After last year’s August currency crisis, the Turkish lira hit the headlines again in late March with a surge in its implied overnight forward rate and exchange rate. The reasons behind this flash rally are convoluted but effectively it was led by short positioning as well as quasi capital controls introduced by the government last summer.
The bout of market volatility came just as local elections saw the incumbent AKP government of President Erdogan lose some of its power, especially in major urban centres.
How will the administration react to this setback – should we expect a swing into great economic populism or more of a progressive reformist agenda? Until there is clarity, concerned investors are likely to exert continued downward pressure on the currency.
Turkey has the second highest inflation in developing markets after its equally troubled EM 'twin' - Argentina. Even though our indicators show Turkish inflation may have peaked for now, we think precarious economic conditions and political uncertainty mean the risk of a full-fledged balance of payments crisis remains.
This fragility is expressed in Turkey’s volatile current account which, as shown below, has flipped back into deficit. Further significant depreciation in the Turkish lira risks a negative feedback loop that will further widen the economic recession.
Looking at 18 previous episodes of currency crisis* in emerging markets below shows that it typically takes four to six quarters on average for GDP to recover to the level before the onset of any currency crisis. Meanwhile in terms of equity markets our backtest shows on average they bottom for 4 quarters before entering a steep recovery phase.
This would suggest that Turkey (and Argentina) possibly have at least two more quarters to endure before a recovery in either GDP or equity markets begins. A continuation of the political crisis and/or failure to address necessary structural reforms will only push this process further out into the future.Important legal information
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