Are Turkey's Troubles Contagious?

How concerned should investors be about the risk of market contagion from Turkey's slump?

Turkey's problems appear idiosyncratic and their spillover effects should be relatively contained unless there is a major investor retrenchment from emerging markets (EM) generally. This appears unlikely as EM holdings are already at low levels.

The situation may indicate potential future risks, however, as major central banks withdraw their extraordinary policy accommodation post-Global Financial Crisis. Financial crises tend to occur in a U.S. Federal Reserve tightening cycle, especially when major imbalances exist. The difference, with respect to Association of Southeast Asian Nations (ASEAN) countries and India, is that external imbalances have turned positive since the “taper tantrum” of 2013. So while Turkey's woes have sparked short-term volatility, the probability of a long-term impact is low.

There are three potential channels of contagion: trade, banking sector exposure and capital flows. Emerging ASEAN and India's exposure to Turkey is small via the first two channels of trade (Vietnam and Malaysia have the largest exposure at around 1.4% and 1% of GDP, owing to their highly open economies) and banking (negligible), while broader contagion is likely to manifest through the slowdown or reversal of capital flows, making it more difficult to finance external deficits.

The basic balance (current account balance plus net foreign direct investment) indicates the ability to finance the current account deficit from long-term funding sources. On this metric, Indonesia and India have small basic balance deficits that must be funded by portfolio capital inflows, with the rest having moderate to significant surpluses. Short-term external debt is also well-covered by international reserves, guarding against the event that such liabilities may not be rolled over during a crisis.