LONDON (Reuters) - Turkey could be heading for another financial crunch but its diminished importance for investors in developing economies and changes in the sector have greatly reduced the risk of contagion across emerging markets.
The lira tumbling to fresh record lows last week reignited memories of Turkey’s 2018 crisis which rocked developing currencies from South Africa’s rand to Russia’s rouble and also impacted shares in Turkish-exposed European banks.
But even that reaction was muted compared to prior decades when contagion from one emerging market to another was taken for granted, such as during the Asian crisis or the Russia crisis.
Reverberations this time might be of even lower magnitude, because investor positioning in emerging markets overall and Turkey in particular looks dramatically different from the summer of 2018.
“Foreign investor participation in Turkish markets has collapsed over the past several years, with non-residents now holding only 6% of (Turkish government bonds), down from 29% in 2013,” said Phoenix Kalen at Societe Generale.
Institute of International Finance data showed emerging markets had suffered a “sudden stop” in capital flows in March with a record $83.3 billion fleeing stocks and bonds amid uncertainty over the coronavirus spread and the oil price collapse.
Turkey, more vulnerable to swings in capital flows, saw the amount of domestic assets held by foreign investors drop sharply. Domestic debt held by non-residents fell from $15.5 billion late-2019 to $8.4 billion in early May. Over the same period, equity holdings by non-resident investors fell from $32 billion to $22 billion, central bank data showed.
“Similarly, there is much less foreign participation in Turkish currency markets due to the interventionist policies, frequent new regulations, and the sporadic funding squeezes,” added Kalen.
Turkey has tinkered numerous times with offshore lira markets in recent years with President Recep Tayyip Erdogan frequently accusing foreign speculators of destabilizing the lira.
In April, the regulator capped local banks’ ability to conduct FX transactions with foreign entities at just 1% of equity, down from 10% previously - a move that sparked a muted markets reaction. Days later, it took this limit down to 0.5%.
A similar offshore 2019 lira squeeze saw overnight borrowing rates soar to over 1,000%, which briefly shored up the lira.
This comes amid a long decline in overseas lira trading with average daily trading volumes in London having shrunk 28% from 2016 to $37 billion last October while the share of total FX trading slipped to 1.3% from 2.3%, Bank of England data shows.
Graphic: Turkish lira in offshore markets - here
Turkey’s waning weighting in bond indexes also lowers the risks for investors. In the JPMorgan GBI-EM index - a widely used emerging local bond benchmark - it has a 3.2% weighting compared to 10% in 2015.
“Turkey has been a source of concern among foreign investors for so long,” said Manik Narain, head of EM strategy at UBS. “There is not the same degree of hit to asset management returns, it’s not the same as if Mexico or Brazil blows up.”
Unlike Turkey, many emerging markets have also seen some vulnerabilities to external flows decrease in recent years. Since the 2013 taper tantrum, current account deficits across major emerging markets have broadly receded while a crunch in debt-to-FX reserves has been focussed in smaller, riskier emerging markets.
Meanwhile emerging markets as an asset class have also changed — there are more countries to invest in and a far broader investor base, including local pension and insurance funds which hold on even if foreigners sell.
“You have seen markets deepen in size, liquidity improve and we think become more sophisticated so investors are more willing to differentiate individual country risks,” said Nachu Chockalingam at Federated Hermes.
Graphic: Emerging markets are more mature - here
Reporting by Karin Strohecker in London, additional reporting by Ezgi Erkoyun in Istanbul and Tom Arnold in London; Editing by Toby Chopra