Market Comment – Turkey: contagion fears seem overdone

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Developments surrounding Turkey have gripped markets. Yields on Turkish government bonds, moving inversely to prices, spiked. The Turkish lira saw a rapid decline over the past few days, before slightly rebounding today. As investors start to question Turkey's ability to service its foreign debt obligations, fears of contagion to other countries are rising. ABN AMRO's Mary Pieterse-Bloem acknowledges that the crisis in Turkey is unlikely to be resolved quickly – but contagion fears seem to be exaggerated.

Worries that Turkey may default on its debt are increasing amid heightened US-Turkey tensions over a US pastor who was detained by Turkish authorities in 2016. These debt concerns, in turn, cause investors to worry about Turkey’s financial woes spilling over to other countries. Mary Pieterse-Bloem, head Fixed Income at ABN AMRO Private Banking: "For markets to regain confidence in Turkey's financial situation, several issues need to be addressed by the Turkish government. Interest rates, for starters, should be significantly increased. Second, Turkey needs to make amends with the US. Third, the Turkish government should moderate its budget plans. And, finally, President Erdogan should signal willingness to talk to the IMF; in the end, it could well be that Turkey doesn't need IMF funding, but it would be reassuring to markets if Erdogan opens up to this idea."

No easy way out

President Erdogan, however, has taken a defiant stance so far – and the Turkish central bank refrains from lifting interest rates further. Pieterse-Bloem: "Given Erdogan’s defiance, it doesn't look like there is a quick solution at hand. The situation will likely deteriorate before it gets better. Turkey strongly relies on external funding. Compared to other emerging markets, Turkey is a bit of an exception, because financial crises in emerging economies usually stem from governments relying too much on external funding. In Turkey, however, corporate borrowers have taken on significant amounts of foreign debt. This would make for a more complex situation in case of a bail-out."

Contagion fears are exaggerated

However, as far as contagion fears are concerned, Pieterse-Bloem believes markets are overshooting: "We've seen spill-over fears flaring up in markets over the past few days, as investors are wondering which parties are directly invested in Turkish assets. Some European banks – particularly Spanish banks – are exposed to Turkish loans. That's why we've seen downward pressure on European banking stocks in recent days, as well as widening spreads on Spanish and Italian government bonds versus German Bunds. But in the greater scheme of things, overall exposure of European banks to Turkish debt is very limited. In our view, contagion fears are exaggerated, because no single financial institution is overly exposed to Turkey."

Spread widening Spain offers opportunity

According to Pieterse-Bloem, the recent rise in Italian sovereign spreads cannot only be attributed to the financial turmoil in Turkey: "Besides contagion fears from Turkey, Italy has to take some domestic hurdles of its own, related to the budgetary challenges the country is facing. For now, we would recommend investors to stay on the side-lines until these domestic issues have played out and not to add to their Italian government bond holdings. When looking at Spain: in an earlier stage, we took a positive stance towards Spanish government bonds – we believe current spread widening represents a buying opportunity for investors who are not 'overweight' in this bond segment yet."

Do you want to read more?

ABN AMRO Group Economics recently published two reports on Turkey. Click on the links to read these reports.

  • Macro Weekly – Epi centre: Turkey
    • Lira slide puts huge pressure on Turkey’s government
    • Contagion effects put pressure on international community to help Turkey
    • German industrial sector still under pressure
    • Chinese imports surge in July
  • Turkey Watch – TRY to recover
    In this publication: US sanctions and fears that Turkey will be unable to repay its foreign debt have caused a freefall of the lira. Our base case scenario assumes a lira recovery to 5 versus the US dollar by the end of 2018. Main risks to our scenario: (1) escalation of US-Turkish spat, (2) negative sentiment spiralling out of control and (3) economic policy mistakes by the Turkish government.