Investor attention has recently focussed on the ongoing economic crisis in Turkey. Year-to-date (YTD), the Turkish lira is down against the dollar by ~70% YTD, with the currency collapsing by ~25% in the past week alone. This week, we discuss how the ongoing turmoil in Turkey may impact global markets and the portfolios we manage on behalf of clients.
Emerging market crisis
While the lira’s collapse was initially sparked by the imposition of sanctions by the US on Turkey, its underlying causes run deeper than just geopolitics. Turkey is currently going through a classic emerging market crisis, and its economy displays all the vulnerabilities that preceded previously observed ones. 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 relatively reliant on borrowings foreign investment inflows. Alongside that, it has a high level of foreign debt exposure, with a sizeable proportion of it having to be paid back quite soon. 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 rapid fall in the currency.
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. It also doesn’t help when 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. Here, the imposition of US sanctions merely acted as a catalyst for already-wary investors to dump Turkish assets en masse. The root cause of it was ultimately economic mismanagement. As with most emerging market crises, the ensuing outcome for Turkey’s capital markets is unsurprisingly ugly – year-to-date, the stock market is down by 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.
The direct impact of Turkey’s crisis on the portfolios we manage is mild, owing to our low exposure towards Turkish assets. Our exposure towards Turkey stems mainly from our emerging market equity and debt holdings, leading to a combined exposure that lies within the low single digits. However, the crisis can affect our portfolios more indirectly through spillover effects into other non-Turkish markets.
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 banks sector has minimal exposure to Turkey outside of 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. 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 Indonesian rupiah, the Argentinian peso and South African rand selling off in particular. A further deterioration in Turkish assets may weigh on market sentiment or spark further de-risking from investors, leading to more volatility within emerging market assets.
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. Here, 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 controls will prevent investors from pulling their money out, they will also further deter foreign investors from lending to Turkey. On balance, a further deterioration in the Turkish situation cannot be entirely ruled out. This obviously translates into more headline risks for our portfolios, 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 being overweight stocks over bond. For now, we do not think Turkey’s crisis is a sufficient cause for us to be making changes to the portfolios we manage.
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. 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.