Turkey remained the key focus for markets with Emerging Markets (EM) feeling the contagion pain.
In many ways, Turkey’s turmoil is a conventional EM currency crisis caused by significant external deficits that have been in the making for some time.
There is value in the Turkey lira (TRY) following its sharp 41 per cent depreciation versus the US dollar (USD) year-to-date.
However, we do not expect cheap valuation to be a sufficient catalyst for a sustained reversal of the currency weakness.
We stay cautious on the lira outlook, as things could get worse before they get better.
Turkey’s central bank lowered banks’ reserve requirements for both TRY and FX-denominated liabilities to improve liquidity.
Turkey’s banking regulator also announced limits on FX swap transactions of local banks to discourage short positions in the currency.
This initial action may well minimise the TRY volatility in the short term, but is unlikely to be decisive enough to durably stabilise the TRY.
More concrete policy tightening, that signals acceptance of the need for economic slowdown to narrow Turkey’s large external deficit, is still lacking.
The alternative policy choices, which carry high domestic political costs, would be to resort to either an International Monetary Fund (IMF) bailout or some form of capital controls.
An IMF-led bailout may require US/Turkey diplomatic conciliation and would typically involve conditionality of orthodox policy tightening that may be difficult for Turkey to agree to at this juncture.
Worries that contagion risk from Turkey’s currency crisis could ripple through trade and financial linkages, took a turn for the worse, as concerns arose about European banks being impacted adversely.
We also saw banking concerns in 2008, but this is not 2008 and Turkey is not the US housing market.
European banks’ exposure to Turkey is more a supervisory question for a small number of European banks.
It is not a systemic one that will impact the overall stability of Eurozone’s banking system.
Contagion risk from Turkey on the EUR seems overpriced.
But our positive medium-term EUR view may continue to face temporary headwinds from growing political noise around the Italian budget process, with the Italian government expected to unveil the budget by the end of September.
We also remain un-persuaded that Turkey, as with Argentina earlier, presents a systemic risk for the rest of EM.
But it will be difficult for EM currencies to shrug off Turkey for now given the ongoing witch hunt to punish EM countries that share similar negative fundamentals as Turkey, namely large external financing needs.
Among the Asian countries, India, Indonesia and the Philippines (to a lesser extent) run current account deficits.
However, the external funding needs, at less than 3 per cent of GDP, seem manageable relative to the size of these countries’ foreign reserves and capacity for policy response.
Given Asia's limited financial and trade linkages with Turkey, Turkey should not pose systemic risks for Asia's growth.
We expect the spillover from Turkey's turmoil on Asian currencies to diminish over time.
China/US trade war risk matters more than Turkey to the outlook for Asian currencies.
There is a sense of uneasy calm in the yuan following recent policy shift to support economic stability in China and indications of the authorities’ declining tolerance for yuan weakness.
Despite recent escalation, the next few weeks should be relatively quiet on the trade front.
No further US action is expected at least until the public consultation period for proposed tariffs on US$200 billion imports finalises on 5 September.Disclaimer applicable to recommendation
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