Turkey’s underlying economic problems have now evolved into a crisis. There have been long-standing concerns around the sustainability of growth and high levels of inflation and two triggers have now resulted in a further sharp fall in the lira in response.


What has happened?

First, there has been increasing skepticism about the independence of the country’s central bank, particularly given its failure to raise rates in response to the current situation. Second, the economic and political relationship between the U.S. and Turkey has deteriorated recently, with the U.S. threatening a range of sanctions in response to the continued detention of a U.S. citizen. These could include possibly limiting Turkey’s access to foreign funding from international organizations. Today President Trump announced a doubling of tariffs on steel and aluminum imports from the country.

 

After the sharp fall in the Turkish lira yesterday, which continued today, markets were focused on a speech by Turkey’s President Erdogan and Finance Minister Albayrak. However, this did not reveal many details about their new economic plans. Instead Erdogan asked Turkey’s citizens to convert foreign banknotes and gold into domestic currency in order to stop the lira sell-off. It is now the worst performing currency year-to-date. Investors have become increasingly concerned in recent months about inflation which has remained stubbornly high with both core and headline inflation accelerating to an annual rate of around 15% which is significantly above the target level (5%). The economic boom has threatened to turn into a bust with capital outflows and a sharp currency depreciation year-to-date, from 3.73 to 6.50, forcing the Turkish central bank to step in previously with emergency rate hikes which have led to only a temporary reduction of distress. The central bank’s reluctance to raise rates further in recent days in response to the deepening crisis has triggered some further questions about its independence, as we noted above.

 

To be fair, this situation would not be entirely new. Turkey has found itself in a difficult situation several times in the last few years and the central bank had, for example, to raise interest rates aggressively in previous years - the last two such times, in 2014 and 2016, were intended to avoid a dangerous sell-off of the lira. However, this time seems more challenging with increasing concerns about external debt and the banking sector, which hasn’t been in focus in previous cases. Furthermore, the U.S. sanctions are putting additional pressure on flows.

 

Market reaction

The Turkish lira hit a record low against the US dollar, falling around 15% so far today (August 10). Erdogan’s speech did little to calm down investor nervousness and the situation further deteriorated after U.S. President Trump tweeted that the U.S. would double tariffs on steel and aluminum to 50% and 20% respectively. 10-Year Turkish USD government bond yields increased by 88.5bp to 8.45%. But the negative market reaction was not only limited to Turkey. Emerging markets currencies were hit across the board. The MSCI EM Currency Index experienced with a 0.95% drop its biggest loss in almost a month. European and emerging markets equities slid more than 1.5% after President Erdogan’s remarks failed to reassure global markets. Investors are also concerned about the exposure of European Banks to Turkey with the Stoxx600 Banks index trading approximately 2.8% lower as of writing. And the S&P 500 erased a weekly advance after President Trump's tariff tweet.


Our view

The situation in Turkey remains crucial for capital markets with inflation likely to rise further, an economy that might fall into recession and challenges for the banking sector. The measures in the "new" economic model unveiled today are unlikely to end the crisis, which finally means accepting that the growth path needs to be changed substantially. Potential steps to be expected (and probably necessary for the market to calm down) would include a change in fiscal policy and short-term further tightening of monetary policy, i.e. moving real rates up. It seems that the only way to induce a necessary disinflationary period and restore investor confidence in the policy framework requires breaking the vicious cycle between a weakening lira and rising inflation with the central bank acting ahead of the markets. However, such an intervention would have a negative impact on the Turkish economy and could cause a recession. The political leadership in Turkey so far has favored growth over price stability and at this stage of the crisis shows no signs of modifying this view. That is unlikely to change without a further escalation of the crisis. That’s why we stick to our cautious view regarding the Turkish lira, equities and bonds. At some point, however, further policy action will be necessary, be it from the Turkish government or the central bank. We will continue to update you on this.

 

However, contagion risks should be limited. The trade impact of a Turkish crisis are limited as the Eurozone’s exports to Turkey accounts for less than 0.6% of its GDP. Nonetheless, a Turkish banking crisis would have some negative repercussions on Eurozone banks. The total exposure of banks in the three Eurozone countries (Spain, France , Italy) with the largest claims in Turkey is €135 billion (or 6% of their exposure to Eurozone countries). Hence, the fallout from Turkey is unlikely to cause a credit crunch in the Eurozone. The situation is also not yet considered critical by the ECB. Furthermore, while the Turkish situation is certainly not helping the emerging market universe, it should not be seen as a proxy for the broader emerging market space considering the much stronger current account balances and less worrying external debt levels elsewhere.

 

Download this CIO Insights Memo as a pdf here

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