Macroscope | Rising political risk in Turkey a reminder of EM vulnerability

On Monday morning, the Turkish lira, one of the most vulnerable emerging market (EM) currencies, fell more than 5 per cent against the US dollar before recovering slightly to finish the day’s trading session down 3.4 per cent - its worst one-day fall since the 2008 global financial crisis.

Turkey has been a focal point for concern for financial markets ever since the US Federal Reserve signalled in May 2013 that it planned to end its programme of quantitative easing (QE). Investors have been particularly concerned about the country’s large current account deficit – still close to 6 per cent of gross domestic product - and the lack of inflation-fighting credibility on the part of Turkey’s central bank.

Yet for much of last year, investors were willing to turn a blind eye to these vulnerabilities, partly because of the complacency generated by heightened expectations that the European Central Bank (ECB) would launch its own QE programme, which it eventually did in March.

However the Justice and Development Party’s loss of its parliamentary majority in a general election on Sunday has knocked sentiment, which had already deteriorated in the run-up to the ballot, with the lira down 18 per cent against the US dollar this year.

The escalation in political risk is making investors a lot more sensitive to Turkey’s economic woes.

This is a reminder that EMs are more vulnerable to political instability than advanced economies, largely because political risk is still deemed to be a more important determinant of both investor sentiment and the creditworthiness of developing economies - even though the economic fundamentals of many EMs are now stronger than those of most advanced economies.