The recent tumble in the Turkish lire and other emerging market currencies has many economists and investors wondering if this could spread further and turn into a full blown crisis. To better understand the latest market news, we’re going to look at similar historical cases.

While there are some similarities between what’s unfolding now and the 1982 Latina American crisis or the 1998 crisis that began in Thailand before spreading into the “Asian Contagion” there are two important differences:

• On an adjusted the sum of money or amount debt involved with Turkey and its immediate neighbors is far less than those prior two events. Also, the size of Turkey’s economy is relatively small. Meaning defaults by Turkey are less likely to trigger a domino effect.  But it can certainly cause ripples.
• During the prior two events most currencies were pegged to the dollar. Meaning they didn’t adjust as the situation unfolded but rather finally reached a breaking point causing a sudden and massive devaluations.  Call it a bursting of the dam.  By contrast, today most currencies are free floating, meaning they are adjusting in real time allowing participates to adjust holdings and manage risk.  No-one should be taken by surprise by a knock out blow.

Personally, I think the above greatly diminishes the chance of a full-blown crisis. But some, such as Michael Harnett, an analyst at Bank of America, warn that we shouldn’t be complacent.

This gist of Harnett’s report is set forth here via ZeroHedge:

While the market is (finally) paying attention to the accelerating Turkish collapse and specifically the risk of contagion to Europe, Asia, and ultimately, US capital markets, the truth is that this crisis has been a long time in the making. In fact, the first break in the “strong Emerging Market” narrative emerged in late April when as a result of rising US interest rates the dollar surge began in earnest (facilitated by China’s first easing announcement on April 17), which in turn sent the both EM currencies, and EM debt reeling…

… to be followed shortly by the plunge in the biggest EM currency of all: the Chinese Yuan.

And as we highlighted in early May, BofA’s Chief Investment Officer Michael Hartnett observed that higher US rates finally caused a higher US dollar (courtesy of the PBOC), at which point “EM started to crack.” But while many had pointed at the collapse in the Turkish Lira, the Argentine Peso, and the Indonesia Rupiah, as cracks in the EM narrative, the truth is that many of these are idiosyncratic stories.

So how could one decide if the Emerging Market turmoil – whether started by Turkey, Argentina, Russia, China, or any other EM country – was set about to sweep across the entire sector, and result in DM contagion? According to Bank of America the answer was simple. This is what Hartnett said in early May:

“EM FX never lies, and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios.”

In other words, to Bank of America, the best indicator of imminent emerging market turmoil, is shown in the chart below dated circa three months ago: if and when the BRL starts sliding, and approaches 4, it may be a good time to panic, as contagion is about to go global.

So while everyone is hypnotized by the Turkish lira, keep a closer eye on the Brazilian Real: once it crosses 4, the real fireworks begin.

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