Turkey’s crisis impact on the euro area - Nomura

Analysts at Nomura explained that with the plunge in the Turkish lira, investors’ concerns of contagion have spread within the euro area's financial markets. 

Key Quotes:

"In particular, the impact on Europe’s banks has been the primary concern of investors. According to a Financial Times article, the ECB is also concerned about the EU’s financial exposures to Turkey. If the crisis drags on, some impact may be felt on the euro area economy, political scene and ECB policy. We examine three channels through which this could occur: 1) banking sector exposure to Turkey; 2) trade linkages and 3) political fallout."

"All in all, the impact of the lira crisis on the euro economy has thus far been limited. However, if the crisis drags on or deepens, it has the potential to affect both the economy and ECB policy. With Italy’s banks already a source of risk to the euro area, Turkey’s crisis adds an extra dimension for the ECB to take into account. Indeed, this is likely to be a key discussion for policymakers at September’s ECB meeting of the Governing Council. For now, however, the ECB looks unlikely to change its forward guidance on net asset purchases (winding down in Q4 this year) or interest rates (on hold through the summer of 2019) in response to Turkey’s crisis."

1. European bank exposures

The first channel is the negative impact on Europe’s banking sector. The latest BIS data for end-Q1 2018 of foreign banks’ exposure to Turkey shows foreign claims on Turkey at the end of the quarter totalled USD223bn (note that this number is distorted downwards due to the depreciation of the lira over the period).

Other exposures amounted to another USD78bn, most of which were in the form of guarantees. Three-quarters of foreign claims’ exposure were in European banks, nearly 80% of which were concentrated in three countries: Spain, France, and Italy. A more appropriate way to assess the knock-on effects to banks is by looking at those exposures as a portion of total bank assets in those countries. Here, Spain’s exposure is larger than that of other countries (Spain 1.9%, Italy 0.5%, France 0.4%).

Though we should not underestimate the potential impact of Turkey’s crisis on Europe’s banks, thus far at least the sector does not appear to have been severely impacted. The CDS of European banks remains low relative to its historical average level and financial conditions are still very loose European banks have strengthened their capital positions over recent years, and the institutions with the largest exposures seem to be retail and commercial banks which are particularly well capitalised. That said, the situation is evolving at a rapid pace, suggesting regular assessment of European banks is required.

2. Trade linkages

The second effect of Turkey’s crisis on the euro area economy is via the trade channel. Despite the geographical proximity of the euro area to Turkey, euro area exports to Turkey are not that large. The share of extra-euro area goods’ exports to Turkey was just 2.9% in 2016. On a country level, Spain has the highest share among the larger euro area countries. The share of euro area service exports to Turkey, again as a proportion of extra euro area exports, was 1.1% in 2016. Italy had the highest share among the largest euro area countries. All in all, the total share of euro area exports to Turkey was 2.4% in 2016 This means that if Turkey’s economy shrank by 10% (while not our forecast it is not by any means impossible – after all, its economy contracted nearly 15% in the year to Q1 2009), then euro area exports could fall by around a quarter of a percent. That would take just over a tenth off euro area GDP which, while noticeable, would merely modestly dent the euro area recovery rather than stop it in its tracks.

3. Political fallout

Turkey is the gatekeeper of the Balkan route for migrants into Europe owing to its refugee deal with the EU, signed in March 2016. That deal required Turkey to stop the flow of refugees, receiving in return: a) EUR6bn financial aid and b) visa-free travel for Turkish citizens into the Schengen area.

With most populists’ parties in the euro area focusing their agenda on the migrants’ issue and with Turkey’s ability to manage the migrants’ flow potentially compromised, the third effect on euro area of the lira crisis may filter into the channel of European politics. Though the number of refugees into Europe peaked in 2015, owing to the agreement with the EU, Turkey played an important role in limiting the refugee inflow. If the inflow of refugees were to increase on the back of Turkey’s crisis, public sentiment could be impacted, with populist parties possibly gaining further momentum as a result.

Conclusions

In sum, the impact of Turkey’s lira crisis on the euro economy has thus far been limited. However, if the crisis drags on or deepens, it has the capacity to affect both the economy and ECB policy. With Italy’s banks already a source of risk to the euro area Turkey’s crisis adds an extra dimension for the ECB to take account of. Indeed, this is likely to be a key discussion for policymakers at September’s ECB meeting of the Governing Council. For now, however, the ECB looks unlikely to change its forward guidance on net asset purchases (winding down in Q4 this year) or interest rates (on hold through the summer of 2019) in response to Turkey’s crisis."