Turkish Contagion

The spat between the US and Turkey is currently roiling various markets, with the greatest impact being felt by other emerging market economies. While there are fundamental reasons to be concerned about Turkey’s situation, we believe the current contagion to other markets is more a reflection of generalized investor anxiety about high market valuations and less about true economic linkages or similarities to Turkey itself.

At the root of Turkey’s problem is its reliance on foreign countries to finance its soaring current account deficit (a broad measure of a country’s trade with others), now at nearly 6% of GDP. The easiest remedy for a current account deficit is a currency devaluation, which helps make exports more competitive and drives down import demand. In doing so, however, a country with a heavy foreign debt load can exacerbate its problems by making its foreign currency denominated debt more difficult to service. In the absence of dramatic and coordinated action by the government and country’s central bank, this conundrum typically scares away foreign investors – afraid of further devaluation, debt default or a systemic banking crisis. Turkey, under Erdogan’s rule, is bucking traditional approaches to the problem, defiantly leaving interest rates too low in the face of a run on its currency and eschewing IMF support. This won’t end well for Turkey, but it won’t end nearly as badly as most think. The country tends to defy worst case scenarios because of its large undocumented grey market trade relationship with Russia and former Soviet countries, which brings in far more foreign currency flows than official numbers suggest.  This, coupled with IMF help, has helped Turkey mitigate disaster in the past. 

Where Turkey goes from here is anybody’s guess, but a look at other emerging market countries shows very little in the way of similarities across the space. Argentina, already reeling from its own economic woes (also sporting a large current account deficit), is really the only other country suffering from such severe balance of payments issues. Asian countries, by and large, have reduced reliance on foreign financing since the Asian currency crisis in 1997, as have most African, central European and Latin American countries. While external debt levels in many of these countries remain high, in a world of mostly free-floating currencies most of these countries have ample reserves to service their debts and roughly balanced trade relationships that preclude draining those reserves.

Of course spillover to larger, richer countries is always a concern in this type of situation as richer countries often have extended banking lending relationships with their trading partners. In this case, Banco Bilbao of Spain, UniCredit of Italy and BNP Paribas of France have some of the biggest exposures to Turkey and have taken the brunt of the market’s reaction as it relates to the developed world. The good news here is that these exposures appear to be isolated to individual companies, rather than dominating any one country, limiting the potential systemic effects of a full blown crisis in Turkey.

One final reason we’re not panicking about Turkey?  We have no meaningful exposure to the country through our emerging markets managers and we are underweight risk benchmarks to emerging markets in general. We have eyed the space for a while due to attractive relative valuations and began tiptoeing into select markets earlier this year, but we generally believe that events unfolding in Turkey will create a reasonable buying opportunity for emerging markets in the near future. We’re not there yet, but we’re getting close.


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