Contagion Risk from Turkey. Where do we stand?

Turkey has been flourishing over the last couple of years with steady economic growth. In the second quarter of this year, the country reported GDP rate of 7.4% thereby even outperforming economic giant like China and converging India.

This expansion however, was mostly fired by foreign currency debt as Turkish banks and corporations ranked up more debt in U.S. dollars.

This borrowing increased consumption and spending and thus Turkey ended up with both fiscal, which is when government spending exceeds revenue, and current account deficit which means that a country buys more goods and services than it sells.

The country is also facing various other issues namely the lack of credibility of its central bank due to no action and worsening relations with foreign countries, including the US where Turkish officials were just sanctioned. Financial markets have been rattled over the past days and there seems to be the idea that a contagion risk into other Emerging Markets will follow. Is this really the case?

1) High Foreign Currency Debt
As we mentioned Turkey has a very high foreign currency denominated debt. This means that external debt becomes more expensive for Turkey to repay as the Lira falls more against those currencies. When we look at the first chart below we can see that Turkey’s debt is however relatively high compared to most of its peers making this less of a risk for contagion.

2) High Current Account Deficit
Turkey also has a current account deficit which is larger than that of many of its peer emerging markets such as China, Russia, South Africa and Argentina. A high number means that the economy required large inflows of foreign money.

3) Low country exposure
Many investors have exposure to Turkey viaExchange Traded Funds or Funds which have an exposure linked to an Index. The MSCI Emerging Markets Index, which is the most popular Global Emerging Markets index and has roughly $2 trillion dollars in assets has only around 1% exposure linked to Turkey.

4) Weaker currency
The majority of Emerging Market currencies have been hammered against the U.S. dollar. Not surprisingly though, as per chart number 2, the worst of them has been the Turkish lira.  While the lira has fallen over 30% in the past month, other currencies like the Brazilian real, Mexican peso and Indian rupee have been much more buoyant.

Even though the above gives us some form of re-assurance about a lower risk of contagion in emerging markets, we will have to face a lot of volatility in the coming days until the market perceives that the Turkish authorities are really responding to tackle these issues.

But what about Europe?

Last week the ECB showed concern regarding exposure of some the major banks in the Eurozone – mainly BBVA, Unicredit and BNP Paribas – in light of the lira’s rapid decline (see chart 3).

The contagion risk here cannot be taken lightly as there are concerns that these banks may not be fully hedged against the swift falls in the Turkish Lira through their exposure to the Turkish banking system. In light of this, European stocks especially those in the banking sector have been heavily under pressure and are down by 2.50% over a week.

In times like these investors would move towards defensive stocks in sectors like utilities, healthcare or consumer staples that tend to perform in periods of stress. Other defensive investments include traditional safe haven currencies like the Swiss Franc (see article) and the Japanese Yen which are providing good opportunities even in times when the US Dollar is continuingly getting stronger.

Gold, which is also considered as a safe haven, is not currently holding off losses with the major reason being a very strong demand for the U.S. Dollar that in turn hurts the price of Gold.

Although financially and strategically speaking, Turkey is considered a small economy with its equity market cap of around $150 billion that is similar to say Netflix in the US, we still need to consider the affect it might have across the globe, irrespective if it’s in Europe or in a faraway Emerging Economy.



Chart source: Factset, The Guardian, Bank of International Settlements, Wall Street Journal, Deutsche Bank

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