Vulnerabilities in the Turkish economy v the Chinese economy

With China’s problems dominating the headlines in recent weeks, Fay Ren, Investment Analyst at Cerno Capitalhighlights a less discussed market that has been concerning the firm in recent periods – Turkey…

Turkey is significant, due to the size of its economy (13th largest among OECD countries) and its geographical and economic proximity to Europe, which accepts circa 55 per cent of its exports. Turkey is in a more vulnerable position than China in several ways: it runs one of the highest current account deficits in the EM universe owing to its dependency on short-term foreign funding to support the economy. Like its EM peers, Turkey has been a beneficiary of large foreign capital inflows, manifest in the significant external leverage built by its domestic corporate sector, masking its waning economic momentum. Gross external debt has doubled from pre-crisis levels to almost USUSD400 billion in Q1 2015. This represents 50 per cent of GDP, which, as noted by financial historian Russell Napier, exceeds the threshold of 30 per cent where historically a country is more likely to default. In comparison, while China’s debt level is much higher in absolute terms, its ability to repay is stronger with the ratio sitting at 9 per cent of GDP.

There are some countervailing elements, however. Falling commodity prices are beneficial to Turkey, being a net importer, in stark contrast to Brazil or South Africa. This will help improve its current account deficit somewhat, if low prices are sustained for longer. Turkey is also the least exposed to China among major EM economies, with less than 1 per cent GDP of exports to the country.

Nonetheless, the end of quantitative easing and the expectation of rate rises in the US may see a reversal of the trend of flows that have been fundamental to Turkey’s economy, signs of this are just beginning to emerge. This will make funding more expensive and debt more difficult to repay, thus making Turkey more vulnerable to capital flight, taking into consideration that almost 25 per cent of their bonds are held by foreigners. These eventualities are often precursors to the introduction of the foreign investors nemesis – capital controls.

Flows within dedicated EM bond funds are increasingly negative. The most recent week has seen USD2.5bn of outflows, the worst level since February 2014, although still significantly below the 2013 taper tantrum period.

On average, Turkey account for 5 per cent of hard currency and almost 10 per cent of local currency EM bond indices, and is weighted similarly in the largest EM Bond funds with few exceptions. Given this level of exposure, coupled with the accelerating negative unwinding trend in emerging market debt, Turkey’s weak fundamentals, high debt levels, and sensitivity to capital flow volatility will yield an increased risk of capital controls being introduced as a counter measure. Should this happen, we will likely experience significant turmoil in EM debt markets and renewed focus on the lending banks

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