Managers keeping eye on events in Turkey

Money managers are closely monitoring a continually changing situation in Turkey to see if the country's economic troubles can be resolved.

A combination of a trade spat with the U.S. — with the potential for further sanctions, high external debt and difficult internal politics have taken their toll on the lira, prompting managers to shed Turkish exposure in recent weeks.

As Pensions & Investments went to press Aug. 17, the lira had lost 7.76% against the dollar from Aug. 9 to Aug. 17 and 44.82% since the start of 2018.

But while managers do not anticipate a quick fix for Turkey's situation, they are not overly concerned about contagion risk to the rest of the emerging markets, nor to Europe.

Last week, Turkey's central bank launched measures to improve liquidity in the market, such as requiring banks to borrow at the — already available — higher policy rates. However, it stopped short of an official interest rate hike.

"The fact they resort to this rather than straightforward hiking to me is a bad sign — (the bank is) still worried about crossing Erdogan," said Craig Botham, London-based emerging markets economist at Schroders PLC, referring to Turkish President Recep Tayyip Erdogan's reluctance to embrace orthodox monetary policy. Mr. Erdogan has expressed his view that higher interest rates cause high inflation.

"The central bank still feels beholden to that frankly bizarre policy view, (which) is a concern. Although the measures have helped support the currency a bit, they haven't addressed the real" issues, and rather are acting as a stopgap, he said.

Turkey's interest rate was held steady at 17.75% at the latest meeting of its monetary policy committee in July. The rate on overnight lending was 19.25%.

Guido Chamorro, co-head emerging market hard currency debt at Pictet Asset Management in London, also acknowledged an "unwillingness to follow orthodox monetary policy ... Looking ahead, we don't really see any lasting solutions to those concerns — the fundamental concerns about the economy, from an inflation perspective and risk (to the) banks, have not changed from two weeks ago to now. And I think the geopolitical concerns are also still in place because of these disagreements between the U.S. and Turkey," he said.

There was "almost a sigh of relief when news came in that Qatar would invest $15 billion to help Turkey prop up their situation," said Joachim Klement, London-based head of investment research at Fidante Partners. Mr. Klement was referring to a pledge by Qatar to "rapidly implement an investment package," according to a notice on President Erdogan's website, Aug. 15.

"In my view that Qatari announcement, while it calms down the nerves, it doesn't really resolve the situation."

Money managers said they have been cautiously positioned when it comes to Turkey, and the country is top of mind for their investor clients.

"In the end the only thing in my view that can calm investors down is central bank (hiking of) interest rates in order to stop inflation and curb credit growth," Mr. Klement said. In July, inflation in Turkey hit 15.85% according to the central bank, up from 15.39% a month earlier and 9.79% in July 2017.

"I think what most of the market and investors would want to see is probably still a hike in interest rates, which doesn't seem to be forthcoming at the moment, and an improvement or easing in the relationship between the U.S. and Turkey — less aggressive statements from either side. But we just don't see those," Mr. Chamorro added. He said executives at the firm are most concerned about sovereign credit "because that's the channel that can be more dangerous if the banking system does start to get into some trouble."

Robeco Institutional Asset Management B.V.'s emerging markets equity strategy has not invested in Turkey for the last 18 months, said Wim-Hein Pals, head of emerging market equities at the firm in Rotterdam, Netherlands.

"We keep away from lira assets until we see more convincing measures from the Turkish government and central bank. Serious monetary tightening is necessary given inflationary pressures and current account worries. The government told investors earlier that capital controls are not being considered so that leaves hiking interest rates as one of the few options left. It is a confidence crisis which could end up in a financial crisis, which hurts the Turkish banks in the first place."

Contagion risk

In the end, money managers said they could not rule out Turkey defaulting on its debt.

Mr. Klement said the steps to a default "usually start with the currency devaluing. (The central bank) usually has to hike interest rates, if that is not enough they go for a loan (from the International Monetary Fund) and introduce capital controls, and if that doesn't help you end up with a default."

He said Mr. Erdogan has "moved himself into a corner where it will be almost impossible to get himself out without losing face."

If the country does not opt for a loan, "you end up with a situation where you take a shortcut to the default. Eventually you will be forced to introduce capital controls and (will) default at least on your external debt," Mr. Klement said.

Despite increasing concern over the situation in Turkey, money managers are not too worried about contagion risk for other emerging markets.

"There are a few channels — the direct one is economic linkages through trade and investment. For most emerging markets, Turkey is not a big deal — there is no reason on a trade basis for Mexico to be worried about Turkey," Mr. Botham said.

When it comes to financial linkages, Mr. Botham said connections are also "pretty limited."

But there are two channels of contagion risk. "One is sentiment — just that it's a risk-off driver. So people just want to get out of risk assets generally…and the dollar (has received) safe haven inflows, with Treasury yields coming back down and the dollar has strengthened. That has real economic implications for emerging markets — a stronger dollar ... means international trade will be softer, (emerging markets) currencies will weaken against the dollar" and there may be inflationary consequences, Mr. Botham said.

But "there's no reason for people to worry that Turkey will cause anything to blow up in emerging markets — it is more a risk sentiment thing," Mr. Botham added.

There has also been market concern over a spillover of Turkey's problems to parts of Europe's banking system, with Spanish and French banks having particular exposure.

"That is all very manageable and not a material risk. I'm not worried that a bank will go under because of Turkey alone," Mr. Klement said.

And one thing the situation in Turkey has done is "made people aware that now the (U.S. Federal Reserve) has started to withdraw liquidity, it is much harder for investors to give unforced errors in emerging markets. I don't think the tightening caused this crisis, but it reduced the amount of lubrication in markets in the event of these kinds of blowups," Mr. Botham said.

Had this situation taken place a year or two ago, there may have been a brief spike in markets, he noted. "Whereas now with liquidity being withdrawn people are more cautious — where there's a problem it is harder to be overlooked."