Tuesday 16 April 2019 11:14 am

Investors fear Turkey's recession could be a contagion risk to emerging market economies – but they have nothing to to worry about

Recent local elections in Turkey saw opposition parties gain control of the country’s economic engines, such as the capital Ankara, while no clear winner emerged in Istanbul, Turkey’s most populous city.

This only reiterated the state of Turkey’s current economy – the country is experiencing its first recession in a decade.

Last summer’s currency crisis, in which the Turkish lira lost 40 per cent of its value, has started to affect households through double-digit inflation, deteriorating living standards, and increasing unemployment.

Read more: Turkey's inflation rate eases to 20 per cent in December

Previously, the country relied on short-term fixes which were intended to boost growth. But now Turkey needs to tackle its difficult reforms face-on. Only then will the economy stand a chance of recovering.

Turkey’s depreciating currency, alongside its corporate foreign currency debt, will unsurprisingly stimulate investors’ fears of contagion across emerging markets.

However, I generally don’t see any contagion risk from Turkey.

Common factors, such as rises in advanced economies’ interest rates and growth slowdown in major countries, can harm the economic fundamentals of several emerging countries simultaneously. These tend to be sources of systemic risk for emerging markets.

Monitoring these factors will still be important, as they may cause trouble in several countries at the same time, which could potentially lead to financial crises. But this is different from a contagion.

In general, apart from an ordinary financial contagion, such as a banking crisis, a cross-border contagion may occur when one country makes investors reevaluate the fundamentals of other countries that are bucketed together.

For example, investors may well think that other members of the “fragile five” (Brazil, India, Indonesia, and South Africa), are experiencing identical problems to Turkey, leading to a financial market sell-off.

This may result in a self-fulfilling prophecy, where the panic and misinterpretation of facts leads to worsening economic fundamentals in countries that did not have any problems to begin with.

However, the stronger the fundamentals of one country, the more immune it will be to such self-fulfilling prophecy. Therefore a market sell-off is likely to be short lived.

Read more: Turkish lira continues its fall as country's foreign reserves dwindle

Turkey’s troubles are unique to the country itself, and so are not likely to lead investors to reassess the fundamentals of other emerging markets.

Of course, it’s important to remember that there is a lot of work to be done to revive Turkey’s economy, whether that is keeping policy rates high for a lot longer, or reconsidering a deal with the International Monetary Fund.

But whether it manages this or not, Turkey’s crisis is not contagious.