In 1997 a currency crisis that emerged in East Asia slowly spread around the whole world, causing the Russian economy, among others, to collapse the following year. With Turkey’s lira in freefall, what are the chances of Asian Financial Crisis-style contagion in other emerging markets and a wider collapse of currencies in the region?

The Turkish lira (TRY) has tanked, losing as much as 45% of its value to the dollar YTD at the time of writing. As European markets closed on August 13, it was struggling to stay stronger than TRY7 to the USD with the government showing no signs of bringing in the emergency interest rate hike of at least 200bp that analysts believe is the very least needed to put a floor under the currency.

Turkish President Recep Tayyip Erdogan’s populist and nationalistic comments in the past four days have only served to drive the currency lower. The implication from the stubborn addresses the strongman has made to various audiences is that Turkey’s economic fundamentals are fine, the crisis is a superficial drama generated by Western enemies of Ankara who are manipulating the financial markets and that Turkey will emerge from its dire straits through its own strength, with no major action required from the government. It seems that Erdogan, widely suspected of having taken over monetary policy, is, to near all-round astonishment, pushing the line that it is just fine to wait until the September monetary policy committee meeting to make the next rate-setting decision.

In the meantime Turkish assets are spinning out of control, stock prices are tumbling, 10-year benchmark domestic bonds have tested a fresh all-time high of 22.69% and Turkey’s credit default swaps have become more expensive than those of arch-rival Greece for the first time since that country sank into its own crisis several years ago. Throwing central bank reserves at the problem is not an option. They stand at a mere $131bn compared to the $458bn Russia has built thanks to its oil and gas revenues.

Collapse is on the cards
A collapse of the Turkish financial system is on the cards as the currency’s death spiral makes bank and corporate credits harder to pay off or refinance. What started out as a currency crisis could now expand quickly to be a more general systemic financial meltdown. And that in turn threatens the economies of the rest of the region and international investors who have lent the Turkish government, companies and banks hundreds of millions of dollars.

How bad is it? The Asian crisis was transmitted to the rest of the world, and Russia in particular, by a collapse in commodity prices. This time round, it's so far a problem with Turkey’s currency, meaning the impact on the wider region is limited. The rest of the world’s saving grace is, all said and done, that Turkey remains a middle tier player in Europe. With economic output standing at $850bn, it is not big enough to bring the rest of the region down, even if analysts believe its crisis will cause significant pain in a lot of countries. But things could get worse.

“Aside from the impact on a few small neighbouring countries, most notably Bulgaria, the direct risk of contagion from Turkey’s crisis to other EMs is fairly low. However, Turkey’s problems may add to the accumulating negative sentiment towards emerging markets in general, and this in turn could make financial conditions more difficult for emerging economies in the coming months,” Capital Economics said in a note.

EM currencies
Other currencies in the region are also on the wane. The Russian ruble is a particular case—although let’s not forget Russia is under attack from the White House with two sets of fresh sanctions packages drawn up that may be imposed in the autumn. The ruble has fallen to below RUB67 to the dollar for the first time since 2014 and that affects the whole of the Commonwealth of Independent States (CIS) as Russia remains an investment node for the former Soviet Union countries many of which rely on remittances from Russia to prop up their economies.

“The fall in the lira appears to have caused sentiment towards EMs more generally to deteriorate today. Most EM currencies are down by 0.5-1.5% against the dollar and central banks in India and Indonesia have reportedly intervened in foreign exchange markets in response,” Capital Economics said.

But the pain has been mitigated as unlike Turkey many of these countries in the region—including Russia and Kazakhstan as the two most important—have freed their exchange rates and have those significant foreign currency reserves to back up their national currency. Likewise, Turkey’s huge current account deficit, at more than 5% of GDP, is also unusual in the region where most governments have narrowed their shortfall or in some cases, like Russia, are running healthy surpluses.

After Turkey, Ukraine is in the weakest position in terms of its exposure to external shocks and on the basis of the speed in growth of its external debt, according to a survey by the Institute of International Finance (IIF).

Ukraine’s foreign reserves fell to $17.7bn last week—equivalent to exactly the required minimum of three months of import cover. The country is running out of money. Only Belarus looks to be in a worse position. It has reserves worth just two months of import cover.

“Trade ties with Turkey are not large either, so a sharp downturn in Turkey shouldn’t be damaging for EM exports. Aggregate EM exports to Turkey amount to just 0.3% of EM GDP. Of course, some countries are more vulnerable than others. Bulgaria’s exports to Turkey are close to 5% of GDP, while those from Russia, Vietnam, and Central Europe stand at 1-2% of GDP. For most, the fallout should be manageable,” Capital Economics added in its note.

