Markets started the week where they left off: alarmed about the imploding financial situation in Turkey and the potential side effects on other parts of the world, such as Asia.

Crisis-hit Turkey’s woes continued to worsen yesterday, raising worries about exposures of other emerging market countries to a rising dollar exchange rate and escalating trade protectionism, with a number of equity markets feeling the pain.

The lira, which crashed last week amid a deterioration of Turkey’s relations with the US and worries about dollar-denominated debt exposure, remained under pressure when markets re-opened after the weekend. 

Fears are growing that Turkey, an emerging market economy that had been seen as a success story after an IMF bailout a decade and a half ago, is once again in deep trouble and now led by a populist with a strong authoritarian streak - Recep Tayyip Erdogan. The country is at odds with the US administration of President Donald Trump, with the row initially prompted by US anger of the detention by Turkey of an American pastor. Trump subsequently announced a doubling of steel and aluminium tariffs – hitting Turkey, for whom these are important exporter earners. Erdogan, in speeches and in print, has showed no sign of backing down. With a significant amount of its international debt in dollars, this means that a rising dollar exchange rate, fuelled to some degree by a strong US economy and expectations of higher Federal Reserve rates, is pressurising Turkey.

The euro-lira rate, which on Aug 13, 2017 showed that the euro fetched TRY4.058, now buys TRY7.831, with the lira plunging over 20 per cent in less than a fortnight. The dollar-lira rate has edged over TRY7.0 before being slightly below that mark late yesterday afternoon in London trade, having been TRY3.53 12 months’ ago.

(The dollar-lira rate)

Source: DBS, Bloomberg.

The S&P 500 Index of US stocks ended last week down 0.7 per cent on Friday; yesterday European bourses fell from the open; Chinese and most other Asian indexes fell from the open.

“Geopolitical dramas have captured the markets’ imagination, yet historically when the Federal Reserve raises interest rates in order to pullback inflation, emerging markets crash,” Peter Rosenstreich, head of market strategy for Swissquote, said in a note.

The lira crisis, by a coincidence, marked roughly the exact 20th anniversary of the Russian debt default (Aug 17, 1998), an event that also coincided with the Federal Reserve-led rescue of hedge fund Long Term Capital Management.

“A signature of crisis is rumour, and they are swirling of global banks cutting credit to Turkish banks. TRY [lira] bulls were hoping for a hammer in the form of higher interest rates from policy makers, but instead got an inadequate response,” he said. “The CBT [central bank of Turkey) micro-tuned, with lower reserve requirements. Rumour is that central banks will move with force later today. However, given President Erdogan’s rhetoric, including an editorial in the New York Times, it’s unlikely that considerably higher interest rates are coming (or will be enough). Turkey could try other options such as capital controls or going to the IMF, yet these would spur crisis, and we don’t believe Erdogan is willing to head in this direction. TRY should brace for more pain,” he added.

Deutsche Bank Wealth Management said Turkey is in crisis.

“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. However, this time seems more challenging with increasing concerns about external debt and the banking sector. Furthermore, the US sanctions are putting additional pressure on flows,” the bank said. 

The bank said that measures needed to calm markets would include a change in fiscal policy and short-term further tightening of monetary policy - moving real rates up. However, such an intervention would have a negative impact on the Turkish economy and could cause a recession.

Although there will be a muted impact on the euro zone, a Turkish banking crisis will hit some lenders in the single currency bloc. The total exposure of banks in the three Eurozone countries (Spain, France, Italy) with the largest claims in Turkey is €135 billion (or 6 per cent of their exposure to eurozone countries). 

Hence, the fallout from Turkey is unlikely to cause a credit crunch in the eurozone, Deutsche said. 

The German lender said there are five banks which in its view have a “meaningful” exposure to the Turkish situation.

“Of these [banks] BBVA is the most exposed, via its Garanti stake. In a worst-case scenario (involving total loss of local equity plus any intergroup funding) we see a range of c.1-12 per cent of group equity losses for these banks. To be clear, this is not our base case, but even if it were to occur, the impact should be manageable for European banks,” Deutsche said. 

IHS Markit, the analysis and research firm, elaborated on the policy risks and challenges for Erdogan and wider world: “The changes to reserve requirements in recent days and the government’s unspecified action plan has done little to stabilize the lira. Significantly more than just official promises of action are needed to exit the current crisis. IHS Markit continues to believe that the most immediate step to be taken to rescue the lira is a sharp central bank rate rise. If this step is taken in conjunction with a shifting of government rhetoric, the plunge of the lira could pause and portfolio investment outflows may slow.”

“Yet another month of net portfolio investment outflows and a sharp drop of reserves from May to June exacerbate the downward pressures on the lira. Since these first-half data, the situation has only continued to worsen. Sharp lira losses in July and August suggest that net portfolio outflows have likely continued since June. Reserve levels have also assuredly fallen in July and into August, particularly with the central bank's recent reserve requirement changes,” it continued. 

“In the absence of aggressive central bank actions, however, the lira will continue to drop and net capital outflows will continue. Without net capital inflows, reserves will fall farther, eventually undermining Turkey's ability to finance its current-account deficit, forcing a more substantial correction of the imbalance in the latter portions of 2018 and into 2019,” it added.