No delight for anyone investing in Turkey

Posted by Adrian Lowcock in Market commentaries category on 14 Aug 18

Turkey’s economic crisis has been weighing on markets recently, but the issue took centre stage this week as the currency tumbled on Monday.  

Turkey has long been seen as a weak emerging market economy as it continues to hold significant US dollar denominated debt, which is sensitive to rising US interest rates and currency fluctuations.

However, the trigger for the current crisis lay at the feet of President Recep Tayyip Erdogan. During his recent election campaign he pledged to keep interest rates low. This was against expectations given Turkey has been struggling with high inflation, whilst it also raised concerns the central bank would become less independent.  These concerns were supported when Erdogan appointed his son-in-law to head up the central bank.  In June inflation climbed to 15.4% and the Turkish central bank unexpectedly decided to hold its key interest rate at 17.5%, causing the Turkish Lira to fall. 

At the same time, tensions with the US have been rising as Erdogan decided to keep an American pastor locked up in a Turkish prison in response to the refusal of the US to hand over his arch rival and religious activist Fetullah Gulen. Trump responded in fairly typical manner and went for the jugular, raising tariffs against Turkey specifically designed to do the most damage to the economy.  With the loss of valuable exports the Turkish economy is only likely to fall deeper into debt.  

On Monday President Erdogan maintained his tough stance to the crisis and continued to blame the US for the current situation and refused to address the issue by raising interest rates. The result, a further fall in the Lira. 

The impact on the Turkish economy is huge, local companies have borrowed too much in US dollars and will struggle to repay their debt whilst the costs of servicing it are rising rapidly, forcing more companies out of business and building up losses in the banking system.  Foreign investors, which have previously supported Turkey’s growth, are increasingly likely to withdraw their funding as the risks of investing in Turkey rise.  The country has a large current account deficit and limited foreign currency reserves and is therefore not well positioned to protect itself and is unlikely to avoid a recession. 

Erdogan has avoided requesting help from the International Monetary Fund (IMF) and is unwilling to do so as it would bring up memories of previous Turkish crises.  However, given that other avenues for financial loans, such as China or Russia, are likely to take time the only realistic solution is for the IMF to eventually become involved, something the US may object to. 

The Turkish crisis looks set to continue for a while longer. 

Contagion risk 

Markets naturally grew concerned over the potential for Turkey’s collapse as it raises the question of contagion risk. If Turkey falls who will follow next? And what is the impact on the global economy, in particular financial institutions?  So far the knock-on effects have largely been in emerging market currencies as investors become more risk adverse in reacting to the current situation. 

Whilst not all emerging markets are in the same situation as Turkey, some are more vulnerable to rising US interest rates than others. With the US economy continuing to grow, interest rates there look set to rise and the US dollar strengthen further. As such other countries heavily reliant on US denominated loans could potentially face similar problems to Turkey. 

In the short term investors should be prepared for higher levels of volatility in Emerging Markets and expect performance between different emerging market countries to vary significantly. For more adventurous, long term investors, the volatility could create some investment opportunities.