How Big Is the Turkish Contagion Risk for Emerging Markets?

Turkey is no small fry. It contributes 1% to global GDP. Beyond the obvious geopolitical concerns, a major Turkish recession would pose a significant challenge for financial markets and for other economies.

Remembering the tremors which Turkey’s smaller neighbor Greece once sent through European and global markets, investors are understandably nervous.

The noise from Turkey adds to concerns about Italy’s 2019 budget and the uncertainty surrounding Brexit. Still, despite the risks, we need to put Turkish issues into perspective. Of course, the Turkish crisis nurtures risk aversion and safe haven flows.

Contagion to other emerging markets

Emerging markets are more vulnerable than developed markets to financial contagion from Turkey. In particular, those emerging markets with problems and imbalances similar to those of Turkey are at risk.

To get a proper sense, one needs to analyze what weaknesses those countries actually suffer from:

• High twin deficits as % of GDP (current account and government budget deficit): South Africa, Argentina, Brazil and Colombia are prominent among them.

• High foreign currency debt as % of GDP: Outside of central Europe, Argentina and Chile have the highest exposure to foreign-currency debt (around 50% of their GDP according to the IIF).

• Dovish national central banks that have a track record of not tightening monetary policy enough to reach their inflation target (e.g. Argentina).

• Political disputes with the United States and are threatened by a potential escalation of tit-for-tat tariffs and sanctions (China and Russia).

Little danger of contagion spreading

There are a number of country-specific problems to be accentuated by the fallout from Turkey. However, there is no reason to expect wide-spread and dangerous contagion spreading from Turkey to a large number of other emerging markets.

The direct exposure of other emerging markets to Turkey via trade or the banking sector is very small. A stronger USD and, in some cases, the risk of U.S. sanctions, remain serious concerns for the most exposed countries.

Big current account deficits coupled with high levels of foreign currency debt can be a recipe for a crisis. However, thanks to strong economic growth since the great financial crisis of 2008/2009, many emerging markets benefit from improved private sector balance sheets and elevated foreign exchange reserves.

This should help most of them to withstand the Turkish tremors with little damage. China looks safe, while high oil prices and an independent central bank support Russia.

Which emerging markets suffered most so far?

A sharp decline in the currency or a sharp increase in credit default swaps (CDS) signal potential trouble. Argentina stands out as the most affected country. It is followed, by a significant distance, by South Africa, Russia and Brazil.

Since the beginning of August, Turkey’s 5-year CDS climbed by about 150bps to about 470bps. This reflects a roughly one in three chance of Turkey defaulting on its debt over the next 5 years (assuming a recovery rate after default of 30%).

Argentina’s CDS increased only slightly less by c120bps to 540bps. The CDS level of other large EM countries did not change much. Russia, South Africa and Brazil CDS levels increased by only 20-40bps during the same period.

The Turkish Lira lost around 15% vs. the USD this month, followed by the South African Rand (10%), the Argentinian Peso (8%) and the Russian Ruble (7%). Most other emerging market currencies lost less than 5% vs. the USD (see chart). For them, the fall-out is very modest.

As of 17 August 7:20am. Source: Bloomberg