Wednesday, August 22, 2018

"Turkey Contagion Fears are Overblown"

August 22, 2018

It’s been quite a hot summer for the Turkish Economy.  Following the presidential election and the inauguration of the new president, in a matter of days if not hours the Turkish Lira plunged to its historical depths.  Lira had never lost so much value at such a speed at such a short time period. On top of the economic problems and the failure of the new government to implement measures to support Lira, the row with the U.S. over the jailed pastor Brunson and President Donald Trump’s off-the-cuff twits have made things worse for the Turkish Lira. 

Now the question economists try to address is whether the initial tremors of a financial crisis in Turkey will turn into a full-blown crisis and whether it will generate contagion and send shock waves to other emerging market economies. So far, the answer to the first question is all depends on the Central Bank and the government’s ability to implement necessary measures to support Lira.  All economists agree that without the proper response from the Central Bank the whole economy will be in jeopardy.

Our analysis of Turkish bank stock returns and volatility connectedness show that the current tremors in the financial sector led to substantial increase in the connectedness of bank stocks, implying that this is a system-wide phenomenon that affects all banks. Volatility connectedness among the 11 bank stocks has increased from 52% at the end of March to 60% by July 10.  From July 10 onwards, the volatility connectedness continued to increase, from 60% on July 10 to 65% on July 31 and 68% on August 17. The rapid increase in volatility connectedness was mostly driven by the biggest four banks. Furthermore, if the current pressure on Turkish Lira and financial markets continues in the next couple of weeks, the volatility connectedness is likely to increase further to reach 80% and above. Such a development would imply that the whole banking system will be in disarray if the government will not announce the required policy actions immediately after the Bayram Holiday.  Everyone knows that the Central Bank must increase the policy interest rate to match the current market interest rates and give a message to investors as the protector of the value of Turkish Lira. There is not much time left.

Figure 1. Return and Volatility Connectedness – Turkish Banks

As for the question about whether the Turkish tremors has led to financial contagion around the globe, we address this question in the current update of our Financial & Macroeconomic Connectedness website.  So far we have updated connectedness graphs for global stock and foreign exchange markets. 

Let us summarize the main conclusion. At least for the time being, our analysis supports the FT’s viewpoint: “Turkey contagion fears are overblown.”  The Turkish crisis has not generated contagion (or what we call connectedness) among the 45 stock markets from developed and emerging market economies around the world.  (See There is no qualitative change in the results when only emerging market economy markets are included in the analysis. One reason for the lack of any contagious effects on others is the size of the Turkish economy and financial markets: Turkey accounts for around one percent of the world GDP and global trade, and even less than one percent of the global financial markets.  Another reason why the tremors of the Turkish crisis are not felt around the globe because, unlike the East Asian countries, Turkey is not viewed as part of a group of countries from a region that share similar economic and financial characteristics.  The 1997 East Asian crisis started in Thailand and spread to other countries in the region that faced difficulties in financial markets. In the Turkish case, there is no such group of countries that the Turkish troubles would pull into a state of financial crisis. 

While the tremors of the Turkish crisis are not generating connectedness to other markets, earlier this year in February both the stock and foreign exchange markets got hit by a surge in volatility following the announcement of a better than expected employment report in the U.S. Markets took this piece of news as the turning point that would lead to a strong policy reaction by the Fed.  Within a week, the main U.S. equity index, S&P 500 fell a by 10 percent.  The reflection of the surge in volatility over the week from February 5 to February 12 was a 9-point increase in the stock market volatility connectedness from 45% to 54%.  The index went up another 4 points in March and early April and 3 points in June to reach 61% in July.  Since then the index hovers around 60-62 % with no upward move.  As of August 17, the volatility connectedness among the global stock markets was 61%.

As of January 15, FX market volatility connectedness dropped below 50%, the lowest level since April 2007. (See However, it did not stay below 50 for long. Within a month-and-a-half the FX market volatility connectedness index jumped to 56%. Unlike the stock markets however the volatility connectedness across FX markets experienced a correction in the next few months. The recent uptick in the FX market connectedness has not been caused by the travails of the Turkish Lira.  Lately in June, following the U.S. trade policy pressure against China and other countries’ volatility connectedness increased back to 56% by August 17. Indeed, Turkish Lira continues to play a very minor role in global FX markets, being a recipient of the volatility shocks rather than generator of the connectedness to other countries.

The cracks in the Turkish financial markets appeared rather too quickly because of the recent diplomatic row with the U.S. on top of the country’s economic woes and the lack of any policy action.  Yet, it appears that irrespective of the speed with which the crisis is developing, the Turkish crisis has not generated volatility connectedness or contagion in global stock and foreign exchange market.

Even when we exclude all developed markets and analyzed connectedness among the emerging markets, the results do no change. Turkey is a small fish in the pond.  Unless we hear troubles coming from elsewhere the travails of the Turkish financial markets are not sufficient to pull down the global markets down.