Analysts say Damage to Euro from Lira Crisis has its Limits

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- EUR/USD trades below 1.14

- Limits to future EUR weakness over Turkish fears

- ECB unlikely to alter monetary policy over Turkey

Foreign exchange strategists with Commonwealth Bank of Australia (CBA) reckon the Euro exchange rates will not suffer lasting damage from the Turkish financial crisis.

The Euro exchange rate complex took a lurch lower on Friday, August 10 when the financial situation in Turkey took a turn for the worse and the Lira underwent a 17% slump.

The Euro suffered amidst concerns for European banks with substantial Turkish exposure and reports confirmed the European Central Bank (ECB) was indeed taking notice prompting markets to view developments as a potential reason for the central bank to delay impending policy changes.

"A textbook currency crisis is unfolding in Turkey. Large and widening current account deficit, check. Growing foreign currency debt, check. High and rising inflation, check. Constrained monetary policymaking, check," says foreign exchange analyst Alvin Tan with Société Générale on London.

The EUR/USD fell below 1.14 as the Turkish Lira tumbled, and the EUR/USD looks heavy at 1.1384 at the time of writing.

Foreign exchange strategists with CBA do however suggest the negative implications for the Euro from the Lira crisis are likely to be limited and that the ECB will not have to change course.

"We do not anticipate significant declines for the EUR because of the economic developments in Turkey," says a note from CBA, dated August 13, adding:

"We do not anticipate a change in the ECB's monetary policy stance because of Turkish economic and political developments. Nor do we believe EUR/USD will decline significantly because of events in Turkey."

Above: The Euro declines below 1.15 vs. the Dollar as concerns for Turkey's financial system grow.

According to CBA research, European bank exposures to Turkey is large in nominal terms but does not constitute a large part of total aggregate lending or profitability for European banks.

A Financial Times report meanwhile suggests the ECB does not yet view the situation in Turkey as critical.

So while there is some risk premium being reflected by the Euro, there are apparently limits to the downside risks from this channel.

However, there remains little reason to bet on a recovery in the Euro under the current circumstances.

"EUR/USD will remain under downward pressure," say CBA who expect the USD to remain bid while emerging market stresses linked to Turkey remain.

But, "we do not see Turkish developments as a repeat of 'Greece' for European banks, EUR/USD and global financial markets. European banking exposure is relatively small and Turkey is not in the Eurozone," adds the note.  

Capital is flowing into safe-haven assets like the Dollar and Japanese Yen at the start of the new week as the situation in Turkey gives traders a reason to reduce positions in riskier assets.

The Lira extended its selloff and fell by up to 11% against the Dollar in thin trading in Asia, before trimming losses after the Turkish Banking Regulation and Supervision Agency stepped in to limit swap transactions on the currency.

The Central Bank of the Republic of Turkey has meanwhile this morning cut TRY RR ratios by 250bps on all maturities and cut FX RR ratios by 400bps for some maturities. The CBRT says the move will provide TRY10bn, US$6bn and US$3b equivalent in gold of additional liquidity.

The sell-off also represents a vote of no-confidence in a new system of government that earlier this year handed President Recep Tayyip Erdogan unrivalled authority, essentially paralysing the bureaucracy in Ankara.

In speeches Sunday, Erdogan remained defiant, vowing never to give in on interest-rate hikes while saying the country is in an “economic war.”

He also ruled out an agreement with the International Monetary Fund.

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