Turkey Watch – TRY to recover

by: Georgette Boele , Nora Neuteboom

In this publication: US sanctions and fears that Turkey will be unable to repay its foreign debt have caused a freefall of the lira. Our base case scenario assumes a lira recovery to 5 versus the US dollar by the end of 2018. Main risks to our scenario: (1) escalation of US-Turkish spat, (2) negative sentiment spiralling out of control and (3) economic policy mistakes by the Turkish government.

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The freefall of the lira is due to a combination of factors

So far this year the Turkish lira has declined by 22% versus a basket of currencies and by 30% versus the US dollar. The freefall of the lira is due to a combination of factors. For a start, investors have aggressively sold the lira because of Mr. Erdogan’s efforts to tighten its grip on the central bank, and to keep interest rates on hold. The Turkish economy shows widespread signs of overheating. The current account deficit stands at 6.5% and inflation has trended above 15% for the last two months.

This plays out in an environment of broader EM stress, with investors concerned about the ever-increasing tensions between the US and China on trade policy, and that the weakness in the Chinese yuan may also reflect weakness in the Chinese economy. Meanwhile, the dollar is being supported by a strong US economy the Fed continuing hiking interest rates. Finally, the failed negotiations over the release of a US pastor by Turkey, and the subsequent introduction of sanctions  by the US on two Turkish ministers, prompted a further fall of the lira over the last two weeks.

In light of these events, investors worry that Turkey won’t be able to finance its external financing requirement of around USD 218bn. As non-resident portfolio flows have been negative since February this year, the funding depends largely on the willingness of investors to roll-over Turkey’s short-term debt. The yield curve has inverted as the 2y yield increased to over 21%. Furthermore the CDS-spread (5y) surged to 354bp (see graph on the left above). These fears are stronger given Turkey’s history of sharp currency depreciations. Between 1960 and 2001, the lira depreciated dramatically, with the dollar strengthening from 2.8 lira to 1,650,000 lira. In 2005 the new Turkish lira was introduced by stripping six zeros from the exchange rate and the name changed to the New Turkish lira with currency code TRY (previously TRL).

Our base case scenario assumes that Turkey will be able to finance its external financing requirement for 2018/19

In our base case scenario we assume that – despite increasing vulnerabilities – Turkey will still be able to finance its external financing requirement for 2018/19 (see: Turkey Watch: Turkey in Crisis). Our scenario is based on the following assumptions:

  • Turkey has much to lose in case of further sanctions by the US. Therefore we think Turkey and the US will work towards a solution palatable to both sides.
  • While normalisation of US monetary policy poses a risk, its cautious approach and reliable forward guidance are limiting the risk of shocks in emerging markets as hikes are already mostly priced in.
  • A broader measure shows that net-capital flows are still positive as the pace of resident capital outflows has been limited and other non-resident flows, including FDI and banking flows, seem to have hold-up. Net capital flows are estimated to be around USD 24bn from January-June 2018 (see graph on the right above).
  • The private sector – and not the government (as is the case for Argentina) – is the largest foreign currency borrower. Over half of the total external debt stems from the private banks and the non-financial private sector.
    – Most of the non-financial private sector is (naturally) hedged. Furthermore, if FX liquidity shortages materialise due to the sharp lira depreciation, the government is likely to provide a back-stop. The government debt ratio is low (below 30% of GDP), and fiscal policy has been prudent in recent years. So the government is able to withstand a period of increasing contingent liabilities.
    – Banks are less vulnerable to lira depreciation. They have plenty of FX liquidity due to a dollarised deposit base. The FX loan-to-deposit ratio is below 85%, while the TRY loan-to-deposit ratio stands at around 146%.
  • We expect GDP growth to cool in 2019 to 2% from 5% in 2018, and the current account deficit is expected to come down to 3.5% in 2019 from more than 6.5% in 2018 (see: Turkey Watch: Crucial central bank meeting)

This will lead to lira recovery

In our base case scenario we think that weakness in the Turkish lira is overdone and a recovery is likely by the end of the year towards 5.0 versus the US dollar. However, in the near term the lira will remain under pressure if investors continue to doubt the ability of Turkey to refinance itself this year. This could result in another 5-10% slide in the lira before a recovery sets in. Next year, we expect the US dollar to weaken across the board. The Turkish lira will also profit from this, but only modestly, as the fundamentals are weak. Our year-end forecasts for USD/TRY for 2019 is 4.5.

There are considerable risks to our base case scenario

For a start, if the political spat between the US and Turkey escalates, the implementation of financial sanctions would paralyse the Turkish economy. Furthermore, negative sentiment towards Turkey and its ability to pay its external finance obligations could result in a downward spiral. Moreover, as explained in our previous Turkey Watch: A most decisive moment, we think there is a likelihood of economic policy mistakes. Turkey must recalibrate its macro-economic policies in such a way that it reduces the aforementioned vulnerabilities, and drives the economy towards a ‘managed slow-down’. This requires delicate policy-making, which may prove difficult given the high domestic political polarisation in a geopolitically unstable region. In case one of these alternative scenarios plays out, the lira could depreciate another 25%.