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Turkey's woes threaten investor confidence in emerging markets

The biggest threat to emerging economies from Turkey's currency crisis is the potential damage to investor confidence, market watchers say, as Turkish companies' exposure to foreign debt presents a singular threat to that country.

The closely watched MSCI Emerging Markets Currency Index fell 1.74% to 1,043.91 as of 9:56 a.m. ET, the lowest level since July 13, 2017, as investors worry that the economic crises in Argentina and Turkey will spread to other emerging market economies, or EMEs.

The Turkish lira ended last week down 41% from the start of the year as President Recep Tayyip Erdogan's resistance to investor demands to support orthodox economic policies resulted in major trading losses. Investors have hoped for weeks that the central bank would react to spiraling inflation by raising interest rates further, and last week reports circulated of a 500-basis-point hike before Erdogan categorically ruled out that possibility.

Other EME currencies were affected as a result, including the South African rand, which sank to 15.3 against the dollar on Aug. 13 before recovering to 14.2 as of 10:20 a.m ET.

"You can already see emerging market yields moving up," said Alexandre Tavazzi, global strategist at Pictet Wealth Management in Geneva. He pointed especially to Argentina and South Africa as potential contagion risks. "Some emerging markets have strong macroeconomic fundamentals, with current account surpluses, and they are not at risk," he said.

Limited exposure

In fact, market commentators say it is unfair to group EMEs into a collective, with Asian economies in particular having limited their exposure to dollar-denominated debt after the Asian economic crisis of 1997.

"We've seen this movie before. Very rarely is it a contagion that spreads throughout the world," said Eric Ristuben, chief investment strategist at Russell Investments, noting that "other exposed countries, like Argentina, have the same basic problem, but this is not an issue that affects the entire emerging marketplace."

Argentina has already gone to the International Monetary Fund, securing a $50 billion loan in June to avoid insolvency. Many commentators say Turkey will be forced to either impose capital controls or seek a similar arrangement from the IMF.

Jeroen Blokland, portfolio manager at Robeco, agreed that the "underlying fundamentals" are "not too bad" for most EMEs. But a research report by Capital Economics said Turkey's problems "could worsen sentiment towards EMs," which are already under scrutiny from the slowdown in China's economy, trade-war rhetoric and tightening monetary policy.

"Those economies with the most vulnerable external positions are again tested by a reduction in risk appetite," said Hasnain Malik, strategist and head of equity research at Exotix. "Argentina is merely one example, but this creates a more difficult environment for the likes of Egypt, Kenya and Pakistan too."

The South African rand is likely to remain under pressure according to Jason Daw, head of emerging market strategy at Société Générale, because South Africa is the second-most-dependent EME on short-term funding after Turkey. "The [South African rand] should continue to be influenced by the Turkish lira crisis through the sentiment channel," he wrote. "Until the lira stabilizes, the prospects for the [rand] are not encouraging."