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Western EuropeSeptember 3 2018

Turkey’s banks brace as Erdoğan’s new economy creates tremors

Strained international relations and the economic interventions of president Recep Tayyip Erdogan are denting confidence in Turkey’s economy. Its banks are relying on their resilience, but ratings agencies are intently watching, as Tom Stevenson reports.
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Erdogan

With the lira suffering a year-long rout in international markets, Turkey needed a sign of political stability, so many hoped the ascension of Recep Tayyip Erdogan to the newly enhanced presidency on July 9 would herald a period of economic calm.

It was not to be. The day after his inauguration, Mr Erdogan dismissed Mehmet Simsek, an experienced former Merrill Lynch economist, as head of the economic and financial policy portfolio, and appointed his son-in-law, Berat Albayrak, as new minister of finance. The country’s main stock market index, the BIST100, fell about 6% on the news. Turkish banks led the losses, with the Turkish banking index (XBank) seeing a 21.6% sell-off over the two weeks that followed the announcement of the new cabinet.

Markets were already concerned about the extent of Mr Erdogan’s influence over Turkey’s central bank, particularly given his somewhat unorthodox views on interest rates (he believes they are positively correlated with inflation). At the latest monetary policy committee meeting on July 24, the central bank left rates unchanged against market expectations of a hike.

Souring relations

Following this, already strained relations between Turkey and the US were damaged further on August 1. The US Treasury department announced financial sanctions against Turkey’s minister of interior, Süleyman Soylu, and minister of justice Abdulhamit Gül over the continued incarceration in Turkey of US pastor Andrew Brunson. The sanctions sent the lira further into freefall and the currency had lost more than 33% of its value in 2018, as of early August.

With the International Monetary Fund warning of potential overheating, inflation climbing above 15%, a current account deficit of 6% and rising, and a diplomatic crisis with the US, the remarkable growth achieved by the Turkish banking sector in 2017 now looks imperilled.

Last year, Turkey’s banks led the economy to 7.4% gross domestic product (GDP) growth as government-backed fiscal stimuli – including a credit guarantee fund (CGF) that supported bank lending – fought off market scepticism. Now the CGF is tapering, funding costs are rising and margins are shrinking.

Abundant global liquidity has protected Turkish banks’ access to international debt markets, though funding costs are still climbing. In June, borrowing costs for Turkey’s banks reached all-time highs and the five- and six-year US dollar-denominated bonds of banks such as Akbank, Is Bankası and Yapı Kredi hit their lowest levels in trading.

Return on equity (ROE) has been steadily reducing across the sector and is now well below interest rates, which stand at about 17%. In addition, Turkish companies with large debt loads denominated in foreign currency have been seeking debt restructurings.

International rating agencies are increasingly sceptical about Turkish banks’ fortunes. On June 1, Moody’s placed 25 of the Turkish banks it rates on ‘negative’ outlook watch, before downgrading all but one (QNB Finansbank) to Ba3 on June 8. Fitch cut its rating for Turkey on July 14.

At the time The Banker went to press, ratings agencies had issued further downgrades for Turkish banks and the sovereign. 

A test of fundamentals

Despite the challenges, Turkey’s banks still have room to manoeuvre, according to Mert Öncü, general manager of Odea Bank, Bank Audi’s subsidiary in Turkey.

“We believe that Turkish banks will prove their resilience against these risks once again, thanks to strong fundamentals, and will overcome the challenges,” he says. “In fact, we still see tactical opportunities in some sectors and companies in the short term. As we aim to strengthen our profitability and asset quality, we have generally
concentrated on export-oriented and higher-value-added companies and sectors in accordance with our new priorities.”

The asset quality of the country’s banks has been declining steadily. The official non-performing loan (NPL) ratio for the banking industry rose in June to just over 3%, but analysts sceptical of the figures say banks have classified loans as ‘performing’ for longer than they should. A more realistic NPL figure, they say, would lie between 6% and 8%.

In the first quarter of 2018, Group II loans (classed as closely monitored loans and other receivables) also surged after the introduction of International Financial Reporting Standard 9 and a string of restructuring requests from large Turkish corporations.

As domestic financial conditions have tightened due to the cool-down in the economy, fresh loan demand has weakened in all segments and restructuring applications have escalated since the beginning of the year, according to Mr Öncü.

“This has led to a slight build-up in NPLs, and some corporates have requested restructuring their debt. But even though these realisations in commercial and corporate loans create some concern over the asset quality of [the] banking sector, we believe that [the] banking sector has enough of a capital buffer to contain the current risks,” he says.

Hedging activities such as cross-currency swaps have raised the cost of funding and an overall foreign exchange mismatch has weighed on the sector’s profitability capability, and on ROE, he adds.

Turkey’s banks are hoping that global market conditions will help lift ROE by the beginning of 2018, once monetary policy normalisations and trade war concerns are fully priced in by markets. “Recovery in ROE will depend not only on the efforts of the banks but also on financial market stability in the medium term,” says Mr Öncü.

Loss of energy?

Some observers, however, believe that Turkey’s problems are more substantial than the financial sector has yet recognised. The lira’s collapse has already been precipitous, but pointing to the planned reduction of the US Federal Reserve’s balance sheet, Oguz Erkol, an analyst at ING Bank Turkey, says that worse pain is likely to come.

“Unlike the crises of the past, such as in the 1990s, we have not seen devaluation all of a sudden but extended over time, and this is primarily due to ample liquidity,” Mr Erkol tells The Banker. He describes a “slow-motion crisis” that shows no signs of stopping, and argues it may be too late for policy-makers to rescue the lira, even if they wanted to.

The banks may not be as insulated from the economy’s troubles as they assume. “We have seen banks’ exposure to the energy industry expanding at a rapid pace, which is yet to be reflected in economic activity. The sectoral contribution to GDP is on a slowly declining trend,” says Mr Erkol.

