Turkey: EM contagion risks look limited and smaller than the 2018 crisis – CE

The latest crisis engulfing Turkey will make it harder for the country to roll over its external debts, with the banking sector particularly vulnerable, explained analysts at Capital Economics. They consider that if Turkey’s crisis worsens, it may cause wobbles in a few emerging market currencies, but there are reasons to think that any financial contagion will be limited.  

Key Quotes:

“The fall in the lira will add to Turkey’s inflation problem and also risks worsening currency mismatches on balance sheets. What’s more, the rise in external borrowing costs will make it harder for Turkish borrowers to roll over their external debts (which are denominated mainly in foreign currencies).”

“Were Turkey’s crisis to worsen, we may still see some form of financial contagion – indeed, the 1% or so falls in some high-beta EM currencies (notably the South African rand and Mexican peso) earlier today reflect this. And Turkey’s crisis in 2018 led to larger falls in EM currencies that were one reason behind a wave of EM interest rate hikes in that year.”

“But there are reasons to think that the impact would be smaller this time around. First, EM currencies generally don’t look they need a significant adjustment. And second, after years of crisis and disappointment, foreign investors have pared back their exposure to Turkey. Non-residents’ holdings of Turkish equities and domestic government bonds are, in dollar terms, only half the size that they were on the eve of Turkey’s 2018 crisis. As a result, absolute losses for holders of Turkish assets would probably be lower, and forced selling of other EMs’ assets might be smaller too. Instead, the big risk in some of the major EMs are home grown in nature (e.g. India’s bank, debt problems in Brazil and South Africa).”