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What the Turkish crisis means for investors

16 August 2018

We look at how the current turmoil in Turkey may affect global markets.

The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.

What you’ll learn:

  • Why Turkey is going through an economic crisis.
  • What options Turkish policymakers have available to resolve the crisis.
  • Whether Turkey’s crisis will severely impact global markets.

Investor attention has recently focussed on the ongoing economic crisis in Turkey. Year-to-date, the Turkish lira is down against the dollar by about 70%, with the currency collapsing by about 25% in the past week alone. This week, we discuss how the turmoil in Turkey may affect global markets and our approach to the portfolios we manage on behalf of clients.

Emerging market crisis

Whilst the lira’s collapse was initially sparked by the imposition of sanctions by the US, its underlying causes run deeper than just geopolitics. Turkey is currently going through a classic emerging market crisis, and its economy displays all the hallmark vulnerabilities of those historical episodes. Despite growing by more than 7% this year, the economy suffers from an inflation rate three times higher than that of the central bank’s target. It has relatively high trade and fiscal deficits, which makes it reliant on foreign investment inflows.

Alongside that, a sizeable proportion of its hefty foreign debt exposure is denominated in foreign currency, making its debt much harder to service as its domestic currency falls further. These problems make Turkey vulnerable to a sudden stop in foreign investment inflows. Should investors get cold feet and stop lending to Turkey, the economy will have to adjust rapidly (and painfully), usually through a sharp fall in the currency.

Identifying vulnerabilities

In previous research, we used a scorecard to assess which countries are most vulnerable to sudden stops in capital inflows. The scorecard uses a number of metrics that help quantify a broad swath of external imbalances within these countries. These include measures that help gauge a country’s external funding needs and its external debt exposures. In addition, we include a number of measures that may help mitigate the vulnerabilities mentioned above. These include the ability to attract foreign investment flows and the adequacy of foreign currency reserves. We then rank each emerging market country based on these measures, and obtain a set of relative rankings based on how vulnerable these countries appear. Indeed, based on our scorecard, Turkey ranks as one of the countries most vulnerable to such a scenario.

Making things worse, Turkey’s institutions are widely perceived to be inadequate to the task of solving its crisis; a president that harbours a misguided view that higher interest rates cause higher inflation, a relatively inexperienced finance minister who is the son-in-law of the president himself, and a central bank which is no longer seen to be independent of political pressure.

As such, the imposition of US sanctions was merely the catalyst for already-wary investors to dump Turkish assets en masse; the root cause was ultimately economic mismanagement. As with most emerging market crises, the outcome for Turkey’s capital markets has been ugly – year-to-date, the stock market is down by approximately 20% in local terms (50% in dollar terms), the yield on a 10-year Turkish government bond has spiked by 8%, and the cost of insuring against a Turkish default has risen to its highest level since the Great Recession.

Contagion

The direct impact of Turkey’s crisis on global markets is mild, owing the relatively small size of the Turkish capital markets. However, the crisis can affect global markets through other indirect channels.

The first indirect channel is through European equities. European banking stocks sold off last week in response to the lira’s collapse, owing to concerns that select European banks have high exposure to Turkish assets/borrowers. Here, we think that the potential spillovers are limited.

The European banking sector overall has minimal exposure to Turkey save a select few banks – Spain’s BBVA, Italy’s UniCredit, the Netherlands’ ING, and France’s BNP Paribas. These four names make up just under 20% of the European banks index and 3% of the wider European equity index. Given these numbers, the negative impact on European equities from a further deterioration in Turkey should be very limited.

The second indirect channel is via souring sentiment on emerging market assets in general. There are signs that the lira’s collapse has begun to spread to other emerging markets with similar vulnerabilities as Turkey, with other currencies like the Indian rupee, the Argentinian peso and South African rand selling off in particular. A further deterioration in may weigh on market sentiment or spark further selling from investors, leading to more volatility across the asset class.

Investment conclusion

There are few easy options for Turkish policymakers, given the severity of the crisis. A sharp rise in interest rates may help stem capital outflows and reduce pressure on the lira. Another option would be to seek help from the International Monetary Fund (IMF), as Argentina did earlier this year. Alternatively, Turkish policymakers can opt for capital controls to restrict investors from pulling capital out. The government’s bellicose rhetoric suggests that for now, it intends to wait out the crisis without resorting to higher rates or IMF support.

Capital controls are unlikely as well – although they would prevent investors from pulling their money out, they will also further deter foreign investors from lending to Turkey. On balance, a worsening of the Turkish situation cannot be ruled out. This obviously translates into more headline risks, so it’ll be wise to continue monitoring events in Turkey.

Nevertheless, we do not see the Turkish crisis as having any significant impact on our fundamental case for favouring stocks over bonds. For now, we do not think Turkey’s crisis is a sufficient cause for us to change our overall outlook for global markets.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

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