‘What happens in Turkey won’t stay in Turkey’: Why this debt crisis could be different

The markets have seen much of this movie before: a heavily indebted country finds itself in crisis, the currency plunges and talk quickly turns to contagion and, ultimately, an expensive globally financed bailout.

In Turkey’s case, the plot line is a little different, however. Where the other debt crises generally involved government borrowing, Turkey’s is mostly a corporate story, making the bailout mechanics more complicated and thus raising fears that what started in a small country with only marginal systemic importance on its face could quickly escalate.

“How can a country where the entire market cap of Turkish equities traded on the Istanbul Stock exchange is less than the market cap of Netflix wreak such havoc? It is all about the direct and indirect impacts,” wrote Katie Nixon, chief investment officer for wealth management at Northern Trust. “There are certain emerging market countries with relatively weak currencies and a heavy reliance on external (predominately dollar based) financing. The fear is that what happens in Turkey won’t stay in Turkey.”

Nixon said that while the crisis does not appear to have major global implications, a strong U.S. dollar coupled with weakening emerging market currencies could fuel the problem.

To date, the debt emergencies in Greece, Cyprus, Italy and other euro zone countries — not to mention Argentina, Malaysia and perhaps Pakistan before long — have had limited global spillovers. Several required bailout loans from the International Monetary Fund, an organization that gets 17.5 percent of its funding from the U.S.

But none have been accompanied by global financial panic.

Yet investors continue to worry which country will trigger the next calamity along the lines of the 1997 Asian financial crisis that looked contained on the surface but soon turned contagious.

“We sense the confusion; there is very real concern being effected globally and things are going rather badly awry,” Dennis Gartman wrote Monday in his daily Gartman Letter.

As he pointed out, the currency crisis is being exacerbated by tensions with U.S. President Donald Trump, who recently announced his intention to ramp up tariffs against Turkey while it detains U.S. pastor Andrew Brunson.

“We find it dismaying that the US had chosen to kick Turkey while the latter is down and is suffering a severe bout of economic pain. But again, this is not merely a Turkish/US problem; this is far more widely spread than Turkey,” Gartman wrote.

Trump’s move helped sink the Turkish lira even more, while the currency has tumbled amid a series of questionable fiscal and monetary decisions by President Recep Tayyip Erdogan. A series of interest rate hikes engineered by the government has failed to stem the lira’s plunge.

That’s bad for debtholders in Turkey, who owe big in foreign currencies but whose assets are held in the rapidly depreciating lira. In total, there’s some $220 billion in foreign debt for Turkish companies and financial institutions.

“It is about credit, since Turkey has been a huge borrower in global capital markets over the past number of years when the world’s central banks were encouraging investors to stretch for yield,” David Rosenberg, chief economist and strategist at Gluskin Sheff, said in his daily market note. “Over half of the borrowing is denominated in foreign currencies, so when the lira sinks, debt-servicing costs and default risks rise inexorably.”

Because the crisis involves private rather than public debt, the IMF could find it harder to justify a bailout. The moral hazard of using IMF funds for corporate debt issues would be substantial.

The results have been felt in most corners of the financial markets.

U.S. stocks have been punished over the last couple of sessions, while the iShares MSCI Emerging Markets ETF was off 1.8 percent in afternoon trading Monday, though Turkish stocks represent less than 1 percent of the index.

More specifically, the iShares MSCI Turkey ETF fell more than 10 percent amid fears that banks in the region would suffer during the crisis. The Turkish stock market is heavily weighted to financials, which make up 27.4 percent of the FTSE All Cap Turkey index’s market cap.

And then there’s the currency.

The lira was off more than 8 percent against the dollar in Monday trading, steepening the nation’s currency woes. Emerging market currencies also were weaker across the board.

“Global investors are now targeting countries with similar economic challenges, whether they be bloated current account deficits, inflationary pressures or high debts denominated in foreign currencies (Brazil, Mexico, Indonesia, and South Africa come mind first and foremost),” Rosenberg wrote.

Investors also are turning their sights to Italy, which has had its own debt problems over the years and is undergoing serious political change that is resisting the continued pleas from European Union leaders in Brussels to straighten out its financial house.

“The Rome vs. Brussels/Berlin circumstances are effectively the same problems that plagued Europe several years ago when Greece was at the edge of the economic precipice, except that Italy’s GDP is effectively 8.1 x’s that of Greece’s!” Gartman said.

“Italy is the country to watch for signs that the proverbial butterfly wings in Ankara (or anywhere else) are setting off a storm in developed economy capital markets,” added Nick Colas, co-founder of DataTrek Research, referring to the classic chaos theory scenario.

Ultimately, there’s still a prevailing sense that the Turkey situation will be resolved without any great global calamity, once again allowing market to dodge worries about another debt crisis, whether it’s in Italy or anywhere else.

Trump, for instance, has gone through multiple rounds of threatening a heavy hand with countries before backing off once he gets at least lip service paid to his demands. Indeed, a Twitter rumor earlier that Brunson was being released from house arrest helped shore up markets at least momentarily.

“Most country-born crises are often found to be idiosyncratic or specific to issues within the country involved and unlikely to contaminate neighboring nations. Risks tend to be centered on lenders that get caught up in financial crisis,” said John Stoltzfus, CIO at Oppenheimer. “Usually the longer it takes to arrive at a solution, the more it costs the troubled country and its economy. That said, we are not expecting that the situation in Turkey will deteriorate to the extent that it poses a threat to the world economy.”