Navigating Turkey’s uncertainty

Turkey’s currency in freefall

The plunge in the lira which began in May now looks likely to push the Turkish economy into crisis mode.

The plunging currency, down more than 40 per cent since the start of the year, has piled stress on Turkish companies that are saddled with unhedged dollar- and euro-denominated debt and raised fears that the country could struggle to meet its large external financing needs.

This would be another headwind for EMs as an asset class, but the scope for wider economic spillovers appears contained.

Last week, concerns about Turkey begun to affect global markets, boosting safe haven demand for the Swiss franc and high-grade government bonds, as well as causing some weakness in the euro and the stocks of European banks.

Turkey’s problems to get worse before getting better

Turkey’s economic situation is largely self-inflicted, resulting from a series of poor domestic economic policies.

Over the past few years, Turkish fiscal and monetary policy has been excessively accommodative, resulting in rapid growth but also a build-up of financial vulnerabilities. Turkey’s problem is not new - it has been festering for some time now. Before last week’s blow-up, we downgraded all Turkish bonds under our coverage to a sell.

Turkey’s problem has been exacerbated by the shifting global monetary environment, with the US Federal Reserve lifting rates and trimming its balance sheet.

Until Turkey puts in place a credible economic plan, we expect things in Turkey to get worse before they get better.

Turkey’s achilles’ heel

Much of the concern is focused on Turkey’s banks, which have increasingly resorted to foreign wholesale markets to finance their domestic lending. About a third of bank lending is in foreign currencies, mostly to corporates. And although the ratio of non-performing loans is currently low, we see this rising markedly ahead as a result of higher interest rates, currency weakness and the forthcoming economic weakness.

Nonetheless, the direct economic consequences for the rest of the world are relatively limited.

This is hardly surprising given that, with GDP of around $900bn, Turkey’s economy accounts for just one percent of the world economy.

Contagion from Turkey to global markets likely to be limited

Foreign exposure to Turkey’s domestic financial markets is relatively small.

Non-residents hold around 60% of Turkish government debt, but this debt is equivalent to only around 30% of Turkish GDP. The market capitalisation of the Turkish equity market is less than 2% of the UK equity market.

There are some risks to foreign banks holding Turkish debt but they are heavily concentrated in Europe.  The Spanish banks’ exposure to Turkish paper is equivalent to around 6% of Spanish GDP, much of which is due to Spanish bank’s operations in Turkey. The exposure of Italian and French banks is relatively limited, and that of the UK and US is negligible.  

Exposure to Turkey via trade links is also fairly small except for neighbouring countries, notably Bulgaria.  So in short, the direct economic hit from Turkey for European economies, let alone the wider world and even Singapore, should be fairly small.

Investment strategy – Stay diversified to tide through volatility

In this more uncertain environment, there is a need for investors to have diversified portfolios to tide through a period of higher market volatility. Investors should note that the Emerging market (EM) bond market is a deep and diversified market. Turkey typically accounts for less than 5% of most EM bond indices. There are opportunities in the EM bond space, but investors have to be more discerning at this point of time.