Financial contagion rearing its head again

Posted By Darren Winters on Aug 15, 2018


Financial contagion rearing its head again

Financial contagion is rearing its head again. Emerging market contagion is now eclipsing euro peripheral debts (which continues to be an ongoing problem).

Emerging market financial contagion look like the most wobbly domino on the bubbly financial landscape

Financial Contagion

As the Fed, (the world’s central bank by default) hikes rates and strengthens (weaponizes) the dollar it is emerging markets dotted along the New Silk-road that are in the line of fire. The so-called “Turkey Dream and the China-Turkish Cooperation under One Belt is being smashed in an ongoing asymmetric battle to keep dollar hegemony intact.

Emerging market financial contagion, namely Turkey might be a good reason to steer a wide berth from bubbly risk assets.

Perhaps the asset bubble might find its pin in the form of emerging market contagion.

How could Turkey’s latest currency crisis cause financial contagion?

Financial markets and economies are globally interlinked like never before. Put another way, an event impacting one region will have an impact, albeit it emotional behavioral impact on another region. It is that one domino falling which is the catalyst for a chain reaction of predictable events.

Set the time machine to 1997 Thailand financial crisis which was the event that caused financial contagion in Asia.

Before the crisis hit Thailand’s economy was booming. Credit was redly available which resulted in a highly leveraged (debt-fuelled) economy. Rampant speculation drove real estate prices to record highs. Economic expansion seemed unstoppable. Moreover, the Thai central bank kept the currency artificially high which also helped to fuel the speculative bubble.

But the party ended when the USD strengthened. Many south-east Asian countries have their currency pegged to the USD. So the USD appreciation resulted in many regional currencies appreciating which made Thai exports expensive. Thai’s current account position deteriorated and its foreign reserves fell sharply then came a collapse in the Thai Baht which was made worse by currency speculators shorting the Baht. Thailand soon found itself in an economic financial crisis as it was unable to service interest payments on its debt.

Thailand was the first domino to fall. The financial contagion spread quickly to Indonesia, South Korea and eventually the whole of Asia.

This current financial crisis in turkey could cause a financial contagion, based on the previous 1997 Thailand financial crisis

Which region is most vulnerable to financial contagion with respect to the current financial crisis in Turkey?

The financial crisis in Turkey brings considerable risk of financial contagion to those banks which have made loans with Turkey.
Eurozone banks have been dumped due to Turkish exposure.

The worse impacted eurozone bank due to financial contagion from Turkey was Italian bank UniCredit, for fears that they are overexposed to risks in Turkey.

One (maybe extreme view) is that financial contagion from Turkey could be the last straw that breaks the eurozone banks, bearing in mind the considerable stress the sector has been under due to the euro sovereign debt crisis of the periphery countries.

The Bank for International Settlements (BIS) has recently shed some light on which banks have exposure to Turkish debt. International banks had outstanding loans of $224 billion to Turkish borrowers, according to the BIS.

The most exposure to loans from turkey is Spanish banks with $83 billion. France is second with its banks exposed to $35 billion of loans from turkey. Italian banks have $18 billion exposure to loans from turkey. UK and US banks have $17 billion each and German banks have $13 billion exposure to loans from turkey.

So a Turkish financial crisis, a credit default due to a collapse in the Turkish Lira would create financial contagion, particularly in the euro zone’s most fragile peripheral euro countries. This is why some market watchers are arguing that the financial contagion brought on by the latest financial crisis in turkey could crash the euro and end the EU.

Turkey could be Europe’s Thailand’s financial crisis which caused the financial contagion in Asia and ultimately led to the collapse of governments

If so would the EU and the euro survive? To prevent an economic and financial meltdown which could lead to financial contagion, particularly in the eurozone the Turkish government is proposing radical (futile) solutions.

“I’m calling out to industrialists, do not attack banks to buy FX,” said Turkish President Recep Tayyip Erdogan in a speech in Trabzon.

“It is industrialists’ duty too to keep this nation on its feet. Otherwise, we will set into motion our plan B and C,” he added.

What might plan B and C mean?
My guestimate is that B stands for blocking capital outflows (impose capital controls) and plan C could mean confiscation of gold and USD (as the country runs dry of USD)

From the case study, we also know that capital controls and confiscations just accelerate the flow of capital out of a country. So plan B and C would only add to the Turkish Lira currency crisis and financial contagion.

Meanwhile, US trade sanctions on China could already be having an impact, albeit on business sentiment.

As I said previously keep your eyes peeled to growing social unrest in China.
Social Unrest Breaks Out In China After “Panic” Bank Run On Peer-2-Peer Lenders.

China’s debt crisis could also cause financial contagion

Indeed, last year foreign banks lending to China hit a record high lured by being able to charge higher interest rates on loans to Chinese borrowers

HSBC leads the pack of overseas lenders. The risk of financial contagion is on the rise. Stay tuned.

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