China downturn “masks trouble in Turkey”

China’s recent stock market and currency volatility have sparked falls in global markets, but also diverted attention from Turkey’s vulnerabilities claims Cerno Capital.

Fay Ren, analyst at the investment management firm, says that Turkey is significant, with its economy 13th largest among the Organisation for Economic Co-operation and Development [OECD] countries, while Europe accepts circa 55% of its exports.

Ren suggests that Turkey is more vulnerable than China in several ways: it runs one of the highest current account deficits within the emerging markets (EMs) as it depends on short-term foreign funding to support the economy.

Like its EM peers, Turkey has benefited from large foreign capital inflows, evident in the significant external leverage built by its domestic corporate sector, masking its waning economic momentum. Gross external debt has doubled from pre-crisis levels to almost US$400bn in the first quarter of 2015.

This represents 50% of gross domestic product (GDP), which, as noted by financial historian Russell Napier, exceeds the threshold of 30% where historically a country is more likely to default. In comparison, while China’s debt level is much higher in absolute terms, its ability to repay is stronger with the ratio sitting at 9% of GDP.

On the upside, falling commodity prices benefit Turkey – being a net importer – in contrast to Brazil or South Africa. This will help improve its current account deficit somewhat, if low prices are sustained for longer. Turkey is also the least exposed to China among major EM economies, with less than 1% GDP of exports to the country.

Nonetheless, Ren believes that the end of quantitative easing (QE) and rate rise expectations in the US may reverse the trend of flows that have been fundamental to Turkey’s economy, with signs of this already emerging.

This would make funding more expensive and debt more difficult to repay, thus making Turkey more vulnerable to capital flight as almost 25% of their bonds are held by foreigners. “These eventualities are often precursors to the introduction of the foreign investors’ nemesis – capital controls,” says Ren

Flows within dedicated EM bond funds are increasingly negative. The most recent week saw US$2.5bn of outflows, the worst level since February 2014, although still significantly below the 2013 taper tantrum period.

On average, Turkey account for 5% of hard currency and almost 10% of local currency EM bond indices, and is weighted similarly in the largest EM Bond funds with few exceptions.

Given this level of exposure, coupled with the accelerating negative unwinding trend in emerging market debt, Turkey’s weak fundamentals, high debt levels, and sensitivity to capital flow volatility will yield an increased risk of capital controls being introduced as a counter measure. Should this happen, significant turmoil in EM debt markets and renewed focus on the lending banks is likely.


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