Turkey’s economy was thrown into uncertainty in late March when president Recep Tayyip Erdogan abruptly fired the governor of the central bank, Naci Agbal, just four months into the job.
Mr Agbal had been praised for engineering a strong rebound in the lira and efforts to tame double-digit inflation, which included a larger-than-expected rate hike just days before he was sacked. In total, Mr Agbal had raised interest rates from 10.25% to 19%. In the aftermath of his dismissal, the lira fell 14% against the dollar, with a strong sell-off among Turkey’s asset markets.
Mr Agbal was quickly replaced with Sahap Kavcioglu, a relatively unknown university professor who has previously served as a lawmaker from Mr Erdogan’s ruling Justice and Development Party, and also as a deputy manager at state-owned lender Halkbank. Following the move, research consultancy Capital Economics predicted a 200 basis point interest rate cut in the short term, as well as further aggressive easing in the second half of 2021.
With Mr Agbal’s removal from the central bank, Turkey loses one of its last remaining anchors of institutional credibility
“Erdogan wants rates to be brought down. Investors shouldn’t be under any illusion that this guy has been brought in to do just that,” says Jason Tuvey, senior emerging markets economist at Capital Economics. “You don’t sack the previous governor and bring in someone else, and expect the new guy to follow the same path as the previous one did.”
All told, it was an unsettling moment, in a country already used to unsettling moments.
Investor confidence
Despite the pandemic, Turkey’s economy has performed relatively well, expanding by 1.8% last year. It was one of the few economies in the world to show positive growth in 2020, even as the tourism sector — which generates more than $30bn in annual revenue — was badly hit, with revenue down by two thirds, according to Fitch Ratings.
Turkey recorded a current account deficit of 5.3% of gross domestic product (GDP) in 2020, after a surplus of about 1% in 2019, largely due to the effects of the pandemic on tourism and trade.
Jason Tuvey, Capital Economics
Before Mr Agbal’s dismissal, the International Monetary Fund had been predicting that Turkey’s economy would grow by 6% this year. Others were equally optimistic.
Now there are concerns that the latest machinations could lead to a significant investor outflow, as foreign investors get jumpy. Turkey’s short-term foreign debt reached $140bn in January, roughly a fifth of the country’s GDP, putting considerable pressure on the country’s finances.
“With Mr Agbal’s removal from the central bank, Turkey loses one of its last remaining anchors of institutional credibility,” Phoenix Kalen, a strategist at French investment bank Société Générale, wrote in a research note shortly after the firing. “Turkey may soon be headed toward another currency crisis.”
Effects on banks
These are concerning times for the Turkish banking sector, with a sharp rise in borrowing costs increasing risk as banks hit a wall of maturing foreign currency debt. Turkish banks need to repay $89bn in external debt over the next 12 months, according to Capital Economics estimates, equivalent to 12.5% of the country’s GDP.
This has echoes of 2018, when the currency crisis left banks with large external debts and with minimal holdings of foreign currency that they could use to repay them, resulting in a sharp rise in borrowing costs. “At the height of the crisis, banks were basically shut out of international capital markets,” says Mr Tuvey, who adds that banks ultimately managed to roll over enough of their debts and draw down their foreign exchange (FX) holdings at the central bank to make debt repayments.
“We’re in a very similar situation,” he says. “The good news is that, for now at least, borrowing costs have jumped since the sacking of Mr Agbal, but not to the extent that these banks are locked out of international capital markets. Under Mr Agbal, banks utilised that period to rebuild some of their FX holdings at the central bank.”
Still, ratings agency Moody’s said that the recent central bank move hurts investor confidence, constraining banks’ access to market funding. “Without central bank credibility, [banks’] market access is likely to again be costlier and limited to short-term syndications,” it said.
Turkish banks, however, have weathered plenty of crises and periods of heightened market volatility in recent years, without seeing their market access significantly curtailed.
Strong banking growth in 2020
Turkey’s banking sector remains highly concentrated, with the seven largest banks accounting for more than 70% of assets. It is dominated by three state-owned banks, Ziraat, Halkbank and Vakif, accounting for a combined 38% of assets in the system. The three banks saw their assets grow by 53.5% in 2020, driven by their role in lending to the economy during the pandemic. Other systematic banks include private lenders İşbank, Garanti BBVA, Akbank and Yapi Kredi.
According to the country’s Banking Regulation and Supervision Agency, its banks achieved a net profit of Tl60bn ($7.43bn) in 2020, up from Tl49bn in 2019, with total assets in the system growing by 36%. Return on equity, meanwhile, stood at 11.64% at the end of 2020 — up slightly on 2019 figures — while return on assets dropped from 1.44% to 1.41%. The overall capital adequacy ratio of the banking system stood at 18.76% at end-2020, slightly up from 2019 figures.
“We don’t think it’s going to be the asset side of banks’ balance sheets that causes any major problems; it’s just their ability to service their liabilities — that’s where the issues ultimately lie,” says Mr Tuvey.
Even so, profitability metrics for Turkish banks are under added pressure due to the rise in interest rates, which is expected to lead to tighter margins.
The spread between local currency loans and deposit rates for the three state banks turned negative in January, according to Fitch Rating, with their combined net profits falling from Tl2.3bn in January 2020 to just Tl6m in January 2021. This contributed heavily towards the sector’s 45% year-on-year fall in net profits, with state banks’ share of net profits falling from 34% to just 0.1%. Net interest income for the banking sector fell by 20% year-on-year in January, while state banks’ net interest income fell by 69%.
Inflation worries
Mr Agbal was not the first central bank governor to incur the president’s wrath. In 2019, Murat Çetinkaya was removed after refusing to bow to pressure to cut interest rates. His replacement, Murat Uysal, cut rates almost immediately, and followed up with further cuts over the following months, but was ousted in November 2020. The country is now on its fourth central bank governor in just two years.
