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Turkey Troubles: Limited Contagion So Far

14 August 2018Emerging Markets

The Turkey financial crisis first sparked off with concern on high inflation. The inflation rate of Turkey rose to 15.85% in June 2018 from 8.5% in December 2016 due to weaker currency, higher energy prices and the government sponsored credit boom.

There have been three important recent catalysts. Firstly, Turkey has detained a US pastor for nearly two years, and resisted calls for his release by the US. Secondly, last week the ECB’s Single Supervisory Mechanism voiced their concern over Turkish borrowers that may not be hedged against Turkish Lira weakness and could potentially default on foreign currency loans. Thirdly, last Friday the US announced a doubling of its tariffs on Turkish exports of steel and aluminium to 50% and 20% respectively. Turkey exported over $1 billion of steel and $60 million of aluminium to the US last year.

The Turkish government responded with two measures. Firstly a reduction in the bank reserve requirement by 2.5% for all maturity brackets, freeing up TRY 10 billion, and secondly a restriction in swap transactions to limit the currency pressures. They also stated that they would not be implementing capital controls. These measures are necessary but far from sufficient. In the absence of sharply higher interest rates the currency is likely to remain under pressure. The weaker the currency, and the longer it is weak for, the greater the damage to the banks and the economy. This could ultimately result in a balance of payments crisis which requires IMF involvement. In Citi’s view, President Erdogan is not likely to approach the IMF for support for some time.

Main European impact on European banks with Turkish exposure
The broad European banks index is down 4.5% over the last two trading sessions, with the biggest losses coming in those banks with significant Turkish exposures. Overall exposure is small, with data from the European Banking Authority showing that overall Turkey credit exposure of European banks is approximately 1% of all European bank assets. Latest data show that Turkish borrowers owe nearly USD 140 billion to Spanish Italian and French banks, with the largest exposure in Spain (which has 36% of total European bank exposure to Turkey), France with 16% and Italy with 8%., leading these banks to fall on Friday between 3-5%.

Broader European equity markets have moved 2.2% lower since Thursday morning driven by Turkish concerns, while Italy and Spain are down 6.3% and 3.8% respectively over the same time period. Given the limited German and Swiss exposure to Turkey, Citi analysts do not expect that Turkish challenges in themselves are likely to end the European bull market which remains underpinned by firming economic and corporate data, although the fragile and fluid Turkish situation could hold back the market recoveries for a short time.

Wider impact on Emerging Markets limited to countries with stretched credit metrics
The chart below shows that short term external financing needs in Turkey remain higher than available FX reserves and has increased since 2013, leaving the economy vulnerable. However, this is not the cases for emerging markets more broadly.

Turkey Troubles: Limited Contagion So Far

Countries in Asia has a much stronger position to defend short term external financing needs, as their current account deficit and short-term external as percentage of FX reserves are much lower.

In the case of Latin America, Citi Analysts believe that monetary policy should remained anchored by Central Banks with floating exchange rates, which coupled with growing levels of domestic pension fund savings provide these economies with larger degrees of freedom in economic policy to tackle external shocks.

Euro and EM FX likely to see short term pressures
The Euro has broken through a significant level of EURUSD 1.15 against the USD, and is down by 3% over the last month. Citi Analysts believe that a resurgent USD driven by safe haven flows, strong US data and widening growth differentials could see further short term pressure for the Euro.

The sharp TRY depreciation has also affected Asian FX market. However, the financial integration between Asia and Turkey is not significant, implying the danger of contagion is quite small. Nonetheless, with investors trying to find countries with similar fundamentals within EM (where South Africa and Russia remain the most vulnerable), it would be inevitable for some Asian markets which heavily depend on external financing to suffer from an escalating risk off sentiment. As a result, EM FX continues to remain under pressure for now.


  • Global markets have been impacted in recent days by fears of where Turkey is headed. This is little different from global fears over Italy back in May. Compared to the short panic over Italy, the difference this time around is that Turkey could see the situation worsen.
  • Citi Analysts have been cautious on Turkish assets for some time, for a combination of economic and policymaking reasons. Within Emerging Markets equities, Citi Analysts continue to favour Asia over EMEA given solid domestic economic growth and supportive valuations.
  • Long term investors should continue to focus on fundamentals and stick to their investment strategy, rather than react to short term sentiment and fear.

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