"Self-Fulfilling Contagion": This Is The Worst Case Scenario For Turkey

With Turkey's inflation soaring to a 15 year high as the ongoing result of a currency in meteoric free fall, coupled with tumbling capital markets and record high interest rates, both from unsustainable domestic imbalances as well as the prospect of a doubling of steel and aluminum tariffs by the Trump administration, and a warning from the ECB about European bank exposure to Turkey...

... traders and investors have expressed growing concerns where potential contagion may strike next, who is most exposed to the Turkish crisis, in the process hitting European stocks and EU banks, and what a "worst case" scenario for Turkey would look like.

To be sure, the FX market's response this week certainly was swift as the currency plunged by more than 20% since last Friday vs. the USD, with JPMorgan analysts warning that policy options for the Turkish government are limited, as policy rate hikes alone would likely no longer be sufficient and could have been counter-productive as it could exacerbate concerns over the banking system, meanwhile president Erdogan remains staunchly opposed to both an IMF bailout and capital controls for now, the two other emergency escape valves that are traditionally used in similar situations.

Meanwhile, fears are also growing about the viability of the Turkish banking sector, with Goldman recently warning that the banks' excess capital would be eroded should the Turkish Lira depreciate to 7.1, not too far from its Friday close...

... which in turn prompted JPMorgan to caution that a comprehensive package is required that includes backstops for Turkey's banks.

So what does that data say?

First, a look at foreign equity exposure to Turkey.

As JPMorgan points out in a note published overnight, despite the sharp movements in the currency, outflows from Turkish equity ETFs have been relatively modest, at least until a few days ago. Turkish equity ETFs saw modest outflows in July, but had seen a reversal of those outflows thus far in August, up to close Aug 9th.

Meanwhile, the short interest ratio for the largest US-listed equity ETF (TUR ) rose sharply during the broader sell-off in EM in late April/early May, but has since moderated significantly. This to JPM suggests Turkish equity ETFs remain vulnerable.

What about trade?

JPMorgan next looks at the largest trading partners of Turkey in terms of exports to Turkey.  The largest 5 exporters to Turkey are China, Germany, Russia the US and Italy, which account for nearly 40% of Turkish imports.

However, while at face value this implies that a continuation of the turmoil in Turkey would hit these countries the most, it is also important to look at how important Turkey is relative to the overall size of exports. Figure 11 depicts the proportion of exports to Turkey as a share of total exports for the 20 largest exporters to Turkey in 2017.

This suggests that the countries that are most vulnerable are other EM countries in the region.

What about financial asset exposures?

Looking at the stock of portfolio and direct investment assets held by foreign investors published by the Turkish central bank, i.e. Turkey’s liabilities from a balance of payments perspective, shows that that Turkey’s portfolio liabilities stood at $160bn in May 2018, three quarters of which were debt securities. In terms of FDI, the stock of direct investment liabilities stood at $140bn in end-May. The country breakdown of net FDI liabilities is only available to end-2017, and around 75% of those liabilities were held be European countries, with largest single country exposure is to the Netherlands at around 18%, which is likely to reflect mainly holdings by investment funds.

Other large European country exposures include Germany, France, Spain, Switzerland and Russia. Of the remaining 25%, around 60% is held by countries in the Middle East.

To JPM this is troubling, because since a significant share of claims on Turkey is likely to be held by investment funds, "this suggests that Turkish assets remain vulnerable to outflows", or in other words, absent a decisive stabilization of Turkey's economic plight in the coming days, the nation could be hit with a reflexive outflow of capital, which would only accelerate the currency collapse.

What about foreign bank exposure to Turkey?

In light of the ECB's Friday warning, which arguably catalyzed the sharpest leg of the Lira collapse, this has emerged as the most pertinent question and precipitated Friday's "contagion" response across European markets. According to BIS statistics, foreign banks held claims of around $220bn on Turkey as at the end of 1Q18, a figure which includes cross-border claims as well as local claims of foreign affiliates. 60% of this reflects exposure to the non-bank private sector. The direct exposure to Turkish banks is lower, at around $50bn, while exposures to the official sector are around $38bn.

Looking at the split by country, Spanish, French and Italian banks are the ones with the highest foreign claims on Turkey, followed by US and UK banks. The good news, at least according to JPM's credit strategists, is that "even for the European banks with the largest exposures to Turkey the impact on fundamentals is likely to be manageable", absent of course further emerging market spillovers.

Besides direct claims, foreign banks also held additional exposure of around $78bn to Turkey via “credit commitments”, “guarantees extended” and “derivative contracts”, which include "the contingent liabilities of the protection seller of credit derivatives contracts, warranties and indemnities, confirmed documentary credits, irrevocable and standby letters of credit, acceptances and endorsements" according to JPMorgan.

Here, approximately 50% of these exposures are held by French, Italian and Spanish banks, and a further 40% by US and UK banks. For derivative contracts and guarantees extended, US and UK banks account for more than 50% of total exposures. Meanwhile, around $9bn of these additional exposures reflects CDS protection on the Turkish sovereign, which has been relatively stable since 2014.

Summing up JPMogan's findings, the bank concludes that "in terms of foreign bank exposures it appears that Spanish, French and Italian banks, as well as US and UK banks through contingent exposures, are most exposed to Turkey."

And while the direct threat of contagion spillover from Turkey appears limited so far, the risk is that an adverse cascade especially among the country's EM peers - should investors scramble to cut their exposure to emerging markets - could ripple and have a magnifying effect on the global financial system, resulting in a repeat of the Asian Financial Crisis if Turkey's economic freefall is not arrested early enough.

Ironically, this "worst case" scenario for contagion could be catalyzed in one of two ways: if Erdogan decides to do nothing, or - paradoxically - if he panics, and implements the most draconian of countermeasures - capital controls.

This is how Robert Marchini, a political strategist at Zenith Asset Management laid out to Bloomberg how he see the "worst case scenario" for Turkey:

Regarding Turkey as a potential 'Black Swan'-level event, I'm skeptical the collapse of the currency per se would be enough of an incident. The market has known for a while Erdogan was leading the country in an economically reckless direction. The real question was when it all would blow up (although I don't think anyone thought it would go down this quickly.) More specifically, I think that the [EU] banks' exposures to both external debt and local operations, while significant, are not at a crisis level.

Where the real risk lies, and one that I think has not been adequately considered, is the markets' reaction to [potential] capital controls. Should Erdogan impose capital controls, in addition to banks' writedowns on [now-toxic] Turkish assets, investors' reaction is likely to be panic and to yank capital out of other EMs before either A. That EM's currency falls further and/or B. That EM's government gets the same idea as Turkey.

This becomes somewhat of a self-fulfilling prophecy, and in my opinion is where the real possibility for contagion lies.

In other words, having done nothing while the Turkish financial crisis spiraled out of control first slowly and then blazing fast, Erdogan now finds himself facing a most unpleasant dilemma: damned if he does, and damned if he doesn't.