Turkey trouble: what's behind it and what does it mean for EM?

The economist’s view

Craig Botham, Emerging Markets Economist:

"Turkey’s current crisis has been a long time coming. The early warning signs were apparent in the 2013 “Taper Tantrum”, but while many emerging market (EM) policymakers heeded the tremors, Turkey’s did not.

"Today, as then, the underlying problem is the country’s high degree of reliance on external financing, though this is worse today than it was five years ago. Short-term foreign financing needs stand at some 18% of GDP, and close to 450% of central bank foreign exhange (FX) reserves. Analysts have warned at least since 2013 that these exposures left Turkey vulnerable to a “sudden stop”, in which foreign capital simply stops flowing, Friday saw those fears crystallise.

"Perhaps three factors have been instrumental in bringing matters to a head.

"First, and the most immediate, looks to have been the sanctions imposed by the US last week. Though not macro-economically significant in themselves, they brought the threat of worse to come, particularly restrictions on Turkish exports to the US, a key source of foreign exchange revenues. This ensured a harsh light was shone on Turkey’s external vulnerabilities.

"Second, central bank independence has long been questionable, and the institution’s failure to hike interest rates at its latest meeting had already triggered pressure on the currency, given that inflation is within touching distance of 16%.

"Third, the gradual tightening of global liquidity, with the Federal Reserve hiking interest rates and withdrawing QE, means markets are far less forgiving of unforced errors than in the past.

"It does not look like Turkey is poised to exit the crisis in the near future. In order to do so the country needs an aggressive rate hike, a resolution to its dispute with the US over the arrest of an American pastor and slower growth to help  bring imbalances under control; all of which do not seem likely in the near-term. There is no apparent source of relief for financing pressures either, with the US unlikely to assist, the IMF potentially hindered by US opposition, and traditional allies like Russia, Saudi Arabia and Qatar either estranged or facing financial pressures of their own.

"For now, the rest of EM seems to be suffering guilt by association, with currencies as diverse as the Mexican peso, Indian rupee, Russian rouble and South African rand all weaker. Turkey itself actually poses limited risk to other EM economies; financial and trade linkages are minor. There may be some risk that European banks, particularly in Spain and Italy, reduce exposures to EM more broadly because of losses in Turkey, but for most EM economies this is not that significant, not least because European banks had already retrenched following the European debt crisis.

Emerging market currencies underperform vs the US dollar


Blue bars represent the year-to-date performance. The orange bars represent the month-to-date performance.

Source: Schroders and Thomson Reuters Datastream. Data correct as at 13 August 2018.

"Market attention may focus on other economies with similar attributes to Turkey, but there is no economy with all of Turkey’s problems. South Africa has some similarities when it comes to external financing needs, albeit on a smaller scale, but it also has a truly independent central bank and inflation under control. Russia is likely suffering because of its own recent encounter with US sanctions, which could be escalated further. But beyond these two it is hard to see why other emerging markets economies should be made to suffer, beyond a general reduction in global risk sentiment.”   

The equities view

Nicholas Field, Global Emerging Market Equity Strategist:

“Turkey has long been a country that has required foreign funding, with the country running a current account deficit greater than 4% of GDP since 2005. As a result it has been subject to considerable volatility as foreign funding conditions have waxed and waned. Most recently, unlike many other countries, Turkey did not seek to improve its foreign funding vulnerabilities after the 2013 “Taper Tantrum”. Today, short-term foreign funding needs stand at some 18% of GDP, and close to 450% of central bank FX reserves, making the country vulnerable to a so called “sudden stop”, where all foreign funding stops. Such a “stop” forces the current account to close and a severe shock to GDP. This is what appears to be happening right now.

“The key underlying issue for potential foreign fund sources is concern over inflation and the direction of monetary policy. Inflation has risen to 16% in recent months, and the central bank has been, in the market’s view, late in raising rates. Questions over the independence of the central bank have also been raised, given the president’s heterodox views on monetary policy, and this has further reduced confidence. The focus on Turkey also occurs at a time when US interest rates are tightening which tends to reduce the availability of foreign capital. Lastly, a political dispute has flared up between Turkey and the US over the activities of an American pastor. Although this dispute has not caused the crisis, it does make the possibility of foreign help for Turkey less likely and so exaggerates its effects.

“In order to arrest the crisis, Turkey needs to regain the confidence of potential foreign funding sources. To do this would most likely require a combination of aggressive interest rate hikes, action to shore up the banking system and fiscal discipline, possibility aided by the involvement of international bodies such as the IMF. None of this looks likely at the present. Without such measures the crisis is likely to continue to worsen. It should be noted however that the Turkish lira is the cheapest it has ever been in real effective terms – a history of almost 50 years. Should stabilisation measures be adopted a substantial recovery is likely.

“In global emerging equity portfolios we have a small position in Turkey and are neutral versus the benchmark. In our Eastern European strategy we are underweight versus the benchmark and positioned in dollar earning companies where possible. Economic contagion effects should be limited with very little trade linkage to other emerging countries and most exposure to Turkish bonds being with developed European banks. There will undoubtedly be sentiment effects on other markets. The euro has been affected and Eastern European countries, as have emerging countries with a current account deficit. However, we would expect these effects to be transitory.”

The debt view

Jim Barrineau, Head of Emerging Markets Debt Relative:

“President Erdogan's refusal to raise interest rates has deepened a crisis in Turkey that is likely to spill over into Europe and other EM assets. Some of the contagion will be fundamental, but some will likely be via asset prices, which is likely to create opportunities for investors.

“Turkey's refusal to address market concerns about its excessive growth rate and burgeoning current account deficit will be a costly exercise for its citizens. And with a roughly 50% nominal depreciation of the currency and plummeting bond prices, local bondholders have effectively experienced a default. Banking stresses and perhaps bond restructurings are quite likely to follow, as will a boost to inflation while growth slows.

“One consolation for investors is that the current account deficit—the largest among big EM countries—should shrink, although in the most painful way possible. Foreign exchange reserves have been declining well before this most recent policy intransigence.

“In our view, likely options available without raising interest rates will be capital controls or loans from China or Russia. A traditional embrace of the IMF in a crisis scenario seems unlikely with President Erdogan's intransigence towards the West. None of these seem imminent, and in their absence contagion risks that could nick growth in the rest of Europe and European assets are high.

“Additional contagion to the rest of EM is more solely focused on asset price movement. Lower-rated credits are likely to be most affected but these have already under-performed significantly in recent months, and could represent good value with further price falls relative to the rest of EM.

“The Turkish debacle comes at a time when EM sentiment is fragile, and much of that is an artifact of a stronger US dollar as the Fed hiking cycle marches on. If Turkish fallout changes perceptions of the Fed's willingness to hike further, an EM relief rally would likely emerge. The probability of that—however low it might seem today—would help provide a floor to some of the worst contagion that we think is simply asset-based, rather than fundamental.

“On the Emerging Markets Debt Relative Return team we are underweight Turkey with zero allocation to Turkish-lira denominated bonds.”