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Turkey: a canary in the emerging market coalmine?
Investors are concerned that Turkey's currency crisis could destabilise emerging markets and the world economy. That's unlikely.
Contagion thankfully doesn’t occur in financial markets too often. But that’s of little comfort to investors right now.
With Turkey teetering on the edge of the abyss, fears are that this erstwhile emerging market star could drag other countries down with it, tipping the world economy into recession and leaving its creditors in Europe dangerously exposed.
Yet what seems clear at first glance isn’t so obvious on closer inspection.
True, Turkey is in a dark place. Its huge foreign currency debts, widening current account deficit and soaring inflation – 16 per cent and rising – testify to a country flirting with a balance of payments crisis, one reminiscent of the sort that regularly roiled emerging markets in the 1980s and 1990s. The NATO member's spat with the US and its diplomatic overtures towards Russia and Iran threaten to make matters worse.
Nevertheless, it’s important not to overstate Turkey’s significance.
To begin with, its probable recession shouldn’t impact other economies directly.
Despite its close ties with the European Union, a population of 80 million and its decade-long growth spurt, Turkey remains a minor player on the world economic stage. It accounts for just 1 per cent of world GDP and only 2.8 per cent of the euro zone’s exports.
It's important not to overstate Turkey's significance... it accounts for just 1 per cent of world GDP.
A greater danger is the damage that might result from a wave of Turkish debt defaults. Turkey borrowed heavily over the past 10 years to finance its growth, mostly in foreign currency. Public and private debt has ballooned from less than 80 per cent of GDP in 2008 to over 100 per cent today. And a rising dollar and higher US interest rates make those debts more costly to service.
That’s a headache for European banks.
They were eager lenders, particularly Spanish and Italian institutions. Tellingly, that fact has not been lost on the European Central Bank, which has begun monitoring the region’s exposure to Turkey.
Still, here too, the risks look manageable. Spain’s banks are the most exposed but their lending to Turkey accounts for less than 5 per cent of their total foreign loans. Italy’s banks come a distant second, with Turkish lending accounting for just 1.9 per cent of their international claims.
Investor sentiment key
By far the easiest way for Turkey’s woes to spread to other markets is via a shift in market sentiment. There is always the temptation among investors to lump emerging nations together and dump their currencies and assets wholesale at the first signs of trouble.
That could happen – after all, Turkey was not the only country whose government and corporations took advantage when US rates were low to boost borrowing.
But dig a little deeper and it’s clear that the country is an emerging market outlier – just as it was during the attempted 2016 coup d’etat, when it was one of the few points of political turmoil in the emerging world.
Its troubling financial plight is far from representative.
The current account positions of developing economies, for instance, have in fact improved considerably since 2013. In aggregate, emerging markets’ current account surplus has grown from 0.1 per cent to 0.8 per cent of GDP over that time. Even among emerging countries with deficits, the gap has narrowed to 1.7 per cent of GDP compared to almost 4 per cent during the taper tantrum of 2013, when markets wobbled after the US Federal Reserve signalled its readiness to scale back quantitative easing.
The notion that emerging market companies are awash with debt doesn’t hold up to scrutiny, either. True, Chinese firms have been big borrowers, but strip them out of the analysis, and the picture isn’t quite so unsettling: company debt as a proportion of GDP in emerging markets drops from over 100 per cent to just 48 per cent, a mere 3 percentage points above where it was five years ago. That compares to 72 per cent for the US, 100 per cent for the euro zone and 103 per cent for Japan.
Mind the gap
Breakdown of Turkey's current account, %, GDP
Source: Pictet Asset Management, CEIC, Datastream. Data covering period 31.12.2011-31.07.2018
Also encouraging is that borrowing is moderating across the developing world, China included. The credit gap – or the difference between the current and trend rate of private debt growth measured as a proportion of GDP – has been falling across all major economies. In China, the differential has dropped from a peak of 27 per cent of GDP to 17 per cent. In Brazil, India, Russia and India, the gap has actually turned negative. What’s more, the proportion of “risky” corporate loans and bonds in the developing world (ex-China) is lower than it was during the 2008 financial crisis, according to a study by the Fed.1
In part, that’s because many of the firms issuing dollar-denominated bonds are exporters whose revenue is predominantly denominated in foreign currency. For these companies, when the greenback rises, the resulting increase in debt costs is offset by the extra revenue earned overseas.
What’s also been overlooked during this recent bout of turbulence is that increases in US interest rates aren’t necessarily bad news for emerging market assets or currencies.
As long as the Fed is tightening monetary policy in response to faster growth, the economic spill-over to the developing world should be positive. An analysis undertaken by Barclays bears this out. The bank found that in every US hiking cycle since the mid-1990s, emerging market currencies and bonds have tended to outperform developed world counterparts.2 The same picture emerges in our own study.
Of course, should the world descend into an all-out trade war, then global growth would deteriorate precipitously. But if, as we believe, the tariff disputes lead to improvements in how the world trading system functions, then the strong fundamentals of emerging markets should come to the fore. Turkey’s woes won’t alter that.
Further reading
A tale of two emerging market crises
Anjeza Kadilli, Economist, Nikolay Markov, Senior Economist
August 2018
After the fall
Alain-Nsiona Defise, Head of Emerging Corporates, Mary-Therese Barton, Head of Emerging Market Debt
August 2018
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