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Aug. 13, 2018, 2:20 p.m. EDT

Why Turkey’s currency crisis is rattling Europe bank stocks and the euro

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By William Watts, MarketWatch


AFP/Getty Images

Emerging markets are enduing a drubbing as a currency crisis in Turkey takes a toll on investor appetite, but the episode also serves as a reminder that Europe’s banking system continues to be seen as a threat to global growth and developed markets.

“The question is whether mass defaults of Turkey’s corporate borrowers, with or without an all-out sovereign debt crisis, will destabilize the eurozone’s already fragile banking sector,” wrote Carl Weinberg, chief international economist at High Frequency Economics, in a Monday note. “Euroland banks are so undercapitalized that if they take a hit, they may have to cut lending to stay within regulatory limits.”

The Turkish lira renewed its plunge on Monday, hitting another all-time low versus the U.S. dollar /zigman2/quotes/210561895/realtime/sampled USDTRY +0.1129% . Turkish authorities moved to boost liquidity, but the efforts weren’t enough to soothe worries about the economy’s financial condition. Other emerging-market currencies and assets were hard hit on fears of spillover effects. The iShares MSCI Emerging Markets ETF /zigman2/quotes/201454250/composite EEM -1.03% , a popular exchange-traded fund tracking emerging-market stocks, trimmed its earlier decline but remained off 0.8%, leaving it down 4.5% so far in August and off more than 9% in the year to date.

“A credit crunch would send the eurozone economy into a spiral,” Weinberg said.

Read: Turkish lira crisis sends shock waves across emerging-market funds

Also see: 3 reasons the selloff in Turkey’s lira matters for markets all over the world

European bank shares were whacked Friday after the Financial Times reported that European Central Bank regulators were concerned about the exposure of Spain’s BBVA /zigman2/quotes/209653399/delayed ES:BBVA +0.14%   /zigman2/quotes/204078760/composite BBVA -0.39% , Italy’s UniCredit /zigman2/quotes/200769686/delayed IT:UCG +0.46% , and France’s BNP Paribas /zigman2/quotes/206351084/delayed FR:BNP +1.03%  to lira weakness. The report said regulators didn’t yet see the situation as critical, but the watchdog was concerned since all three maintain significant operations in Turkey. Specifically, regulators worry that Turkish borrowers might not be hedged against lira weakness and could begin to default on loans denominated on other, strengthening currencies.

The Stoxx Banks index extended a decline on Friday to about 2% on Monday, leaving it down around about 8% so far in August, according to FactSet data. European stocks overall were dragged lower again, with the pan-European Stoxx 600 /zigman2/quotes/210599654/delayed XX:SXXP +1.14%  losing 0.2% on the session, while Italy’s FTSE MIB index /zigman2/quotes/210598024/delayed IT:I945 +1.47%  shed 0.6% and Spain’s IBEX 35 index /zigman2/quotes/210597995/delayed XX:IBEX +0.86%  dropped 0.7%.

U.S. stocks had been attempting to shake off global weakness, with the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.11% down 0.3% in midday action after trading on both sides of unchanged during the session. The Turkish situation offered another headwind for the euro /zigman2/quotes/210561242/realtime/sampled EURUSD -0.1628% , which lost 0.2% versus the dollar to trade at $1.1393 in recent action.


Bank of America Merrill Lynch

Some economists argued that the total exposure is manageable.

“Of course, investors are also worried about the implications of Turkey’s problems for the eurozone’s banking system and economy. But while these concerns add to the long list of recent headwinds for the euro, neither the overall exposure of banks in the eurozone to Turkey nor the direct links between the region’s economy and the country is large,” said John Higgins, market economist at Capital Economics, in a note.

Others see the potential for significant ripples.

The lira’s plunge “raises the local currency counterpart of the nation’s burgeoning foreign currency debt to unbearable levels,” said HFE’s Weinberg. “A lot of that is owed to eurolanders who have jumped into Turkish assets for yield.”

The threat, he wrote, is that Turkey’s woes could “ripple out and hammer EU institutions. Cascading problems may transmit instability to EU banks. Uh oh.”

Meanwhile, Turkey’s woes come as worries about Italy’s sovereign debt and its banking sector were moving back into the headlines.

A continued selloff in Italian government debt sent the yield on the country’s 10-year government bond /zigman2/quotes/211347230/realtime BX:TMBMKIT-10Y +0.16%  up more than 10 basis points Monday to 3.09%, touching a two-month high. The yield premium demanded by investors to hold the Italian 10-year over its German counterpart /zigman2/quotes/211347112/realtime BX:TMBMKDE-10Y -1.41%  widened to more than 280 basis points, or 2.8 percentage points, the largest since late May. A widening spread between the sovereign pair is often viewed as a sign of the perception of increase anxieties about Italy, with Germany, the largest among the eurozone economies, tending to attract buying from investors seeking safety. Bond yields fall as prices rise.

Italy has drawn particular concern from market participants because of its overall debt and a recent election that has observers fretting that it the southern European country’s financial health.

The Italian economy’s government debt load stands at 133%. Investors have remained nervous following the formation of a government last spring led by a pair of populist parties who have stoked fears of a fiscal showdown with its eurozone partners. Worries about Turkey and uncertainty about the Italian government’s economic plans have gotten the blame for the recent weakness in Italian bonds.

See: Here’s why Italy and financial markets are still headed for a showdown

“Our main concern is broader EM contagion, rather than Turkey in isolation. Still it feels like these risks pale next to the Italian sovereign risks,” wrote credit analysts at Bank of America Merrill Lynch, in a Friday note.

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William Watts is MarketWatch's deputy markets editor, based in New York. Follow him on Twitter @wlwatts.

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