do I think Turkey will turn into a major contagion episode? I think a key answer is what happens in Brazil," the Harvard professor said in an interview, citing high liquidity, political uncertainty and a debt-to-GDP ratio not seen in two centuries. "You don’t want to get caught with your proverbial pants down."
Latin America’s largest economy slowed in the second quarter after the nation dug out of its worst recession in a century. It’s particularly susceptible to Turkey’s turmoil given their shared lenders: Should those European banks grapple with soured loans, they may be less willing to extend Brazil further credit.
Brazil is also grappling with widespread corruption probes and a fiscal deficit as it spends on debt servicing. In addition, a pall of uncertainty hangs over October’s presidential election.
Here’s what else Reinhart had to say:
What separates Turkey from past crises?
"One important factor that affects degree of contagion is: To what extent is the shock a surprise? Thailand was a big surprise. The World Bank had just issued a report on the East Asian miracle. Mexico was a big surprise. It had been upgraded a few months before the December 1994 crisis. Turkey’s been ailing for a while. If you have, in Gabriela Garcia Marquez’s words, the "Chronicle of a Death Foretold," you’re giving investors more time to get out."
What Turkish surprise would jolt markets further?
"If Turkey were to come in and have a sovereign default, I think that would be a surprise. If the outcome is one in which you get more corporate defaults and capital controls, that wouldn’t be a game-changer. A sovereign default would be a game-changer for Brazil."
"At this stage, that’s not my baseline. Don’t get me wrong: Defaults can happen for strategic political reasons. Ecuador defaulted when the new government came in and said we don’t want to recognize old debt. But in terms of being driven to it, Turkey’s not there yet."
Are there any risks markets are underestimating?
"I don’t think Turkey’s only problem is the currency crisis. Turkey had a sustained boom in lending. Credit growth. Its private saving rate kept declining. Credit accessibility increased dramatically. The credit boom was fueled by capital flows. Booms in domestic borrowing often end in banking crises. I am deeply suspicious, because I’ve seen this before."
"Perhaps the reason an interest rate defense hasn’t been pursued is because they’re worried about banks. Thailand’s interest rate defense was at best feeble. It was feeble because the central bank was already extending credit to a whole range of finance companies that had invested in real estate. Real estate peaked in 1996. And you had a big chunk of finance companies underwater. So in that context, if they raise interest rates, you’d exacerbate an existing bank problem. A central bank in those conditions is faced with a dilemma: Raise interest rates to defend the currency, which other things equal will hurt the banks, or you can let the exchange rate go and try to keep interest rates as stable as possible to avoid exacerbating a banking problem."
"My suspicion is Turkey already has a banking problem, and that’s made the central bank more leery about a full-fledged interest rate defense."
How severe is EM contagion right now?
"There’s already been a very contagious episode for EM the last few months. It’s not been a good period and you’ve had capital outflows, you’ve had weakening in equity markets. We’ve already been in a more contagious episode than we had been since the late 1990s."
Where are the havens?
"I remember Stan Fischer as Governor of Bank of Israel. He always thought having liquid markets was such a good thing, and when he became governor he thought twice about it. During the Russian crisis, nobody sold Bolivia short, because nobody owned it in the first place."
"In moments like that, the stampede is into U.S. Treasuries. It doesn’t matter the origin of the crisis. It doesn’t matter if the U.S. has the crisis. It’s not often you see people running into a burning building, yet when the 2008 crisis originated in the U.S., people still ran into the dollar."
"When the dust settles, I think there will be differentiation and you will get more people looking at countries like Colombia or Ecuador in Latin America or some Eastern European countries. You would start to get countries where there are fewer excesses, but that comes later."