Turkish Lira Crisis Raises Contagion Fears

What happens in Turkey may not stay in Turkey.

Will emerging market currencies fall like dominos following the collapse of the Turkish lira, or is the Turkish crisis a unique situation that will be contained? There are a number of common elements in big emerging markets (EMs) that raise legitimate concerns about the potential for a broader EM currency crisis.

For one thing, the dollar is strong and US interest rates are rising. Countries with large current account deficits and weakening currencies are having a more difficult time repaying their dollar-denominated debt.

The Institute of International Finance (IIF), a global association of financial institutions based in Washington, DC, warned early this year that EM risk was rising, especially for Turkey and Argentina. It said there was a growing possibility for contagion to other EM markets because nonresident flows to these countries have been unusually large in recent years.

“Our analysis showed that these flows built up in a few countries in particular, so that ‘concentration risk’ could be a conduit for contagion to broader EMs,” the IIF stated in a recent publication authored by Robin Brooks, managing director and chief economist at the IIF, along with associate economist Jonathan Fortun and research analyst Tariq Khan. “South Africa, Indonesia, Lebanon, Egypt and Colombia are especially at risk,” the report states.

The August 14 report was released on the same day that Argentina took emergency steps to protect its sinking currency and minimize contagion from Turkey’s ills.

Argentina’s central bank raised its benchmark rate by five percentage points, to 45%, the highest in the world. The move came just as the International Monetary Fund (IMF) began its mission to Argentina after granting the country a $50 billion credit line in June.

“It is difficult to see how a large IMF program would be available to Turkey under current conditions,” Stephanie Segal, deputy director and senior fellow at the Center for Strategic and International Studies, wrote in a recent commentary.

Turkey’s President Recep Tayyip Erdoan has disregarded IMF advice, such as allowing an independent central bank to raise interest rates. Erdoan’s decision to name his inexperienced son-in-law as treasury and finance minister hasn’t helped his cause, says Segal.

The Trump administration appears far less concerned with the potential for contagion in the global financial system than previous US administrations, says Segal. “Further complicating matters for vulnerable EMs, many Republicans in Congress have made clear their opposition to IMF ‘bailouts,’ ” adds Segal, “most recently in a letter from more than a dozen senators to US Treasury Secretary Steven Mnuchin opposing IMF programs to ‘countries that have accepted predatory Chinese infrastructure financing.’ ”

EM contagion worries rose when India’s rupee fell to a record low of more than 70 to the dollar last month. The effect of rising crude oil prices on inflation has caused a bond market sell-off amid concerns about financing government debt at a time of capital outflows. At the same time, the appointment of Swaminathan Gurumurthy, a conservative commentator close to Prime Minister Narendra Modi, as a part-time director at the central bank, has led to accusations that the bank’s independence is being compromised.