Short and Sharp: Is Turkey the canary in the coal mine?

Global markets have increasingly had to contend with multiple sporadic risk events. But is the latest one, the Turkish crisis, just another isolated incident? Or, is it symptomatic of the challenges facing the global economy today, and therefore perhaps the first of many dominos to fall?

Turkey’s crisis mainly stems from its unhealthy domestic imbalances. Rapid economic growth, fuelled by a sharp increase in credit growth and fiscal spending, has resulted in a significant widening of Turkey’s current account deficit, while the country is also heavily dependent on volatile short-term foreign capital. Adding to this unappetizing mix is a central bank that’s been tainted by doubts about its independence and credibility because policy rates have failed to respond to rising inflation, now running more than 10% above the central bank’s target. President Trump’s decision to respond to deteriorating relations by introducing sanctions and tariffs on Turkish goods has added fuel to the flames.

On their own, these idiosyncratic issues are worthy of triggering a sharp loss of investor confidence and a rush of capital outflows. But coupled with an increasingly challenging external environment involving tightening liquidity and financial conditions, Turkey is facing conditions that are typical for an emerging market crisis.

But are investors right to fear that the recent strengthening in the U.S. dollar, shrinking Federal Reserve balance sheet, and increasing trade tensions may trigger a systemic emerging market crisis? I would argue no.

After all, Turkey’s domestic economic problems have made it particularly vulnerable to the current challenges facing the global economy. It stands out as the only large emerging market country where the private sector is running a large savings deficit and is therefore highly dependent on capital inflows. In fact, Turkey is also one of very few emerging economies where key macro stability indicators are stretched.

In marked contrast to Turkey, and to conditions during the late 1990s Asian crisis, many emerging economies now run current account surpluses, or small deficits, and their ratios of foreign exchange reserves to short-term external debt tend to be reasonably high. As a result, few of them are susceptible to balance of payment crises and most can deal with capital outflows. It would now take a very severe withdrawal of foreign capital to spark a widespread emerging market crisis.

Admittedly, several major emerging economies face elevated political risk – either from the domestic side or internationally, including Argentina, Brazil, Mexico, Russia, and South Africa. But, unless they are also riddled with significant economic imbalances, dependency on foreign capital, and unorthodox policy making, their vulnerability is limited.

In any case, prospects for most emerging markets look brighter next year. As I detailed in my previous Short and Sharp, valuations are once again looking attractive, so emerging Asian markets are ripe for a turnaround if and when trade tensions fade. In addition, various technical factors suggest that there is limited room for further U.S. dollar appreciation – potentially removing the key reason many investors are approaching emerging markets with trepidation. By contrast, a long and painful adjustment lies ahead for Turkey – its problems go deeper and will not be resolved so easily.

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