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Explore: Turkey Contagion? Not So Fast…

Turkey Contagion? Not So Fast…

Turkey Contagion? Not So Fast...

Front and center in the news lately is the concern over Turkey’s currency crisis, with the country’s lira falling against the dollar by as much as 20% in one day.  Last week’s downfall was led in part by President Trump’s doubling of tariffs on imported Turkish steel and aluminum along with continued heated rhetoric over an American pastor being held in the country.  Couple this with Turkey’s authoritarian president, Recep Tayyip Erdogan, and his brash tone toward international and domestic policies, and you can see the idiosyncratic factors that sent the lira tumbling.

But the question on investors’ minds is whether Turkey’s currency fallout will spill over to global financial markets, triggering a widespread market blowback.  The answer?  Unlikely.

To better understand why it won’t, you must first understand the fiscal and monetary woes that are unique to Turkey.  Its economy has a rather large current account deficit, meaning they spend more on imports than they make on exports.  In fact, Turkey’s current account deficit, as a percentage of gross domestic product, stands to be the largest amongst emerging markets, with Argentina the next closest. To finance this deficit, Turkey has had to borrow extensively – more than any other major emerging market – in foreign currencies such as the US dollar.  As the dollar strengthens and the lira weakens, it has become more expensive for Turkey to pay back its foreign-denominated debts, leaving their economy extremely vulnerable to the strong dollar and an economic slowdown.

Adding to this, President Erdogan has been quick to criticize the autonomy of his country’s central bank, even going as far as appointing his son-in-law as the Treasury and Finance Minister.   Erdogan has publicly pushed his theory that high(er) interest rates are “the mother and father of all evil” and increasing them will lead to further inflation, even though the opposite is the truth.  These domestic challenges have left the country with an inflation rate double that of any other major emerging market economy besides Argentina, which has given way to further turmoil in Turkey.

If not yet apparent, Turkey is in a world of its own.  While other emerging markets, such as Argentina, have shown one or two similarities, none of them have experienced the woes to the same degree that Turkey has.  What other emerging markets are doing that Turkey has so willingly resisted is raising interest rates to help curb inflation and stabilize their country’s currency.  In Argentina – the country with the closest resemblance to Turkey’s monetary imbalances – the central bank took emergency steps to fight off ongoing market turmoil by hiking its benchmark rate by five percentage points.  Other countries, like Indonesia, have followed suit.  If history tells us anything, it’s that the countries that take the necessary action to improve their currency imbalances during times like these are the ones safe from further fallouts.

Still, fear is lingering in the Eurozone as the surrounding banks saw a selloff in their stocks earlier this week.  The theory playing out in markets is that, because of the substantial exposure to Turkish debt on European banks’ balance sheets, they will bear the brunt of the potential storm. But investors may be overreacting.  While the European financial sector will likely see defaults on some Turkish loans, they still have a significant cushion to cover any losses.  These banks stand far above the European regulators Tier 1 capital ratio – a ratio of a bank’s equity to its assets – at 15.26% vs. the 10.50% requirement.  Some pundits suggest that, at most, 0.2% would be shaved off their ratios if those Turkish loans went sour.

Case in point: the currency situation taking place in Turkey is far from contagion.  Keep a long-term outlook because Turkey’s red flags stand out amongst peers – not with its peers.

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