By Frédérique Carrier & Anastasia Diangelaki
Turkey continues to dominate both financial and political headlines. The Turkish lira has plunged versus the U.S. dollar, while President Recep Tayyip Erdogan seems to have entered into a foreign and trade policy clash with the West, particularly the U.S.
The country’s travails are mainly self-inflicted, in our view, and, while risk appetite may retreat for a while, we see the situation as manageable both for emerging markets (EMs) and its close neighbour, the EU.
What got Turkey into this mess?
Since the start of Q2, renewed U.S. dollar strength has hurt EMs, putting more strain on vulnerable economies such as Turkey, a textbook case of a fragile economy vulnerable to changes in liquidity conditions.
Populist policies to prop up a lengthy political cycle, loose monetary conditions, and a buildup of domestic credit have resulted in inflation running close to 16 percent. The country’s current account deficit, ballooning to 6 percent of GDP, ultimately needs to be financed by foreign investors.
Markets are concerned about the ability and willingness of Turkey’s policymakers to adopt credible measures to remedy the situation. Over the years, Erdogan has exerted influence on Turkey’s central bank to favour lower interest rates and claims sole authority to appoint rate setters. He has reshaped his economic policy team, which is now headed by his son-in-law. Measures announced over the last few days have fallen well short of investor expectations.
Geopolitics are also in play with U.S.-Turkey relations at a nadir, reflected in the detention of a U.S. pastor and the imposition of trade tariffs on both sides.
According to RBC Global Asset Management, “Turkey will need to deliver a substantial interest rate hike in order for the situation to improve materially. This would not only help stabilise the currency but it would also send a signal to investors regarding the independence of monetary policy, helping to quell investor concerns. We would also need to see a normalisation of relations with the U.S. in order for the economic sanctions to be alleviated. In the absence of these policy responses, the lira may continue to weaken, which would further erode macro stability.”
Contagion in emerging markets?
Even if the diplomatic row is resolved and measures are implemented to stem the lira’s decline, current conditions mean that the crisis in Turkey may get worse before it improves.
However, this needs to be put into context. Turkey accounts for less than 1 percent of the EM equity indexes and less than 4 percent of the EM fixed income indexes. This also appears to us to be an idiosyncratic case, at least for now. Although other EMs such as Brazil remain under the market’s radar, global growth and the pace of U.S. monetary policy tightening should remain the main drivers for the asset class.
Importantly, EMs are now in much better shape than they were during the 2013 “taper tantrum” episode. Back then, the Fed signaled its intention to taper asset purchases, eventually leading to significant outflows from the asset class and a 35 percent decline in EM currencies versus the dollar through 2015. Since then, foreign exchange reserves as a share of imports have increased and current account deficit countries have seen an improvement in their external imbalances—most EM countries’ economies are not overheating.
There are also significantly fewer dollar-pegged currencies than in the past. Although EM government debt levels have continued to rise, a number of EM economies have managed to reduce vulnerability to external shocks by shifting debt to local currency.
How about contagion to the EU?
The EU could be impacted by the developing crisis through its links with the Turkish economy, namely trade and the banking system, though here again, the impact seems manageable to us.
The trade links are limited, with Turkey representing a mere 3 percent of the EU’s total exports. During Turkey’s 2001 recession, when GDP contracted by 6 percent, eurozone exports to Turkey shrunk by 30 percent. Should a fall of this magnitude occur again, it would shave some 0.15 percent from eurozone GDP growth, currently pencilled in at 2.1 percent for 2019. The impact could be even less, given European companies are now more adept at switching to new end markets, as they did when sanctions were imposed on Russia in 2014.
Exposure to the banking system also seems containable, with Spain, France, and Italy the most exposed.
Even in a worst-case scenario, the tier 1 core capital ratios of those banks with exposure to Turkey would not materially change, and would remain close to an adequate 11 percent or above, in our view. Moreover, while a complete collapse of the Turkish banking sector would cause difficulties for some eurozone banks, we believe European banking authorities would likely have the tools at their disposal to contain the damage.
One potential fallout of the Turkish crisis is migration. A deep recession could cause the more than three million Syrian refugees currently in Turkey (as part of a deal signed with the EU at the height of the refugee crisis in 2016) to leave for the EU. Such a development could strengthen support for anti-immigration parties—which are also often anti-EU—throughout the union.
The situation is still unfolding, with Turkey expected to announce new economic measures. Though the country’s issues are largely country-specific, the shift in global monetary policy could exacerbate them. While we believe risks of contagion are limited, it is more important than ever for investors to remain vigilant.
Non-U.S. Analyst Disclosure: Frédérique Carrier and Anastasia Diangelaki, employees of RBC Wealth Management USA’s foreign affiliate Royal Bank of Canada Investment Management (UK) Limited; contributed to the preparation of this publication. These individuals are not registered with or qualified as research analysts with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since they are not associated persons of RBC Wealth Management, they may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.