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. Last Updated: 07/27/2016

Turkey Lets Lira Go Into a Free Fall

Turkey saw a flashback of Russia's 1998 financial crisis Thursday as it abandoned efforts to prop up the lira and watched the currency plummet 40 percent in a free fall.

But while Russia-based traders kept an anxious eye trained on the turmoil, they predicted that strong fundamentals would allow Russia to emerge from the storm unscathed. The stock market appeared to agree, with the RTS Index rebounding 3.97 percent to 168.83 Thursday after a massive 7.9 percent loss the day before.

The lira was allowed to float for the first time Thursday in a dramatic bid to curb Turkey's financial crisis. The currency plunged 40 percent to 1 million lira to the U.S. dollar in the morning, but later cut its losses to about 28 percent as markets applauded the float.

Turkish Prime Minister Bulent Ecevit, who is himself under pressure to make changes in his government, said the market would settle down further as the lira floated freely.

"Recent indicators and movements show there was actually a problem in the economy in Turkey. And this exploded, it emerged," he told reporters in Ankara in remarks reported by Reuters.

He said the government, which abruptly scrapped its IMF-backed controlled-currency system with the float Thursday, will continue with reforms and make inflation a top priority.

Market watchers said it is unlikely that Turkey's woes will spill over its northern borders thanks to a number of strong economic factors in Russia.

Macroeconomic fundamentals — Russia's trade balance, exchange rate and fiscal performance — remain strong, and the political scene is stable as no battles are looming between parliament and the Kremlin, economists said.

In addition, Turkey makes up a meager 2.5 percent of Russia's foreign trade, if government's estimates are to be believed, they said. The statistics exclude billions of dollars in gray imports brought to Russia by shuttle traders.

Russia's exports to Turkey amounted to $2.2 billion in January-November 2000, while imports stood at $245 million, according to the State Statistics Committee. Shadow imports stood at $3.5 billion, according to estimates made by Renaissance Capital.

A third reason Russia may feel little pain from the tumult is linked to the relatively small amount of outstanding currency-denominated bonds in Turkey. The country makes up a meager 2 percent of JP Morgan's EMBI Plus index, which tracks the performance of emerging market debts.

"Were it Russia or Brazil, we would see quite a different picture," said Coast Sullenger, head of Europe emerging markets with Lombard Odier Bank, in a telephone interview from Geneva.

Russia has a share of 7.7 percent on the EMBI Plus, while Brazil makes up 22.5 percent and Argentina has 23.1 percent. That means fund managers who track the index are likely to have a small share of Turkish paper in their portfolios, meaning a drop in prices should not trigger a major sell-off.

Market players were nevertheless closely monitoring bond prices Thursday. "If yields on Russian debts break through Turkey's curve, it could have a major effect on bonds," said James Fenkner, strategist with Troika Dialog. "But most of the losses are behind us."

So far, Russia's portion of the EMBI Plus index pays a premium of 1075 basis points to U.S. Treasury bonds, while Turkish paper bears a premium of 954 points.

"One indication of a contagion is a spike in yields," Sullenger said. "They've widened a bit, but nothing else happened."

Russia's benchmark 2028 Eurobond dropped 2.5 percentage points to a yield of 14.5 percent since the start of the week, but the adjustment was not nearly as dramatic as the bloodshed in Turkey, where yields topped 4,000 percent.

Turkey's decision to let the lira float and the resulting slide closely mirror the Russian Central Bank's actions in the weeks before the August 1998 crash.

The International Monetary Fund pushed through a bailout loan of $7.6 billion to Turkey at the end of last year.

The IMF funds helped prevent the bubble from bursting for a few months.

Likewise, Russia got an ill-fated bailout tranche of $4.5 billion from the IMF just weeks before its crash that it then spent in a few short days as it struggled to keep the ruble stable.

The Turkish Central Bank spent some $7.6 billion on Monday alone in a bid to prevent the lira from slipping, but it gave up Thursday and opened the valve to let some steam out.

The international players likely to suffer most from the meltdown in Istanbul are German banks.

Deutsche Bank issued a report Thursday saying German banks had an exposure of about $10 billion on their hands. International claims on Turkey amounted to $43.9 billion in September 2000, according to data from the Bank of International Settlements. In contrast, claims on Russia in the middle of 1998 stood at $75.85 billion, with German banks being the largest lenders.

But unlike Russia, Turkey never gave up a commitment to repay its debts.