Turkey Contagion: How Deep Can It Get?

The Turkish lira has dropped 35% as of August 16, putting pressure on inflation as well as the country’s debt-heavy corporations and banks. Investor jitters have spread over the past week to some other emerging markets and European banks with Turkish exposure, but we don’t expect contagion to expand much further from here.

To be more specific, despite the recent turmoil and Turkey’s fundamental challenges, we don’t believe that markets are in for an emerging market collapse on the order of the 1997 Asian financial crisis, a European financial crisis or global contagion.

That’s not to say that Turkey’s situation won’t get worse before it gets better, or that some global investors won’t sell out of emerging markets. But at the end of the day, Turkey’s problems are highly country specific, and there are still worthwhile opportunities across emerging markets. In fact, the sell-off may create more attractive entry points in certain assets.

But if there were ever a time to be highly selective and active in fast-changing markets, this is it.

No Place Quite Like Turkey

People walking next to a currency exchange office in Istanbul, Turkey, on Monday, August 13, 2018.

When one emerging country runs into trouble, nervous investors tend to look for others with similar problems. But the scale and mix of Turkey’s issues is unique.

For one thing, Turkey owes a lot of money—53% of GDP—in foreign currencies, one of the highest foreign debt loads in the developing world. Turkish corporations did the bulk of the borrowing, encouraged by a decade of easy money in the developed world and a government program that guaranteed bank loans to businesses.

Turkey also has one of the highest current-account deficits in the emerging world at 7.1% in the first quarter of 2018. Meanwhile, the country’s foreign-currency reserves cover only some 75% of upcoming debt payments, lower than the vast majority of emerging economies.

Turkey’s political situation also sets it apart, starting with the credibility of its economic team. After his reelection in June 2018, President Recep Tayyip Erdogan removed cabinet members who had helped steer the country on fiscal and monetary issues and installed his son-in-law as treasury and finance minister.

Erdogan, a fierce critic of higher interest rates, has also called into question the central bank’s independence. The Central Bank of the Republic of Turkey raised eyebrows in July 2018 when it kept interest rates steady after inflation vaulted to a four-year high of 15.4% the previous month. Now, with investors and several major Turkish business associations calling for a significant rate hike to defend the lira, central bankers have imposed more moderate measures instead.

Finally, there’s Turkey’s clash with the United States over a North Carolina pastor accused of terrorism. The US imposed sanctions on two Turkish officials over the issue, and each country has since imposed tariffs on the other. Neither seems to be backing down.

Two Paths To A Resolution

Turkey has two options to end the crisis immediately. It could announce (and stick to) a medium-term macroeconomic plan that includes a sizable interest-rate hike, fiscal tightening and the installation of a credible economic team. Or, it could seek financing from an institution like the International Monetary Fund, which would likely require similar reforms. (Qatar has reportedly pledged some $15 billion in development funds to Turkey.)

Either option would reassure foreign investors, but fiscal and monetary tightening tend to depress growth in the short term, making them politically unpalatable. Then again, if the situation worsens, the political calculus may change.

What if Turkey does nothing? Is it time to cut and run from emerging markets? We don’t think so.

Still Reasons To Like Emerging Markets

In a world of slowing growth, emerging economies are expanding faster than those of developed markets and have solid earnings growth. Turkey’s woes aside, emerging markets rely a lot less on foreign capital than they did as recently as 2013.

Valuations also play a role in sizing up the opportunity. Emerging-market stocks are trading at a 25% price-to-earnings discount to those in developed markets. Bond prices are similar to US high yield, but with higher credit quality. In fact, the recent sell-off exposed select fixed-income opportunities in sub-Saharan Africa and the Middle East—both of which should benefit from higher commodity prices. Opportunities have also surfaced in Central America and the Caribbean, which should be relatively immune from US trade rhetoric.

Meanwhile, the valuations of some emerging currencies are beginning to look attractive, but bear further watching. As for Turkish assets: proceed with caution. A continued sell-off may well create some real opportunities in Turkey, but it’s important to research what’s on offer and carefully weigh the potential risks and rewards to avoid walking into a value trap.

Contagion Risk Exists

There’s also still some potential for broader contagion. If investors panic, the strong flows into emerging stocks and bonds that we saw in 2016, 2017 and the first quarter of 2018 could begin to reverse course. In a world of tightening financial conditions driven by shrinking G3 central bank balance sheets, a stronger dollar, higher developed-market interest rates or a combination of all three factors, countries that investors perceive to be most vulnerable–for instance, those with high current account deficits–may continue to face challenges.

What about Europe? Several banks with significant Turkish assets have seen their stocks tumble, but from our perspective their exposures are manageable. Besides, the European financial system is stronger and less interconnected than it was just a few years ago. While rising levels of nonperforming loans at the exposed banks could slow credit growth on the margins, we don’t foresee these effects spreading through the financial sector or denting overall economic growth.

In short, investors have to walk a very careful line in timing their investments and balancing risk. But Turkey’s story largely belongs to Turkey alone. There are enough good things happening in emerging markets to justify staying in and selectively adding to exposure when opportunities arise.