The rapid rate of inflation is a source of considerable concern for Turkey. It has been running at more than 15% and, even if it drops, it will still likely remain in double digits for the foreseeable future.
“Inflation has remained above the central bank’s target of 5% since 2010 and has averaged 10.2% over the past 10 years,” says Erich Arispe, senior director of sovereigns at Fitch Ratings.
Mr Arispe adds that entrenched high inflation expectations have led economic agents to shorten their planning horizons in terms of consumption and investment decisions. “And it has hindered the development of a long-term local currency savings market, leaving the private sector reliant on external financing and Turkey vulnerable to a deterioration in investor sentiment.”
For the banking sector, it creates additional challenges.
“I think the interest rate volatility is the biggest issue, because some banks are relatively less resilient to this volatility, in addition to currency volatility [which] could also trigger some new non-performing loan (NPL) formation in the medium term,” says Sevgi Onur, vice-president and banking analyst at Istanbul-based Seker Invest, who adds that private banks are likely to be more resilient to interest-rate uncertainty.
Halkbank is also currently on trial in the US, on charges of helping to violate sanctions against Iran. Halkbank denies wrongdoing.
Lending surge
Turkey’s economy grew strongly in the second half of 2020, driven in part by a near doubling of lending by state-owned banks as a direct response to the pandemic. GDP grew by 5.9% in the fourth quarter alone.
State-owned lenders accounted for much of the recent loan growth, as they intermediated most of the loans issued under Turkey’s Credit Guarantee Fund facility, and also saw increased mortgage lending as part of a larger campaign.
In April 2020, it was also announced that Turkish banks needed to maintain an asset ratio of at least 100%, though this was subsequently lowered to 95% for deposit banks (Islamic banks were given a lower 80% ratio requirement). This was part of efforts to pump money into the economy during the pandemic, with the rule effectively forcing private banks to lend and buy more government bonds. The regulation was repealed in November as part of normalisation efforts.
Interest rate volatility is the biggest issue, because some banks are relatively less resilient
At the same time, early on during the pandemic, banks in Turkey began to allow clients to postpone paying loans, while regulatory forbearance relating to loan classification was also introduced, meaning NPLs could be classified as 180 days overdue rather than 90 days, and Stage 2 loans as 90 days overdue rather than 30 days. “Loan deferrals create seasoning risks and potentially delay the recognition of problem loans, while also supporting borrowers and banks through the pandemic by giving them some breathing space,” says Lindsey Liddell, head of Turkish bank ratings at Fitch Ratings.
These measures, combined with higher volumes of loans, have meant that the percentage of loans classified as non-performing has shrunk overall.
“If you look at the NPL ratio for this market, at the end of February 2021 it was 4%, and at the end of December 2019 it was 5.3%. We have a scenario where NPLs have actually gone down in this country,” says Ms Liddell. “However, reported NPLs do not fully capture underlying asset quality weakness, in our view.”
Foreign currency
The make-up of the loan book is also a continuing source of concern, with FX loans making up 44.6% of Turkey’s corporate loan book, according to Capital Economics. The central bank also has just $11bn in foreign currency reserves, after state banks sold $130bn in 2019 as part of efforts to stem the devaluation of the lira.
Domestic foreign currency deposits actually grew by 20% to $236bn in 2020, which helped support foreign currency liquidity and banks’ repayment of foreign debt. However, if deposit flows were to be reversed, the risk would be significant.
In early April, Fitch said that refinancing risks for Turkish banks had increased following the change of governor. However, liquidity is “sufficient to cover a short-lived market closure and a moderate outflow of foreign currency deposits,” it added.
Erich Arispe, Fitch Ratings
There is considerable risk here, with Turkey being in no position to defend the lira for any length of time, which could result in further depreciation of the currency and more instability for its banks.
“Every time the lira depreciates, this increases the debt service burden for foreign-currency borrowers,” says Ms Liddell. “This is also a highly exposed banking sector in terms of investor sentiment, given banks’ large share of foreign liabilities (equivalent to 20% of sector funding at end-2020) — a high proportion of which is short-term, which leaves them vulnerable to shifts in market sentiment.
“The latter situation is attributable to the fact that there is very limited long-term local currency funding available to Turkish banks,” she adds. “This ultimately comes back to the fact that there’s weak confidence in the lira and inflation is high. It’s all connected.”
Looking ahead
Since the beginning of the pandemic, some had been predicting a retrenching of the banking sector, potentially leading to mergers or some foreign players reducing their exposure to the market. In February 2020, UniCredit reduced its stake in Turkey’s third-largest lender, Yapi Kredi, from 31.9% to 20%, selling shares worth $484m.
However, with such a concentrated banking sector, big changes seem unlikely. “At the top level it’s less likely, but we might see some underperforming small tier-two, tier-three bank mergers or acquisitions — some kind of consolidation might happen,” says Metin Esendal, director of equity research at Renaissance Capital.
“If you’re a tier-two or tier-three bank, you need to be more aggressive, and when you look at the return on equity, you’re making less than your cost of equity, and eventually these types of consolidations happen,” he adds.
However, Mr Esendal points out that these deals would have likely happened anyway. “It will just accelerate what would otherwise have happened in the next five years; it doesn’t change the overall situation.”
Looking ahead, much could depend on decisions taken at the central bank level, and by how long the pandemic’s effects on the economy last.
Ms Onur says that Seker Invest was predicting the first quarter of 2021 to be the worst in terms of margins for Turkish lenders, and expecting to see some improvements from the second quarter onwards. However, this was before the recent changes at the central bank. “Now we have a slightly different outlook. The second quarter will probably be the weakest one in terms of the margin outlook of the banking sector,” she says.