Turkish non-financial firms currently hold an all-time high of $55bn in foreign debt and a number of energy companies are among the wave of restructuring requests. The Turkish government had hoped to transform the energy industry in order to reduce the share of energy imports in the current account deficit, which currently stands at about 65%, or $36bn.

Although Turkey is a coal-rich country, the share of coal in electricity production is limited to about 30%. Seeking to boost the industry, the government introduced investment and tax incentives that saw investment of about $95bn in the electricity sector over the past 15 years. But the energy sector now appears to be both over-indebted and underperforming, signalling the possibility of over-investment.

“Energy seems to be performing terribly,” says Mr Erkol. As the lira declines, the debt burden only increases. Should a large number of Turkish corporates default on foreign debts, international financial markets could be shaken even further, presenting the real risk of a financial crisis.

New strategies

Turkish corporations have an estimated $221bn open foreign exchange (FX) position, corresponding to about 26% of GDP. “This raises concerns. However, corporates’ foreign exchange position needs to be analysed correctly,” says Hakan Ates, chairman of Denizbank, a Turkish bank formerly owned by Russia’s Sberbank and recently bought by Emirates NBD.

“Turkey stands out among developing economies for its high banking standards thanks to lessons learned during the 2001 financial crisis. In addition, Turkish banks have the buffer of $90bn in liquid assets,” says Mr Ates. “Turkish corporates act cautiously with their extensive crisis experience. Moreover, while the real sector is a net FX debtor, other agents of the economy are either net creditors or have a balanced FX position, such as households.”

However, the availability and cost of liquidity will be crucial, and will require the “utmost attention”, particularly as monetary tightening continues in the advanced economies, says Mr Ates, who adds: “In order to achieve even higher growth rates with better profitability, banks should be allowed to manage liquidity more effectively.”

Banks will need to seek new sources of wholesale funding as the loan-to-deposit ratio in the sector hit 120%. New strategies such as securitisation of loan portfolios may assist in addition to traditional channels. 

A cautious approach

If this proves possible, Mr Ates believes the banking system can sustain compound asset growth, profit growth and solid capital adequacy ratios until at least 2027.

In June, Moody’s ranked the Turkish banking sector’s macro profile as “weak”, but said banks have sufficient liquid resources to cover capital markets obligations. The rating agency estimates that Turkish banks have enough unencumbered liquid FX assets to cover about 10 months of wholesale liabilities.

Are the banks ready for potential shocks? The sizeable credit guarantee programme pursued in 2016 and 2017 produced growth and put the asset quality of Turkey’s banks on a good footing, says Ömer Aras, chairman of QNB Finansbank, which was taken over by Qatar National Bank in 2016.

“Slower loan growth and higher corporate income tax will now be posing downward pressures on the profitability of the sector,” he says. “Having said that, the fundamental strengths of banks, such as high capitalisation, will help mitigate the negative impact of aforementioned challenges.”

The government’s credit stimulus may have lowered NPL ratios, but should the distressed debt burden prove larger than expected, as some analysts believe, the effects should soon become apparent. Banks are already showing signs of caution. Mortgage volumes are down as the mortgage lending-mania driven by state-owned banks of the past two years comes to an end and weighted average interest rates approach 16%.

There are reasons to be prudent, according to Finansbank’s Mr Aras. “Inflation and the current account deficit might remain elevated in the period ahead, posing upside pressures to the exchange rate and interest rates, and such risks could render the macroeconomic background more challenging for the banking sector to operate in,” he says.

A ‘vicious cocktail’

Turkey’s new political order and its institutionalisation of an outsized role for Mr Erdogan in economic policy-making has not been well received internationally, and the knock-on effects have been widely felt.

Sam Finkelstein, head of emerging markets at Goldman Sachs, described the current Turkish economic policy-making environment as forming “a vicious cocktail”. “One has to be nervous about Turkey,” he said in an interview on Bloomberg TV. “They are doing everything wrong.”

International markets saw Mr Simsek, the former deputy prime minister with a finance and economy portfolio, and Naci Agbal, the former minister of finance, as competent technocrats and a moderating element in the Turkish government. Mr Albayrak has no such reputation.

The country’s banks must now contend with worse sentiments than ever at a time when a series of challenges are at risk of intersecting. Inflation is consistently registering well above the central bank’s forecasts, and the current account deficit is no longer covered by the central bank’s net international reserves.

Russian roulette

Turkey’s policy responses to these challenges now resemble “Russian roulette”, according to Atilla Yesilada, an adviser for Turkey at management consultancy GlobalSource Partners and a former director of Egebank Global Research.

“There is really no certainty or regularity, no rhyme nor reason to Turkish policy-making. Are we promoting growth or are we in a mode of austerity? Is the central bank tightening or is that on hold? It’s not chaos, it’s anarchy,” says Mr Yesilada. “All investors can do is pull the trigger and hope the gun isn’t loaded.”

Both domestic and international observers agree that the wider Turkish economy is in for a tough time. However, the resilience of the country’s financial sector is widely acknowledged. Mr Yesilada nonetheless argues that the banks will not be shielded from the effects of the present turbulence. “The banks are not in bad shape, but their profitability and the asset quality of their loan portfolios is deteriorating, and they are deferring loans,” he says.

Dealing with the challenges will first require honest analysis. “Denial has become a national pastime. Ankara denies the problems, industry denies the problems, the banks deny the problems,” says Mr Yesilada. “At some point it will be time for a rude awakening – in my view, probably before the end of the year.”

The key test for the country’s banks will be whether the capital buffer the industry has built up, together with its experience of crises, will withstand the waves made by Mr Erdogan’s new system.  

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