Eurobanks and US investors
Oddly European banks are more exposed to a meltdown than Turkey’s CIS neighbours as they have financed so much of the borrowing binge that has placed the country in the precarious position it is in today.

“[The European Central Bank] is concerned that Turkish borrowers may not be hedged against the TRY’s weakness and could begin to default on foreign-currency loans, which make up about 40% of the Turkish banking sector’s assets,” The Bank of New York Mellon said in a note on August 12. “Signs of this began to emerge on [August 10] with key European banking stocks under pressure and the euro being hit on the back of this as investors reassessed how the ECB might react from the monetary policy perspective.”

American investors are also exposed to Turkey, for one because they own nearly 25% of outstanding Turkish bonds and more than half of publicly traded Turkish stocks, according to the Institute of International Finance (IIF). However, again, Turkey remains a relatively small market. While US investors play an important role in its economy, the share of Turkish assets in their overall portfolios is not very large and lies within the institutions’ ability to absorb considerable losses.

“While stocks were hit on Friday, the losses were modest when compared to the market’s performance over the past month and a half. Similarly, while the 10-year Treasury yield is under downward pressure, it still remains within the ranges of recent months. Moreover, while it’s certainly true that the $ has made some significant gains in recent days, these have been selective (notably against the EUR),” BNY Mellon said.

Outsized exposure
Last week the ECB began to get seriously concerned over several banks that have an outsized exposure to Turkey—namely Spanish bank BBVA, Italian bank UniCredit and French bank BNP Paribas—after the TRY dropped 12% during August 10.

The ECB, however, says the situation is not yet critical as although the sums of money involved are large, they are not such a big share of the banks’ total credit exposure. The ECB is actually more concerned about the exposure of the local banks that may not have hedged their exposure to local debt—if they go under they will start to default on their international obligations, which make up around 40% of the total Turkish banking sector’s assets. According to the Bank for International Settlements, known as “the central banks’ central bank,” local lenders, including foreign-owned subsidiaries, have dollar claims worth $148bn, up from $36bn in 2006, and euro claims worth $110bn, the Financial Times reported.

Spanish banks are owed $83.3bn by Turkish borrowers, French banks $38.4bn and Italian lenders $17bn in a mix of local and foreign currencies.

With Erdogan’s encouragement, Turkish banks and companies went on a borrowing splurge that ramped up economic growth at ‘Chinese speed’, but the bills are now coming in and the debt-fuelled economy looks likely to career off the rails. The question is no longer whether Turkey will enter a recession, but how deep that recession will be. Analysts at Goldman Sachs have determined that a depreciation in the lira to below TRY7 against the dollar “could largely erode banks’ excess capital”. There could be plenty of struggles to keep heads above water.

But having been burned in the country’s 2001 crisis, Turkish banks are said to have somewhat learnt their lesson and are often described as well run and cautious. Despite the economic problems, non-performing loans (NLPs) are at only 3% of total loans and the banks are well capitalised. The challenge they face now is not from mistakes they have made, or loose regulation; it is simply from the scale of the meltdown under way.

But this crisis has been a long time coming. bne IntelliNews has been reporting all year on the impending meltdown. The long run-up has given bank owners, especially foreign-owned banks, plenty of time to get ready.

Carlos Torres Vila, chief executive of BBVA, which owns just under half of Turkey’s Garanti Bank, told the FT that the group was “really very, very well prepared for the situation.” The bank reduced the weight of its foreign currency loan portfolio a month ago and increased the weight of inflation-linked instruments.

UniCredit invested a reported €2.5bn in a 40.9% stake in local bank Yapi Kredi, but the currency devaluation has seen the value of the stake fall to €1.15bn. Analysts at the bank said the bank could cope with the loss. BNP Paribas owns 72.5% of retail bank TEB but this investment only amounts to 2% of the bank’s total assets and the bulk of the bank’s funding was financed by local deposits and not foreign borrowing.

While the direct impact of Turkey’s crisis on the other EMs is expected to be limited, the problems reflect a more general cooling off this year of international investors’ sentiment when it comes to emerging market destinations for their capital. Countries like Ukraine and Russia need to tap international investment capital with eurobond issues, or increasingly via their domestic debt markets that are being hooked into international settlement systems. But with the souring mood and the higher returns now on offer in developed economies as a result of a cycle of loosening that has commenced, that is getting more difficult and expensive.