Market Views: After Turkey, who will tumble next?

After witnessing the Turkish lira currency plummet in recent weeks, many investors are fretting about the potential spillover into other emerging market economies, accentuating capital outflows from these markets.

Anyone around in 1997 – when the term 'financial contagion' was the height of fashion – will recall how the Thai baht crisis spread to Indonesia and South Korea and also put the Hong Kong dollar, Malaysian ringgit, and Philippine peso under intense pressure, before wrecking havoc elsewhere.

Turkey, like other emerging markets, has large external financing needs in order to drive its economic growth, with its current account balance as a percentage of GDP at around 5.6% of GDP in 2017 according to the World Bank.

That dependence on foreign currency loans is a concern for investors, especially as Turkish monetary policy credibility becomes more tarnished and the lira tumbles.

The currency started the year at TL3.79 versus the dollar, before weakening past the TL7.00 mark on August 13, representing a nearly 46% drop in value. It has since steadied but it's a shaky respite.

A timely loan package from Qatar announced on Thursday worth up to $15 billion has helped to shore up the currency. But that's peanuts when set against the amount of euro- and dollar-denominated debt issued by lira-earning Turkish entities and scheduled to mature in the next year and beyond, let alone when compared with Turkey's total external financing needs.  

So concerns about the Turkish economy, and other economies with similarly large current account deficits, remain.

We asked a private wealth currency specialist, a currencies and emerging markets investment strategist at an asset manager, and two FX brokerage strategists how investor sentiment might be further impacted and which other emerging market might also edge into the firing line.

The following extracts have been edited for clarity and brevity.

Moh Siong Sim, currency strategist (Singapore)

Bank of Singapore

If we look at why the lira has been sold so sharply, the underlying economic problem has been one of large external financing needs. We've come to a point where foreign investors are losing confidence over Turkish policy makers' credibility and have been unwilling to finance that large external deficit.

There's been a witch hunt, a roundup of the usual suspects, in terms of identifying emerging market countries that share similar weaker fundamentals as Turkey ... [among the] countries that stand out within Asia, countries that run current account deficits, would be India, Indonesia, and to a lesser extent the Philippines. ... [Other candidate] emerging markets are Brazil, South Africa, and Mexico to a lesser degree. But all the current account deficits of these countries are less than 3% of GDP, so it’s very manageable. Given the witch hunt that's going around, these currencies have come under pressure, but I don't think it's a systemic risk for emerging markets as a whole ...

I think it's hard to put a time frame to it. What we have seen so far, in terms of the measures taken to address the currency crisis, is not decisive enough ... We need to see more concrete policy measures, especially in terms of tighter fiscal and monetary policy to slow down the economy somewhat and to lower the external financing needs.

John Hardy, head of FX strategy (Copenhagen)

Saxo Bank

If the lira continues to weaken, we will tend to see (as we already have seen to a large degree) those currencies from countries with the largest external debt exposures and current account deficits weakening the most. Among these are the South African rand, Indonesian rupiah and Brazilian real. But the bigger question is in Asia, where further US dollar strength could see China allow its currency to weaken to new lows versus the US dollar – to above Rmb7.00, which is seen as a line in the sand of sorts. If this happens, global risk appetite could suffer and currency market volatility and uncertainty could escalate again.

It is becoming increasingly difficult to speculate against the lira itself as the Turkish authorities are doing what they can to limit market liquidity and the market has already started pricing in a significant further decline in the currency [in the FX forwards market] ... So speculators may prefer to look at other fragile emerging market currencies for further weakness if the severity of the situation intensifies and feeds a wider contagion.

Sven Schubert, specialist investment strategy currencies and emerging markets (Zurich)

Vontobel Asset Management

Significantly higher volatility in liquid emerging-market currencies [like the lira] usually leads to negative spillover effects. Their magnitude depends on a country’s economic and financial relations with other emerging markets. Turkey’s ties with other emerging economies are moderate, so the contagion effect should be limited. Therefore, we don’t anticipate any [other] massive sell-offs ...

However, investors tend to shoot first and ask questions later. In this case, they typically sell currencies that are liquid (e.g. the Mexican peso) and/or have similar fundamentals (e.g. the South African rand). Don’t get us wrong, South Africa seems – from a political and fundamental point of view – better positioned, but regarding external financing needs (current-account deficit) and short term external debt indicators (e.g. debt ratio to foreign-exchange reserves) there are fundamental similarities.

Emerging markets have another problem: with the US Federal Reserve likely to continue to increase interest rates and the European Central Bank (and other major central banks) mulling similar moves, global liquidity conditions are tightening. This is particularly troubling for countries with high current-account deficits. Therefore, currencies like the South African rand or Turkish lira will likely face headwinds in the near term, unless concerns about a further escalation in the trade war abate ... Asian currencies – where central banks manage the respective exchange rates against the US dollar – are likely to lose less on a relative basis ... However, should trade war fears persist, you may not want to be invested in the currencies of export-dependent economies [such as] the Korean won or Malaysian ringgit ...

We turned neutral on emerging-market local-currency debt in early May, giving up an overweight stance. We may rethink our position in the event of game-changing events that have a certain possibility of occurring between the coming autumn and winter. If the Fed signals a pause in its policy-tightening, global growth outside the U.S. (and in emerging economies in particular) accelerates or fears of an escalating trade war recede ... we could adopt an overweight stance in emerging market local debt – and possibly equities – again.

Jameel Ahmad, global head of currency strategy and market research (Cyprus)

FXTM

There have been a wide variety of different losers across the globe as a result of the Turkish lira crisis, and it can be said that any currency that is not a conventional safe haven, such as the Japanese yen and dollar, has faced headwinds [as a result] ...

The largest impact that it had on financial markets is that it weakened risk appetite across the globe, meaning investors developed a significant reluctance towards taking on risk. This consequently limited [the] attraction [of] investing heavily in emerging markets. The emerging market currencies that are seen as high yielding were the ones to suffer most, including the South African rand, Mexican peso and Brazilian real. However, all emerging markets across the globe were hit negatively by the lira crisis ... Even the euro took a dive on fears Europe is exposed to a potential banking crisis in Turkey. There is a significant amount of Turkish debt that is denominated in euros and concerns are now brewing that Turkish debt holders might struggle to meet their obligations.