The sharp drop in lira by 70.6% year to date and rising cost of insuring with the 5-year credit default swap hitting the highest since April 2009 to 429.7 on 10 Aug raised fears of a potential crisis. This comes with the drop for risky assets in favour of safe haven assets like the USD and Japanese yen. Meanwhile, there are two other key worries — the euro inflicted by trade and euro banking crisis, and the risk of emerging market (EM) debt crisis.

We expect some dent on the euro economy from the trade surplus with Turkey. A full-blown Turkish banking crisis can impact euro banking. But the fallout on euro economy could be small and the risk from Turkey causing any credit crunch in any part of the euro zone looks low as the ECB has ammunition. This explains the sharp lira sell-off having limited spillover into the euro, reducing the euro contagion effects at least for now.

But the risk on EM cannot be ruled out. Countries with heavy foreign USD-denominated debt will face strong pressure from a strengthening greenback and rising interest rate by the US Fed. Apart from Turkey, the risk is on Argentina, the Philippines, Brazil, Indonesia, Mexico and Malaysia.

Vulnerability on the MYR is partly due to high public debt of about 80% of GDP, gross financing that needs around 10.4% of GDP and about US$80 bil maturities coming in 2019.

With the high vulnerability of the lira, Turkey may approach the IMF or seek other external support. Room for control measures seems a distinct possibility. Should capital control come into force, it may open the door for other highly vulnerable EMs to also explore the idea.

A. Shift to safe haven assets

• The Turkish lira weakened throughout 2018 by more than 70% against USD, including a 15.6% fall on 10 Aug 2018 when it hit a new all-time low of 6.43 after US President Donald Trump announced plans to double the aluminium and steel tariffs to 20% and 50%, respectively (see Tables 1 & 2).

• At the same time, the cost of insuring exposure to Turkish debt climbed to the highest level since 2009. Turkey's fiveyear credit default swaps rose to 16.1% to 429.7 on 10 Aug, hitting the highest since April 2009.

• Hence, investors are busy shifting out of risky assets and into safe havens such as the USD and the Japanese yen.

B. Is euro in trouble?

• The economic turmoil in Turkey can have consequences for the euro zone. The euro area runs a trade surplus with Turkey, having exported €63 billion (US$76.2 billion) in 2017.

• Besides, the concern is also on European banks likely to be impacted by the weak lira. The risk of a full-blown Turkish banking crisis having some negative repercussions on euro zone banks that have large credit exposure to Turkey or own Turkish banks is on the cards.

• Data from the Bank for International Settlements (BIS) showed that Spanish banks are due US$82.3bil by Turkish borrowers; French lenders are owed US$38.4bil; and banks in Italy are owed US$17bil. So Spain's BBVA, Italy's UniCredit, and France's BNP Paribas could be particularly impacted from the weak lira (see Table 3).

• But overall, we feel the euro zone banking exposure could be fairly small to cause a significant crisis. Also if Turkey loses the economic power to purchase foreign goods, there could be a direct impact, although it may turn out to be small on euro zone growth.

• The reason being despite the sharp lira sell-off, the spillover into the euro was limited, implying that the euro contagion effects may be more muted than initially feared. Our view may hold for the time being unless the implications for the European banking sector deteriorates materially and the impact on the economy turns out to be worse off.

• Besides, even if we are wrong and a potential meltdown of the Turkish banking sector causes serious trouble for some euro zone banks, bank supervisors in the region would have sufficient tools at their disposal to contain the damage. So the fallout from Turkey that could cause any credit crunch in any part of the euro zone seems highly unlikely.

C. Risk of EM crisis

• The risk of an emerging market (EM) contagion cannot be ruled out. The lira’s dramatic slide against its main rivals was symptomatic of a broader theme in emerging markets. We believe countries that rely heavily on foreign, mostly USDdenominated debt will face strong pressure from a strengthening greenback which has been on an upswing since April (see Tables 4 & 5).

• The fear of a default is on the cards, especially with the rising interest rates in the US, where the US Fed Reserve is expected to raise interest rates two more times in 2H2018. It has exacerbated the strain on emerging markets, which use local currencies to pay down their dollar-backed debts.

• Turkey leads the pack of countries that maintain a high dollar-denominated debt burden. Argentina can also be counted among that contingent of troubled emerging-market economies. Others include the Philippines, Brazil, Indonesia, Mexico and Malaysia.

D. Is Malaysia vulnerable?

• The Malaysian ringgit (MYR) is fairly well correlated with the lira, around 79%. From our assessment, for every 1% drop in the lira against the USD, the impact on the MYR is about 0.04% in an immediate note and 0.01% in lag one period, suggesting the combined effect on average is around 0.025%. Over a longer period, the impact is about 0.18%. With the lira experiencing a high risk of a potential crisis, the risk on the MYR is moderately high compared to countries like Argentina, Brazil, and Mexico.

• The vulnerability on the MYR is partly due to Malaysia’s high public debt of about 80% of GDP, gross financing that needs around 10.4% of GDP and about US$8.0bil maturities coming in 2019 (see Table 4).

• Hence, with our view that the USD will exhibit a strengthening momentum in 2018 and the Japanese yen benefiting from the safe haven status, our MYR outlook for 2018 stays around 4.08–4.10 against the USD with a 2%–3% swing.

• In the meantime, with the high vulnerability of the lira, we think Turkey may need to approach the IMF or seek other external support. Otherwise, capital-control measures seem a distinct possibility. Should capital control come into force, it may open the door for other highly vulnerable emerging markets to also explore the idea.

Source: AmInvest Research - 13 Aug 2018