While the headlines focus on the political rhetoric, in many respects this is an old fashioned emerging market crisis prompted by a ballooning of external debt at both the public and private level. In the near term, the sharp depreciation in the Turkish lira, the worsening relationship with the US, and the imposed sanctions, increases the risks of the short-term debt rollover by Turkey and puts significant pressure on the Turkish financial system. Over the years Turkey has built up significant external imbalances, in particular with a high stock of short-term external debt ($180bn at the end of May) and also non-financial corporations running a short US dollar position north of $200bn.

The main corporate sectors under pressure are energy, real estate and construction, which have significant FX mismatches. The Turkish lira depreciation will impact their ability to service their debt and will put a further strain on the Turkish banking sector, where we have already seen capital ratios decline in recent quarters as a result of the currency weakening. Asset quality has also deteriorated significantly driven by energy and construction companies. In fact, Q2 was the first quarter in which corporate risky loans have begun turning into non-performing loans. Given that the state has taken an unorthodox route in addressing the Turkish lira depreciation, the prospects for the asset quality in the Turkish banking sector are quite dire.

Given the unorthodox policies adopted by the authorities - in particular the lack of independence and credibility of the central bank - a balance of payment crisis and outright bank run cannot be ruled out. Access to capital has been closed for external debt and the government would struggle issuing local debt in the current market environment. Given the historical high dependency of Turkish banks on the wholesale USD funding, it will be important to monitor the willingness of international banks to lend to Turkish banks and corporates post the US sanctions.

The refusal to adopt an orthodox response or raise interest rates despite the current turmoil leaves the outcome for the Turkish economy increasingly binary. Turkey is geopolitically important. While the list of economic problems faced by Turkey is growing, there is a limited number of possible solutions, including an aggressive interest rate hike to defend the lira, an IMF program, capital controls, and bilateral loans from countries such as Russia, Saudi Arabia, China, etc. For Turkish corporate debt holders and for emerging market assets more broadly the most concerning outcome would be the imposition of capital controls. But given Turkey's heavy reliance on foreign funding, policymakers are likely to avoid imposing capital controls, at least for now.

Turkey's current quagmire is quintessentially 'emerging market', but in this instance applies uniquely to Turkey. While many countries have large external financing needs, Turkey stands out for its heady short-term external debt, used to fund a wide current account deficit, while persistently maintaining ultra-loose policy. What could make Turkey a systemic EM problem is capital controls, triggering large EM fund sales and forced fund suspensions. The developed market impact is chiefly in European banks.

However, we find exposures to be far smaller than headlines suggest: if Turkey defaults overnight, some of the most exposed Spanish banks would probably wipe just one year of earnings.

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