August is not usually the time for “deep in the weeds" analysis of global financial markets, but the currency crisis in Turkey — which has seen the Turkish lira drop by 15 percent in just the last two weeks — has made this somewhat unavoidable. As our regular commentary readers know, this story has filled up the available news space when it comes to international economics.
For today, I would like to unwrap the concept of “contagion" that keeps getting discussed by the financial press. They've been exploring if this current currency crisis has parallels with the “Taper Tantrum" of two and a half years ago, or the Asian currency crisis of 1997, or even the Mexican peso crisis of 1994.
There are two aspects of this: direct economic ties and portfolio effects.
Direct economic ties: How does Turkey fit within key supply chains of the global economy? For example, the crisis definitely affects Europe's heavy equipment industry as Turkey is the fifth largest export destination for such capital goods.
Portfolio effects: Investors tend to lump emerging markets together, so that when one country goes down there is a tendency for capital flight from all the others. Mexico occupies a strangely precarious place in this ecosystem. It still gets lumped in with that EM space but its markets are developed enough that they offer good liquidity and easy trading, so investors can quickly sell the peso when emerging markets are under stress.
While everyone seems to tag on a “too early to tell" caveat when discussing this, the consensus is that Turkey will not cause anything resembling a real crisis, but it will certainly hurt certain sectors in the financial markets.
What is interesting is that we know what President Recep Tayyip Erdoğan has to do. So far, there have been a few measures focused on short sellers addressing liquidity, but for a more permanent solution Turkey would need to raise rates by 400 or 500 basis points and ask for International Monetary Fund (IMF) assistance. This was more or less the original remit for the IMF — helping countries overcome currency crises back in the Bretton Woods era. But the IMF is unpopular since they impose many conditions. Turkey did get a lifeline from Qatar, but we will see if that is enough.
My View: Currency crises come and go. While always dangerous, the structure of the global financial system today, which includes stress tests for banks and more floating exchange rates to absorb some of the financial pressure, should be able to contain the damage from this episode until it gets resolved.
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