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Turkey’s currency crisis

The impact of Turkey’s currency crisis on the European economy

Turkey is currently going through a classic emerging market currency crisis, with the lira currently down 70% year to date against the dollar.

Driven by the same vulnerabilities that triggered previous emerging market crises, the affect is being felt across investment assets, with the stock market down by 50% in US dollar terms and the yield on a 10-year Turkish bond jumping by 8% year-to-date.

Credit default swap spreads have also widened to their highest levels since the economic crash of 2008.

What’s behind the slump?

Despite growing by more than 7% this year, the Turkish economy suffers from an inflation rate three times higher than that of the central bank’s target. Its high trade and fiscal deficits makes it relatively reliant on foreign capital inflows and a sizeable proportion of its foreign debt exposure has a short maturity profile.

The imposition of US sanctions, in response to the Turkish detention of American pastor Andrew Brunson, were a catalyst for already-wary investors to dump Turkish assets en masse.

What does this mean for the European banking sector?

The recent crisis in Turkey has weighed on the European banking sector. As the Turkish lira nose dived, European banking stocks have been particularly hard hit, owing to worries that some of these banks have high exposure to Turkish assets and borrowers.

Overall, however, the sector has minimal exposure to Turkey outside of a select few banks: Spain’s BBVA, Italy’s UniCredit, the Netherlands’ ING, and France’s BNP Paribas.

Media reports indicate that the European Central Bank is aware of the risks, although the situation is cited as being “not yet critical”. Given these numbers, the sector-wide impact from a further deterioration in Turkish assets is limited, in our view. The price movements are indication that the market is already bracing for the negative impact on these banks’ equity and book values.

Loan growth
Source: Datastream

Are there opportunities here for investors?

The European banking sector has long been a source of interest for value shoppers. Yet, whilst the same sector has soared at the other side of the pond, shares in Europe’s banks have mostly languished. Cost efficiency, non-performing loans and negative interest rates are just some of the factors which have weighed on banks’ profitability.

However, with the European economy showing signs of a healthy revival, the fundamental outlook for European banks is likely to improve from here.

What is being done to mitigate risks?

In response to this recent volatility, the Turkish central bank has reduced reserve requirement ratios (that is, the percentage of deposits banks are legally required to hold as cash), while also easing rules that govern how banks manage their lira and foreign-currency liquidity.

These, however, are merely short-term measures to improve banking system liquidity and bolster investor confidence. Given the severity of the crisis and the size of Turkey’s macroeconomic imbalances, it is likely that Turkey will ultimately require help from the International Monetary Fund.

Unfortunately, President Erdogan’s bellicose rhetoric suggests that Turkey may instead choose to go at it alone. Here, we think that there is a non-negligible risk of a Turkish default, and it is plausible that the situation may deteriorate further. This obviously translates into additional headline risks for the European banking sector, but a more serious systemic shock to the sector is unlikely for now.

Trailing PB relative to market
Source: factsheet

Take-outs

The fundamentals underlying our positive view on European banks remain intact. As domestic growth stabilises, evidence trickles in of increased demand across corporate lending, mortgages and consumer credit.

A further deterioration in the Turkish situation isn’t implausible, but unlikely to pose a systemic solvency risk to the wider sector. Valuations are currently low relative to history. This implies higher upside potential, should our base scenario play out as expected.

The sector is likely to remain hostage to European political uncertainty, but this can often draw attention away from a marginally improving picture of underlying fundamentals.  Robust growth should continue acting as a tailwind for loan growth – a key driver of bank profitability. Alongside this, the weight of non-performing loans, so long a burden on profitability, capital requirements and the ability to lend, should continue to lighten amidst this improved economic backdrop.

Meanwhile, banks’ capital positions have significantly improved in recent years, with the European sector’s core regulatory capital as a proportion of total risk-weighted assets having doubled in the last decade. All in all, the sector remains an attractively priced, albeit risky, long-term play on European growth.

Nerves of steel and patience are still required, but still likely to be rewarded in our view.

Investments can fall as well as rise in value. Your capital or the income generated from your capital may be at risk.

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