Turkey crisis puts other emerging nations and investors at risk

Turkey is at the heart of the turmoil now sweeping through emerging markets. But it is merely a symptom of the troubles, not the cause, and investors would do well to remember that crisis could befall other emerging nations just as easily and quickly.

With sentiment towards emerging markets as weak as it is, it’s not hard to imagine high levels of dollar-denominated debt, wide current account deficits and reliance on foreign capital triggering an investor stampede for the exits elsewhere.

It’s a sobering thought for the retail investors who have a chunk of their retirement funds in “emerging markets”. They might like the idea of, say, 10 per cent or even higher returns, but at the risk of stating the obvious, there’s a reason emerging-market yields are so high.

How aware is your average mom and pop in, say the US or Europe, of the fragility across potentially dozens of emerging nations where their pension plans are invested? Do they get sufficient warnings of the risks?

Of 478 emerging market corporate bonds tracked by Citi, only two have tighter spreads so far this year, and 476 have wider spreads. The only countries in Citi’s emerging sovereign bond index showing positive returns are Mongolia and Belize.

“We have not heard that they were the subject of many investor overweights,” Citi wrote in a note.

Some analysts point out that the spillover from Turkey should be limited. Turkey accounts for only 1 per cent of global gross domestic product. The exposure of European Union banks is less than 1 per cent of EU GDP. US banks have $18 billion exposure to Turkey, just 0.1 per cent of their total assets.

More broadly, emerging markets have higher reserves, more flexible exchange rates, less leveraged banks and lower inflation than ever before, suggesting their economic and financial fundamentals are more robust.

According to Oxford Economics, only a third of emerging markets have a “non-negligible” risk of a sovereign crisis today, compared with 65 per cent in 2008 and 72 per cent at the time of the “taper tantrum” in 2013.

But the global pool of dollar liquidity, which emerging market economies and financial markets still rely on heavily to survive and thrive, is shrinking as the Fed raises rates and reduces its balance sheet. Other dominoes could fall.

A working paper last month from the Bank for International Settlements shone a light on the recent surge in dollar-denominated debt across emerging markets and the dangers it poses to emerging markets.

Growth in dollar-denominated bonds issued by EM borrowers has been rapid, reaching an annual rate of 17 per cent at the end of last year. The wave of borrowing has been broad-based, and particularly strong in China, Brazil, Chile and Turkey. Dollar-denominated debt issuance in these countries has never been higher, and the rise since the early 2000s has been eye-watering. Of 12 emerging countries’ dollar bond issuance totals highlighted in the BIS paper, only Russia’s is not currently at a record high.

This shift to raising more debt on the international capital markets and relying less on banks makes borrowers more vulnerable to spikes in long-term US interest rates, the dollar, and market volatility.

“A snapback could have several potential triggers ... but the key is a sudden shift in risk assessments,” the BIS said.

The BIS finds that a major catalyst for investor sentiment towards EM is the dollar. When the dollar is weak, risk appetite is stronger, and vice versa.

As the BIS notes, the outstanding stock of dollar credit to non-financial EM borrowers has roughly doubled since 2008, to $3.7 trillion. And the dollar is strengthening, especially against emerging currencies.

“Long-term investors are thought to be a stabilising influence in financial markets, absorbing losses without triggering insolvency.

“However, we are reminded from time to time that such investors can have limited appetite for losses, and they can join in a selling spree.”

Selling has already begun. MSCI’s emerging markets equity index entered a bear market last week, falling more than 20 per cent from its January peak. The MSCI emerging currencies index is the lowest in a year, down almost 10 per cent since April.

Investors’ risk assessments of Turkey have suddenly shifted, and the spillover is beginning to be felt.

Emerging markets have higher reserves, more flexible exchange rates and lower inflation than ever before