In recent weeks, China has dominated the headlines; in particular the recent stock market and currency volatility have sparked fear across global markets. Looking forward, we would highlight a less discussed market that has been concerning us in recent periods: – Turkey.

Turkey is significant, due to the size of its economy (13th largest among OECD countries) and its geographical and economic proximity to Europe, which accepts circa 55% of its exports. Turkey is in a more vulnerable position than China in several ways: it runs one of the highest current account deficits in the EM universe owing to its dependency on short-term foreign funding to support the economy. Like its EM peers, Turkey has been a beneficiary of large foreign capital inflows, manifest in the significant external leverage built by its domestic corporate sector, masking its waning economic momentum. Gross external debt has doubled from pre-crisis levels to almost US$400 billion in Q1 2015. This  represents 50% of GDP, which, as noted by financial historian Russell Napier, exceeds the threshold of 30% where historically a country is more likely to default. In comparison, while China’s debt level is much higher in absolute terms, its ability to repay is stronger with the ratio sitting at 9% of GDP.

There are some countervailing elements, however. Falling commodity prices are beneficial to Turkey, being a net importer, in stark contrast to Brazil or South Africa. This will help improve its current account deficit somewhat, if low prices are sustained for longer. Turkey is also the least exposed to China among major EM economies, with less than 1% GDP of exports to the country.

Nonetheless, the end of quantitative easing and the expectation of rate rises in the US may see a reversal of the trend of flows that have been fundamental to Turkey’s economy, signs of this are just beginning to emerge. This will make funding more expensive and debt more difficult to repay, thus making Turkey more vulnerable to capital flight, taking into consideration that almost 25% of their bonds are held by foreigners. These eventualities are often precursors to the introduction of the foreign investors nemesis – capital controls.

Flows within dedicated EM bond funds are increasingly negative. The most recent week has seen $2.5bn of outflows, the worst level since February 2014, although still significantly below the 2013 taper tantrum period.

Exhibit: Dedicated EM bond fund flows

Dedicated EM bond fund flows

Source: Barclays Capital

On average, Turkey account for 5% of hard currency and almost 10% of local currency EM bond indices, and is weighted similarly in the largest EM Bond funds with few exceptions. Given this level of exposure, coupled with the accelerating negative unwinding trend in emerging market debt, Turkey’s weak fundamentals, high debt levels, and sensitivity to capital flow volatility will yield an increased risk of capital controls being introduced as a counter measure. Should this happen, we will likely experience significant turmoil in EM debt markets and renewed focus on the lending banks.

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