Turkey: What we are watching on contagion

Thought of the day

by Chief Investment Office 10 Aug 2018

Turkey's financial woes are starting to take a toll outside its borders. The euro dropped 0.6% versus the US dollar after the European Central Bank (ECB) expressed concerns about exposure of European banks to Turkey, while Turkish assets have continued their rapid depreciation. At the time of writing, the Turkish lira is down 7% versus the US dollar today.

We will be watching three main potential avenues of contagion: 

  • US dollar-denominated emerging market bonds. Turkish sovereign spreads have widened significantly, from 185bps year-to-date to 477bps. But the JPMorgan EMBIGD is a well-diversified EM sovereign bond index, comprising 67 countries, of which Turkey accounts for just 3.5%. As such, while further widening is possible in the absence of tighter monetary policy and greater fiscal prudence, the impact on the index as a whole should be relatively muted, in our view. And it is important to note that we do not believe that Turkey faces an imminent solvency issue: Net government debt is 23% of GDP, based on IMF data. We overweight diversified USD emerging market bonds, which have an attractive 6.4% yield and limited exposure to Turkey. 
  • European banks. Spanish banks are owed USD 83bn by Turkish borrowers. French and Italian lenders have USD 38.4bn and USD 17bn, respectively of Turkish loans outstanding. USDTRY rising above 7 could lead to more concerted pressure on the banking sector, in the absence of the Turkish state stepping in or support from foreign investors (e.g. Qatar). This is relevant both for bank equity investors and for those invested in euro high yield. At 12%, European banks represent the second-largest sector in the euro high yield index. Within Europe, we underweight Eurozone financials in our sector allocation. 
  • The euro. The single currency has been unsettled by market concerns that a deepening crisis in Turkey could lead to the ECB taking longer than expected to normalize policy. While ongoing pressure on Turkey could result in near-term euro weakness, in the longer run we see scope for the currency to recover if Eurozone economic surprises turn more positive. We do not believe that European exposure to Turkey is substantial enough alone to trigger a U-turn in ECB policy. We are neutral on the euro. 

As the crisis evolves, events in Turkey will have a short-term impact on assets outside the country. But at present, we don't expect the impact to prove long-lasting for well-diversified global investors.

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