Turmoil in Turkey: Risk or Opportunity for Emerging Markets Investors?

By Joyce Huang, CFA - August 14, 2018

After a reprieve in July, volatility has returned to emerging markets assets, thanks mostly to tumult in Turkey. A series of damaging political and policy decisions has sent Turkey’s currency and financial markets into a tailspin. Meanwhile, contagion fears have fueled sell-offs in other emerging markets (EM), creating potential opportunities for investors.

What Is Driving the Turmoil in Turkey?

Several factors are fueling the recent turbulence in Turkey, including:

  • Structural imbalances in the economy and high dependence on external financing;
  • Loose monetary policy resulting in credit-driven growth and high inflation;
  • Loss of investor confidence, due to perceived lack of independence of the central bank and escalating political tensions with the U.S. and Europe.

Together, these issues have created a downward spiral in the Turkish lira, which has fallen to levels the market has not seen before. Subsequently, credit spreads have widened to levels investors last witnessed during the financial crisis. The lira’s collapse is largely self-inflicted. The lack of appropriate policy response to a deteriorating macro environment triggered the currency’s downturn. Escalating political tensions with Western allies, whose funding is critical to the Turkish financial system, also pushed the lira lower.

Turkey has significant external financing needs, which makes it among the nations most susceptible to Federal Reserve rate hikes. Turkey has insufficient national savings to finance its investments, so it must attract foreign money to keep its economy growing. Accordingly, Turkey runs a very large current account deficit,1 currently 6 percent of gross domestic product (GDP). The country’s external debt has been increasing over the past few years, particularly for corporations and banks. As their foreign-currency-denominated debts have been growing, their assets available to repay those liabilities have been shrinking. Today, the gap between corporate assets and foreign currency liabilities is three times what it was in 2008.

Why Is the Lira Plunging?

The inaction from Turkey’s central bank is exacerbating the lira’s decline. Rather than aiding the currency, policymakers have focused on maintaining high rates of economic growth.

Since President Recep Tayyip Erdoğan won reelection in June, the central bank has lost its independence. After the election, Erdoğan refused to pass the reforms needed to improve the Turkish economy—reforms the market had anticipated. Instead, Erdoğan named his son-in-law minister of finance, severely hampering the central bank’s independence.

The central bank did not hike rates in July, which further eroded investor confidence. In addition, Erdoğan has made several speeches that rattled investors. Together, these factors have sent the lira’s value plunging nearly 45 percent this year.

Politics also has played a role. Turkey’s diplomatic relationship with the U.S. has deteriorated significantly. Turkey has detained an American pastor since October 2016, accusing him of terrorism. Escalating political tensions prompted the U.S. to impose sanctions and increase tariffs on steel and aluminum from Turkey. This action also has contributed to the lira’s decline.

Is There a Real Chance Turkey’s Economy May Collapse?

High interest rates and the lira’s plunge are making it more difficult for companies to pay back their U.S. dollar-denominated loans. Accordingly, the number of corporate defaults has increased, putting pressure on the banking system. Turkish banks depend heavily on external funding from European and U.S. banks. If defaults rapidly increase and macroeconomic conditions worsen, external funding may disappear, and the Turkish banking system could grind to a halt.

In addition, Turkish banks have sizeable U.S. dollar deposits. Given the waning confidence in Turkey’s financial system, there is a risk that people will start withdrawing those dollars quickly. Such a “deposit run” would be extremely costly to contain and likely would lead to bank failures and severe economic decline.

Then What?

Turkey would have to participate in an International Monetary Fund (IMF) program. Similar to its recent action in Argentina, the IMF would offer Turkey a financing arrangement to help curtail the nation’s outstanding debt. However, as a condition of that aid, Turkey’s government likely will have to make big policy changes. It remains unclear if Erdoğan would accept conditions associated with an IMF bailout.

Turkey also may secure bilateral loan arrangements with other countries. However, this option is more complicated, due to the size of Turkey’s financing needs. Turkey needs approximately $200 billion yearly to cover its current account deficit, roll over its short-term debt, and cover its external debt amortizations.2

Can Turkey’s Problems Spread to Other Emerging Markets, or Even Developed Markets?

Given the size of Turkey, there is a risk the impact on emerging markets sentiment may be severe. However, the effects on global trade and finance are not as significant. Moreover, the problems are largely self-inflicted and specific to Turkey.

The last significant sell-off in emerging markets assets occurred in 2013, and it also targeted countries with high funding needs. But compared with the “Taper Tantrum” of five years ago, we believe most emerging markets countries are in better economic shape today. Currencies are more free-floating,3 and most remain undervalued. Furthermore, current account balances across the largest emerging markets countries are steadily improving.

We have seen continued weakness in other countries that rely on external funding, such as South Africa and Indonesia. But, unlike Turkey, central banks in those and other emerging markets countries have indicated they will raise rates if necessary.

What Do Turkey’s Woes Broadly Mean for Emerging Market Investors—Heightened Risks or Better Opportunities?

We view this current unrest as an opportunity to invest in emerging markets assets offering solid fundamentals and attractive risk-adjusted returns. While risk remains elevated in certain countries, we believe the widespread negative market sentiment has unfairly punished many others. We continue to favor an active management approach that seeks opportunities and relative value across all sub-asset classes and countries.

Joyce Huang, CFA
Joyce Huang, CFA
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      1The current account deficit is a measurement of a country’s trade where the value of the goods and services it imports exceeds the value of the goods and services it exports.

      2Amortization is the paying off of debt with a fixed repayment schedule in regular installments over time like with a mortgage or a car loan.

      3A floating exchange rate is where the price of a currency is set by the foreign exchange market based on supply and demand compared with other currencies. This is in contrast to a fixed exchange rate, in which a government entirely or predominantly determines the rate.

      International investing involves special risks, such as political instability and currency fluctuations.

      Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.

      The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.