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Western EuropeSeptember 3 2018

Can Turkey avoid an economic crisis?

Fears of Turkey's currency woes turning into a full-blown crisis are being fuelled by a diplomatic row with the US and president Recep Tayyip Erdoğan's unorthodox views on interest rates. Peter McGill reports.
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Turkey economy

Turkey’s economic crisis has a simple enough diagnosis and a textbook cure. Whether the patient will accept it, however, depends largely on president Recep Tayyip Erdoğan, who now holds unprecedented powers in the country, as well as his mercurial US counterpart, president Donald Trump. The two are involved in a tense geopolitical stand-off.

Turkey has been refusing US demands to release an American evangelical pastor, Andrew Brunson, who is facing charges of espionage and links to terror groups, and on August 10, Mr Trump tweeted that he had authorised a doubling of US import tariffs on Turkish steel and aluminium. He sent the tweet (“Our relations with Turkey are not good at this time!”) in the middle of a speech by Turkey’s new treasury and finance minister, Berat Albayrak – Mr Erdoğan’s son-in-law – whose appointment was only announced in July.

Fuel on the fire

Emergency measures announced by Mr Albayrak were long on principle but short on detail and the doubling of US tariffs “just poured fuel on the fire”, says Viktor Szabo, senior investment manager at global asset management company Aberdeen Standard Investments. 

The Turkish lira fell 18.5% against the US dollar in just one day. “The short-term solution is simple: raise interest rates aggressively and rein in credit to cool down the economy and bring inflation in check,” is Mr Szabo’s advice. “Send a clear message to investors that the problem is understood and will be decisively addressed.”

Turkey’s central bank later eased reserve requirements for commercial banks, and restricted dollar-lira swaps, but foreign investors were unimpressed by the action and the lira resumed its rout, reaching an all-time low of 7.24 to the dollar on August 13, almost half of its value at the beginning of the year.

Mr Erdoğan showed no sign of backing down. Ratcheting up the rhetoric, he urged his countrymen to convert all their dollars and gold to lira, threatened a boycott of American electronics, and accused the US of economic “war”. He also hinted that Turkey might quit the Nato fold for Russia’s warm embrace.

Ghost of crises past

Charles Robertson, chief economist at Renaissance Capital, says Turkey shows eerie similarities to economies such as Thailand and Indonesia at the time of the Asian financial crisis of 1997-98, having borrowed heavily in foreign currency to support high growth at the expense of a widening current account deficit. This leaves Turkey vulnerable to recent dollar appreciation and the tightening of US interest rates by the Federal Reserve as it winds down quantitative easing (QE).

Thanks to QE, Turkish banks and corporates were able to gorge on cheap and abundant foreign liquidity after the global financial crisis of 2008/09. Lucas Irisik, portfolio manager and senior analyst at Nikko Asset Management, points out the “enormous” growth in credit to non-financial Turkish corporates, from 30% of gross domestic product (GDP) in 2009 to 70% of GDP in 2018, and estimates that about half of the new loans were in foreign currency.

The headline net short foreign exchange position of non-financial corporates – the FX mismatch between their assets and liabilities – has roughly trebled since 2008, from around 9% of GDP ($70bn) to 25% of GDP ($220bn) today. The good news is that for short-term debt with maturities of under 12 months, the FX position of the corporates is still in surplus to the tune of $6bn.

Central bank figures show Turkey’s total external short-term debt, including all instruments maturing within one year or less, regardless of their original maturity, to be $180.6bn. Adding the current account deficit of $57bn takes total financing needs for the year to $237.6bn.

Of this, Nikko Asset Management estimates $82bn may be left uncovered by debt rollovers, assuming rollover ratios similar to those during the global financial crisis.

So far, lira depreciation has not led to a big increase in non-performing loans (currently about 3% of total loans) or a deterioration in bank capital levels, but this may soon change. “The lira’s continued weakening since the end of 2017 poses a major risk to banks’ capital levels and asset quality,” Standard & Poor’s warned in May.

Borrowing from abroad

Yasemin Engin, assistant economist at Capital Economics, notes how until 2011, Turkey’s banks were able to fund their lending entirely from domestic deposits, but as growth in lending outpaced that of deposits, the banks increasingly borrowed from abroad to fund their domestic loans. “Turkish banks have a structural lack of long-term lira funding,” S&P noted in its report.

Turkish banks’ loans now exceed deposits by 32%, according to Nihan Ziya Erdem, chief economist at Garanti Securities in Istanbul. “In Turkish lira terms, the loan-to-deposit ratio is 160%, in foreign currency terms it’s 104%,” she says. “In the past couple of years, global financing conditions were very positive for emerging markets, and with the soundness of the Turkish financial system, Turkish banks were able to borrow from abroad at low cost.”

