The effect of the lira crisis on emerging markets

THE heavy sell- off in Turkey’s market is starting to spill over into other emerging markets, especially those that need to draw on the global savings pool to finance persistent current account deficits or countries with a direct linkage with Turkey’s economy.

Still, traditional direct trade and banking contagion channels from Turkey to other markets remain limited, although European asset markets were affected the most, given the elevated lending exposure in developed Europe.

While the contagion from Turkey through the trade and banking channels are likely to be limited in general for emerging markets, investors are likely to sharpen their gaze on the more vulnerable, focusing on funding needs, institutional strength and relations with the US.

Turkey’s increased diplomatic tensions, with the US coupled with weak institutions and external vulnerabilities, have driven the recent weakness in its assets, and we think the pressure on them could resume as aggressive political rhetoric take centre stage and suggests a reduction in Turkey-US political tensions is not likely imminent.

While the authorities have mitigated pressures on the foreign exchange with liquidity tightening measures through monetary easing measures, the bar for a decisive rate hike remains high.

Even such an action may not provide a long-lasting anchor to the lira’s stability as the political tensions will not likely die down soon.

This could also increase the financial burden.

However, we believe that Turkey’s sovereign default risk remains limited in the near to medium term and we believe that the sovereign curve offers attractive opportunities in the mid term.

Due to the ongoing spat, a slew on central bankers initiated policy responses to mitigate the effect.

In terms of policy actions by emerging markets’ central banks, Argentina and Indonesia have tightened their policies in response to the recent pressures on their currencies.

In India, the focus has centred on disappointing July trade numbers, with US dollar-Indian rupees reaching historical highs, rather than the larger-thanexpected drop in inflation for June, which should have been welcomed by bond market participants.

On the domestic front, the KLCI took an early hit, initially, inline with regional weakness.

However, the market remained resilient, backed by strong domestic supports.

Investors should be cautious trading into the market given the uncertainties on how these policy changes will impact Malaysia’s market.