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Turkey has in recent years been one of the fastest-growing economies in the world, but its impressive growth numbers were fueled by foreign currency debt. Economic experts said that the country’s borrowing resulted in deficits in both its fiscal and current accounts, and Turkey doesn’t have large enough reserves to rescue the economy when things go wrong. Making the situation worse for Turkey, according to the economic experts, is President Recep Tayyip Erdogan’s preference to keep interest rates low even though inflation is more than three times the Central Bank’s target.
The deteriorating state of the economy is President Erdogan’s Achilles’ heel and the biggest threat to his currently unrivalled authority. Matt Phillips of the New York Times stated that Turkey is the front-burner concern at the moment, but what really is getting people’s attention is the prospect that the financial problems there could spread to other fast-growing but risky countries. If history is any indication, that has the potential to quickly turn a local crisis into a global one.
It is worth noting the fact that Turkey is no small fry. According to the recent data of the World Bank, Turkey contributes 1% to the 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 neighbour Greece once sent through European and global markets, investors are understandably nervous. Holger Schmieding, Chief Economist at Berenberg Bank in London stated that the noise from Turkey adds to concerns about Italy’s 2019 budget and the uncertainty surrounding Brexit. Still, despite the risks, Turkish issues should be put into perspective. Of course, the Turkish crisis nurtures risk aversion and safe haven flows
Holger Schmieding noted that 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 analyse, as World Bank and IMF data revealed, what weaknesses those countries actually suffer from. High twin deficits as percentage of GDP, South Africa, Argentina, Brazil and Colombia are prominent among them.
High foreign currency debt as percentage 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 IMF). 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).
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. Carsten Hesse, European economist at Berenberg Bank in London stated that the direct exposure of other emerging markets to Turkey via trade or the banking sector is very small. A stronger US Dollar and, in some cases, the risk of United States sanctions, remain serious concerns for the most exposed countries.
According to Carsten Hesse, 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.
The most crucial question here is that which emerging markets suffered most so far? James Dorsey, a Senior Fellow at the S. Rajaratnam School of International Studies stated that 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. James Dorsey further noted that since the beginning of August, Turkey’s 5-year Credit Default Swaps 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 Credit Default Swaps increased only slightly less by 120bps to 540bps. The Credit Default Swaps level of other large Emerging Market countries did not change much. Russia, South Africa and Brazil Credit Default Swaps levels increased by only 20-40bps during the same period.
The Turkish Lira lost around 15% vs. the US Dollar last 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 US Dollar For them, the fall-out is very modest.