Though questions have been raised on the possibility of a “currency crisis” since the recent failed coup in Turkey, analysts at JPMorgan rule out the possibility as local residents are not dollarizing deposits and Turkish banks have the ability to roll over short-term external debt. Saad Siddiqui and colleagues suggested in their July 22 research piece titled “EMEA EM Local Markets Compass” that investors be selective in pursuing EM FX carry strategies in August.

EM bond funds witnessed large inflows in July

Siddiqui and team argue that the rally in EMEA EM rates and currencies has paused over the past week after a strong run post-Brexit. They attribute the pause to rising core yields and a drop in commodities prices, despite still-strong EM fund inflows. They note that solid economic activity data from the U.S. has driven rates across the U.S. yield curve higher by around 20bp over the past few weeks. The JPM analysts point out that while data surprises for the U.S. are now close to a one-year peak and unlikely to move substantially higher, near-term risks are skewed towards yet-higher core yields as the markets still play “catch-up” to data surprises:

EM fixed income flows

Siddiqui and colleagues note that EM bond funds witnessed very large inflows in July, and high frequency local bond flow data for EMEA EM suggests that South Africa and Turkey have benefited the most from this. They note that since Brexit, Turkey has received $1.2 billion in non-resident flows. The analysts believe a continuation of EM local bond inflows and increases in rates exposures would be supportive for EM duration and the analysts’ view of OW EMEA EM local bonds position in the GBI-EM Model Portfolio:

Increase in EMEA EM rates exposure

EM FX tends to perform poorly in August

Citing statistical data, the JPM analysts point out that EM FX doesn’t tend to perform well in August. Their analysis reveals that there is some fundamental justification for this pattern in EMEA EM, as the seasonality in currencies tends to match the seasonality of current account balances. The analysts believe it would be sensible to be selective in pursuing EM FX carry strategies and focus on relative value. Their favored currency to earn carry remains RUB, while their preferred outright trade as a hedge against seasonality in August is long USD/ILS call spreads:

EM FX - poor performance in August

Though questions on the possibility of a “currency crisis” are popping up following the sharp weakening of Turkish asset prices in recent days, the JPM analysts believe the conditions are not in place for such an outcome. To buttress their argument, the analysts studied the following factors: (a) potential for local deposit dollarization, (b) the ability of Turkish banks to roll over short-term external debt, and (c) global risk appetite and market conditions. Their analysis reveals that households and corporates haven’t been increasing their dollar deposits in the recent sell-off. Siddiqui and colleagues note that Turkish banks hold substantial FX deposits at the central bank, liquid FX assets held abroad, and unpledged FX government securities to help meet short-term external debt rollovers.

On the other hand, Bloomberg News reports that Turkish credit risk has now surpassed that of Pakistan, as the chart below shows. As Bloomberg states:

“S&P pointed to similar statistics in explaining its downgrade of Turkey. The country’s net foreign exchange reserves of an estimated $32 billion cover only about two months of current-account payments, giving it little room to maneuver, the firm said. Turkey will likely have to roll over about 42 percent of its external debt, more than $170 billion worth, in the next year, and political instability makes promised reforms to reduce dependence on foreign financing unlikely, S&P said.”

As Erdogan grows (even) more erratic, autocratic and continues to crush all opposition, how much more will that risk increase? And who would possibly buy that debt knowing that Erdogan is, in effect, the one now guaranteeing it?

Turkey, Currency Crisis, JPMorgan