Turkey Watch: Turkey saga continues, but contagion is expected to be limited

by: Marijke Zewuster , Georgette Boele , Nora Neuteboom

In this publication: The freefall of the lira has come to a halt for now. Substantial lira depreciation makes the corporate external debt burden increasingly problematic. A recession is on the horizon, but the depth of the recession depends on the measures taken. Spill-over to other emerging markets is expected to be limited. But there are plenty of other risks for the emerging market universe.

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The lira down 41% year-to-date

After we released our Turkey Watch – TRY to recover last week, the lira took another beating. USD/TRY rose above 7.2 last Friday, at its peak. Rising tensions between the US and Turkey added fuel to the fire, while measures to halt the fall were seen as insufficient.  Since then the lira has recovered somewhat, helped by the announcement this morning that FX swaps will be limited to 25% of banks’ equity (previously 50%). This will limit the ability of locals to do FX swaps. USD/TRY is now back to the low 6’s at the time of writing. The fall in the lira will result in a significant rise in the already high inflation rate (15.9% in July) in the coming months, and a sharp fall in purchasing power. Turkey is still in the eye of the storm and it is therefore difficult to forecast what the actual outcome will be. In all scenarios, however, a recession next year seems likely. Still, the magnitude of the recession and the pace of recovery later on will differ substantially depending on the policy choices that are made.

Difficult to find alternative financing

The measures taken by the government and central bank so far are not sufficient to turn the tide. President Erdogan seems uninclined to allow the central bank to raise interest rates, and even less so to ask the IMF for support. As the diplomatic spat between Turkey and the US continues to unfold – and as the US is the largest foreign holder of Turkish bonds (over 30% according to IIF) – the question arises as to how Turkey will be able to continue fulfilling its external financing requirement of around 25% of GDP this year. Erdogan hinted he is working on ‘alternatives’ such as China, Russia and Iran. Finance minister Albayrak confirmed this strategy by saying Turkey wants to diversify its foreign financing. While this may provide some short-term relief, it will not fundamentally solve the funding shortage that Turkey is facing. President Erdogan has in recent years tried to improve the relationship with the Gulf States. While the GCC would favour a stable Turkey, it is unlikely they will provide substantial support. The GCC just announced a support packages for one of its own members, Bahrain, which is projected to be in millions, not in billions, and which took over a year (!) to finalize.

Russia may indeed feel that the enemy of your enemy is your friend. However, Russia does not have the financial means to support Turkey. It has largely depleted its sovereign wealth funds, and still has high contingent liabilities because of its pension system. China may provide funding, but is unlikely to pick up the full bill, as this would also send a clear signal from China towards the US, which may not be in China’s foreign policy interests. While funding by non-Western countries may relieve some of the pressure of the funding shortage, it unlikely to be enough to cover the external financing needs.

With or without interest rate hike, a recession seems unavoidable

In 2017, 75% of the external financing requirements were financed by short-term portfolio flows, i.e. ‘hot money’ (see Turkey Watch: Turkey in Crisis), while FDI flows finance only a minor part. According to a recent publication of the IIF, funding of the external financing needs (estimated at around USD 200 bn, or around 25% of GDP) is still available. The rollover rate of external debt stood at some 110% in Q2, but the cost of funding is rising. In order to avoid an acute balance of payments problem, substantially higher interest rates and for example an agreement with the IMF are probably inevitable. This would probably trigger a recovery of the lira towards 5.5 versus the US dollar. Higher interest rates, however, would lead to a sharp slowdown in lending and most likely a contraction of the economy next year. The sharp fall in domestic demand will lead to fewer imports as well, and hence to an improvement in the current account deficit. Lower growth, higher interest rates and on balance a weaker currency would still make it difficult for certain companies to fulfill their external debt obligations, but an national debt crisis would be avoided. If the government opts to only hike rates in line with inflation, or worse, to leave interest rates as they are, capital outflows will continue, resulting in a further collapse of the lira of around 25%, which would equate to USD/TRY at around 8.2. More and more corporates will encounter difficulties to pay their debt obligations, while the imports of goods and services becomes increasingly difficult and very expensive. Most likely this leads to a more abrupt and more pronounced contraction of the economy and in the worst case to a sovereign debt crisis as well.

Spillover to other Emerging markets will be limited

At the start of the week, several other emerging markets, such as for example South Africa, Indonesia, Russia, Argentina and Brazil saw their currency weaken. Furthermore country spreads rose, while stock markets across the world were also hit. In Europe, spreads widened in several southern European countries and the euro dropped below 1.15. Still we think that this all is a temporary phenomenon. What makes Turkey stand out is the combination of a high current account deficit, and relatively high levels of private sector foreign indebtedness, of which a high share is short term. Looking at the current account deficit, only Argentina – with a deficit of 5% of GDP – comes close to Turkey, while Argentina has high foreign debt levels as well. Foreign debt levels have risen substantially in other emerging markets as well, such as Brazil, Chile and Colombia, but they have much lower current account deficits. It is therefore not surprising that Argentina would be hurt most. In May, Argentina hiked the interest rate to 40% and went to the IMF for support. This week Argentina hiked the policy rate further to 45%.

Still, there are plenty other risks remaining for emerging markets

In our base scenario, global conditions remain supportive for EMs, financial conditions accommodative, and contagion from an unfolding crisis in Turkey limited. There are, however, several factors which could cloud this picture. An escalation of trade tensions is for example an important risk, as is a sharp slowdown in China and a further sharp weakening of the Chinese yuan. Either would hurt trade and create downward pressure on commodity prices (particularly metals) and emerging market currencies, as well as weighing on the growth of many advanced and emerging economies. Monetary tightening in the US and a stronger US dollar are risks as well. This could hurt investor appetite in broader financial markets, and would affect capital flows to all emerging markets negatively. EMs with high external financing requirements, low FX reserves and a strong dependence on foreign portfolio inflows will be the ones most exposed to these risks. Particularly exposed are those that have weak fundamentals such as high corporate FX debt, weak public finances and/or political uncertainty. This points again to Argentina and Turkey as the countries that are most vulnerable to negative shocks in the global economy.