The dramatic unraveling of Turkey’s lira has ignited fear in markets around the world that the country’s currency woes could ripple through the world’s banks, notably in Europe.
Hand-wringing over Turkey’s economic health under the stewardship of President Recep Tayyip Erdogan is nothing new. Consternations about Ankara have been gathering steam since the 64-year-old won a sweeping, but disputed, snap-election victory in June.
On Friday, things came to an apparent head, with the lira USDTRY, +16.6077% breaching another key level when the U.S. dollar bought more than 6 lira, just a week after touching 5 lira for the first time on record, according to FactSet. One dollar last bought 6.2832 lira, up more than 13%. Similarly, the lira was down some 12% against the euro EURTRY, +15.0582% , which fetched 7.1684 lira at last check.
Here’s what the investors need to know about the Turkish lira and its potential impact on markets:
1. Emerging-market contagion?
The lira’s dramatic slide against its main rivals was symptomatic of a broader theme in emerging markets. Countries that rely heavily on foreign — mostly dollar-denominated — funding have been struggling with a strengthening U.S. currency, which has been on an upswing since April.
Read: How much of the emerging-market carnage can be blamed on the Fed and the dollar
On top of that, rising interest rates in the U.S., where the Federal Reserve is expected to raise interest rates for an eighth time since late 2015 in September, has exacerbated the strain on emerging markets, which use local currencies to pay down their dollar-backed debts.
Turkey has led the pack of countries that maintain a high dollar-denominated debt burden. Argentina can also be counted among that contingent of troubled emerging-market economies, and analysts have long speculated that Ankara and Buenos Aires could become the first dominoes to fall in a wider emerging-markets unwind.
Turkey’s annual external financing needs, including both its current-account deficit and maturing debt, come to around $218 billion, according to the Institute of International Finance. That number could grow to $240 billion, representing 28% of GDP. More than half of that debt is dollar-denominated, according data from Eurizon SLJ Asset Management (see chart below).
Read: Here’s one more factor that could add to emerging-market headwinds
According to a Financial Times report, the European Central Bank has grown increasingly concerned about Turkey’s condition and a potential contagion of its problems, particularly with respect to its financial sector. This report sparked a selloff in European SXXP, -1.07% and U.K. stock markets UKX, -0.97% , reflecting investors’ current worries.
2. Turkey’s economic and political climate
Beyond the risk of contagion that emerging-market wobbles could have on developed markets throughout Europe, the lira slide also intensifies Turkey’s domestic issues, such as its high inflation. Consumer-price inflation rate has been in the double digits for a protracted period, with a July reading of 15.8%, which was up slightly from 15.4% in June.
The Central Bank of the Republic of Turkey has intervened at numerous points this year, with little success, to stave off the lira’s drop and stabilize inflation. Meanwhile, Erdogan, after his June re-election, has been fiercely critical of the central bank’s actions and higher interest rates.
After the CBRT declined to lift interest rates at its last meeting in late July, market participants have been anxious about the waning independence of the central bank. Since his re-election Erodgan has accumulated more power, and tightened that grip in recent weeks by appointing ministers without parliamentary approval.
On Friday, Erdogan called on Turkey’s citizens once again to exchange their foreign-currency holdings and gold for lira.
Technically, a weaker currency makes a country’s goods more attractive on the global market, which is why President Donald Trump has frequently complained of currencies like the euro EURUSD, -1.0846% and China’s yuan USDCNY, +0.3606% weakening against the greenback, despite their slides being largely related to other factors such as worries about a trade war and monetary policy.
But for Turkey, the euro-dollar exchange rate is also of importance, given Ankara’s trade with the European Union, which is accounted for in U.S. dollars, as well as Turkey’s imports, which are also accounted for in dollars.
That means that if the euro is weaker Turkey gets paid less for its exports and its imports are more expensive. The euro has dropped 3.6% against the dollar in 2018 so far, according to FactSet.
3. Diplomatic relations
Making matters worse are Turkey’s diplomatic and trade spats with the U.S. Relations between Ankara and Washington have suffered on the back of the detention of U.S. evangelical pastor Andrew Brunson, with Turkey dismissing calls for his release. The U.S. has introduced sanctions over the issue, on top of the existing trade tariffs that already affected Turkey.
Friday, Trump tweeted that existing aluminum and steel tariffs would be doubled in light of the weakening lira.
Turkish relations with Germany, home to millions of Turkish immigrants, have also worsened over the past year, leading market participants to point out that such infighting between NATO allies was highly unusual.
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