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BrackenApril 24 2016

Turkey's FX risk and how to manage it

Turkey's banks face an increased credit risk due to the foreign exchange positions of their debtors. Gürcan Avci and Arif Esen look at ways the banks can manage this risk at times of volatility.
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Increasing foreign exchange (FX) volatility is the major problem of emerging markets' financial systems. And although banks in Turkey are perfectly capable of managing their own FX positions thanks to strict regulations and recent experiences, their exposure to the FX position of their debtors – non-financial firms – increases their credit risk.

This currency-induced risk is caused by the net short FX position of the real sector, whose assets are in local currency, compared with their FX-denominated liabilities. Recently, the Turkish banking sector’s position has been heavily criticised due to the extent of its exposure to this risk. Its existence is an inconvenient truth.

Ways to manage the risk

Borrowing credit in FX terms is 10% cheaper than borrowing in Turkish lira terms. Because of this, FX credits owed to the Turkish banking sector amount to $174bn, whereas the non-financial sector’s net FX short position was $175bn as of June 2015. Cash-flow mismatches expose firms to payment difficulties in times of lira depreciation, which requires the proper management of currency-induced credit risk by banks.

Non-financial firms that use credit in large amounts already possess natural hedge mechanisms. The fact that the future cash flows of these firms are FX indexed creates a blurry picture on their balance sheets. This becomes particularly apparent in the project finance and tourism sectors, which are the two main drivers of Turkey’s economic growth.

The total risk of project credits in the Turkish banking sector was about $51bn as of June 2015. Firms that use project finance credits operate with a short FX position. However, renewable energy, dock and airport, and chemical industry projects’ cash flows are FX denominated. When renewable energy projects are considered, there is an FX-indexed price guarantee mechanism at the time of production. In Turkey, highway and bridge projects are financed through the build-operate-transfer work model and their pricing mechanism is already guaranteed in FX terms by the government. Moreover, loans provided to coal, cement and chemical industry-related investments are FX denominated. Costs and sell prices of raw goods in these sectors are FX indexed, too.

Because of this, we think that projects with natural hedging mechanisms should be considered when we evaluate the currency risk in the real sector. We calculate that credit provided to these projects amounts to $20bn as of June 2015.

The tools for the job

Derivatives are one of the most prominent tools for hedging against currency risk. Although using derivatives for hedging purposes is not a common method used by non-financial firms, corporations with strong risk management practices manage their positions with forwards and FX options. Furthermore, banks force firms to use derivative-based transactions in terms of loan agreements’ closure terms. We analysed the derivative transactions aiming to hedge FX positions of these firms and reached a portfolio of $10.4bn FX credits hedged within this frame.

In addition to the size of the currency-induced credit risk, its management is another important issue. We investigated the common standards employed by the main six players of the Turkish banking sector. First, banks evaluate short FX positions of non-financial firms considering their industry. The ability of these firms to reflect the currency movements into their sales prices is an important determinant of the credit decision. Also, the high level of personal FX assets of shareholders of these firms also constitutes an important risk decreasing mechanism unique to Turkey.

Banks’ approach in FX credit provision to the tourism sector, whose income is in FX terms, differs from the retail sector, where the income is in local currency. The long- and short-run costs firms’ short FX positions can cause in case of a lira depreciation are analysed with scenario analysis and other stress tests. The results are then compared with earnings before interest, tax, depreciation and amortisation, net profit and equity, according to which final decisions on the credit provision, amount of collateral and credit are met. FX-denominated collateral is also subject to these stress tests. In some cases, a firm’s short position on a solo basis arises out of a strategy implemented on a consolidated basis, when banks also consider a consolidated FX short position. This position of non-financial firms is considered in the modelling of a credit rating.

The demand for FX credit of non-financial firms in emerging markets such as Turkey exposes them to currency risk. However, analysing the extent of banks’ credit risk exposure caused by this FX risk only by considering the current position is wrong. Our revaluation of the currency risk indicates that when hedging mechanisms of these firms (both natural and through derivatives) are taken into account their short position level decreases by $30bn at least. Risk management mechanisms, which cannot be quantified in credit provision periods also decrease the total amount of risk to a significant extent.

Gürcan Avci is a director at Ernst & Young and Arif Esen is a senior bank examiner at the Banking Regulation and Supervision Agency of Turkey.

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