For Capital Economics, such reliance on foreign wholesale funding is a weakness. “Banks now have a large short-term external debt burden – equivalent to about 12% of GDP – that needs to be rolled over on a regular basis. If foreign funding were to dry up, a credit crunch would ensue,” says Ms Engin.

Ms Erdem of Garanti Securities dismisses such talk as alarmist. “Turkey is able to find external financing from foreign banks, so there is no foreign currency liquidity problem at the moment. The banks are full of foreign currency,” she says.

Turkish households are not allowed to borrow in foreign currencies, and most foreign-denominated debt is held by corporates. Some are exporters with foreign income streams, but others are domestically focused and have only lira revenue to service their foreign debt. “The Turkish banks are trying to switch their foreign currency loan book to Turkish lira loans because corporates with high foreign currency debt are now having problems,” says Ms Erdem. “It’s not a broad-based problem. It could be a problem for companies that have Turkish lira revenue to repay foreign currency loans.”

Sectors at risk

The extent of unhedged total liability is a key question for investors. Mr Irisik says the experience of a previous currency crisis in 2000 taught Turkey’s corporates “how to deal with lira volatility, and they started utilising financial hedging”. However, many may have baulked at the cost of hedging or felt confident of being able to pass on any depreciation losses through higher consumer prices during the economic boom. Services such as property, utilities, hotels and restaurants are now considered most at risk, as they borrowed heavily in foreign currency but have fewer sources of FX revenue than manufacturers.

In 2017, Turkey’s real GDP grew at a blistering – and unsustainable – rate of 7.4%. The primary driver was government stoking of demand. Shortly after the failed army putsch in 2016, the government guaranteed about $60bn-worth of loans, and increased spending on infrastructure, creating as many as 1.6 million new jobs, according to Mr Irisik. This year brought another stimulus package worth $34bn, mostly tax cuts for favoured corporates. Shortly before the June presidential and legislative election, there was an even more populist package costing close to $6bn that included handouts to retirees before and after religious holidays.

Negative side-effects from this over-heating of the economy included “a deteriorating current account deficit and persistent double-digit inflation”, said S&P in its report. The rating agency also criticised a government-sponsored credit guarantee fund in which the government covers 7% of losses on a portfolio basis. The fund merely “delayed, but not prevented, a liquidity squeeze in Turkey’s private sector”.

Normally, a central bank would have tightened rates to prevent a build-up of inflationary pressure, but according to Mr Irisik, Turkey’s central bank, the TCMB, has consistently been “behind the curve” in monetary policy. The last rate rise, of 500 basis points to 17.75%, was in May.

New powers for the president

Thanos Papasavvas, founder and chief investment officer at ABP Invest, believes Mr Erdogan “gave the nod” to the TCMB for political reasons. “He feared that if there was a real currency crisis just before the elections, his credibility at home would have been damaged, and there would have been a much higher probability of not winning,” says Mr Papasavvas. “Let’s not forget he brought the elections forward from 2019 out of fear that economic imbalances of the recent past would have caused pressure in the currency and interest rates.”

A flurry of presidential decrees in July just hours after Mr Erdoğan was sworn into office further added to concern about the central bank’s independence. The president gained sole responsibility for appointing the governor, deputy governor and other members of the Monetary Policy Committee; the requirement that deputy governors have at least 10 years’ professional experience was lifted; and the governor’s term was shortened from five years to four.

The same decree granted Mr Erdoğan the power to choose the heads of the national intelligence agency, the national security council, senior prosecutors and the head of the national statistics agency.

Turkish stocks, bonds and the lira all tumbled as it was further announced that Mr Erdoğan’s son-in-law would head the new Treasury and Finance Ministry, side-lining two veterans trusted by the markets, Mehmet Simsek and Naci Agbal. Moody’s Investors Service said perceptions about a loss of central bank independence would have negative consequences for the “cost and availability of the foreign capital inflows on which Turkey’s economy and financial system depends”.

The rating agency also flagged Mr Erdoğan’s “vocal opposition to conventional monetary theory” that has led him, and other top officials, to argue that interest rates and inflation are positively correlated – so that monetary policy should be loose, rather than tight, in order to bring down prices.

Mr Erdoğan has also blamed the 2016 coup attempt on Fethullah Gülen, a Turkish Islamic cleric who lives in self-imposed exile in the US state of Pennsylvania. The president launched a massive crackdown on Mr Gülen’s alleged supporters, purging tens of thousands of people from government jobs. The US, however, has refused Turkey’s requests to extradite Mr Gülen. In turn, Turkish authorities have accused Mr Brunson of aiding the Gülen movement in its alleged involvement in the coup attempt. It remains to be seen whether either side will back down any time soon. 

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