Turkey Watch – The crisis: a long time coming

by: Nora Neuteboom , Georgette Boele

  • Turkey will face a severe crisis; we have adjusted our growth forecast to -3% in 2019
  • Troubles have been building up over time. US diplomatic spat was the trigger for the currency crisis
  • Non-financial corporate sector is directly in the line of fire
  • Crisis will spill over to the banking sector and FX liquidity issues will become more prominent
  • Government’s fiscal position will worsen on the back of support provided to banks/corporate sector
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Introduction

Over the last weeks, the Turkish economy has been caught up in a perfect storm. For some time now, there have been concerns about overheating as inflation is high (almost 18%) and the current account deficit has continued to deteriorate (currently 6.5% of GDP). In the latest round of presidential elections Erdoğan consolidated his power and further weakened the independence of the central bank. The lira started to fall sharply on 10 August, as the diplomatic spat between the US and Turkey escalated. Since the beginning of the year the lira has deprecated 42% against the dollar and 41% against the euro. Measures taken by the central bank, which resulted in higher funding rates for lenders and higher costs for holding TRY short positions, caused a short rebound of the TRY. However, this was not sufficient to allow a substantial recovery of the currency. 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 whether Turkey is still able to turn the tide and prevent an economic crisis. In this publication we elaborate on the causes of the crisis in Turkey and present our new base case scenario.

The crisis was a long time coming

While the proximate cause of the recent sharp currency deprecation may have been the diplomatic spat between Turkey the US, the ultimate cause lay deeper. The country has experienced a decade-long credit boom, largely funded by ‘cheap’ dollars and euros on international markets and funded by the government-backed Credit Guarantee Fund (CGF) loan scheme. According to the latest Article IV consultation by the IMF, a large part of this cheap credit was spent on non-productive investments such as the real estate market. Significant consumption and investments combined with a low savings rate resulted in a large current account deficit. The larger current account deficit was accompanied by a rise in non-resident portfolio inflows, which increased Turkey’s reliance on volatile short-term capital inflows (i.e. ‘hot money’). A very large share (around 75%) of the current account deficit is financed by short-term portfolio flows. As a result, Turkey is highly exposed to a change in investor sentiment. Increasing inflation, which reached almost 18% in August, on the back of high domestic demand, higher oil prices and lira depreciation, eroded household incomes. On top of that, under president Erdoğan, checks and balances have largely been eliminated from the Turkish political system. The president controls the media, the bureaucracy, and the courts. Erdoğan consolidated his power as he was re-elected in the first round of the presidential election on 24 June. He appointed several loyalists to important positions and weakened the independence of the Central Bank. On the back of these development, over the last 3 years, the credit rating agencies have been downgrading Turkey on a structural basis.

  

Global sentiment turned

These Turkey-specific developments play out in an environment of broader EM stress, with investors concerned about tensions between the US and China on trade policy. Meanwhile, the dollar is being supported by a strong US economy and the Fed’s continuation of interest rate hikes. This makes investment in EMs less attractive and has prompted a reversion of capital flows, in particular from the weaker EMs towards the US.

In light of recent events we have changed our base case scenario for Turkey and now expect the country to face a recession in 2019. Our scenario is based on the following assumptions:

1. We expect the US-Turkey relationship to deteriorate further

The pastor Brunson case has already resulted into sanctions from the US. Turkey pursued a nationalistic, tit-for-tat response, imposing tariffs on US products. The case is far from resolved as the Izmir court formally rejected an appeal to lift Brunson’s house arrest and travel ban. US Treasury Secretary Steven Munchin announced that further sanctions are “ready to be put in place” if Brunson is not freed. The US-Turkey partnership will be tested by a number of other issues as well. Firstly, there is the issue of US support for the Syrian Kurdish People’s Protection Units (YPG), which Ankara considers as a terrorist group related to the PKK. Secondly, Turkey’s purchase of S-400 missile defense systems from Russia defies US sanctions on Moscow and emphasizes Turkey’s increasingly cozy relationship with Russian President Putin. This has resulted in President Trump signing a law to prohibit the delivery of F-35s if Turkey follows through with the purchase. Thirdly, there is the Halkbank case. US authorities have accused Halkbank of violating the sanctions against Iran. The size of the fine is still uncertain. Last but not least, in the worst case Turkey may threaten closure of the US Air Force base at Incirlik. On social media, Turks have rallied in favour of the move. So far, we have not seen signs that this will actually happen, but if the US imposes further sanctions against Turkey, it is not a scenario we can exclude.

2. We expect the central bank to cautiously hike rates in line with inflation

In our Turkey Watch: July 24 crucial central bank meeting we explained that Erdogan is trying to improve the overall positions of households by stimulating economic growth. Therefore, so far, raising interest rates did not fit with the government’s growth strategy. Yet, as we already predicted, sharply rising inflation may put a halt to this strategy. With inflation trending towards 18% and thereby considerably eroding household incomes, we feel Erdogan may reconsider his strategy and perhaps choose to fight inflation after all (or will try to find a middle-way between curbing inflation and stimulating growth). This view is reaffirmed by the statement of the central bank on Monday 3 September that the monetary stance will be adjusted at the 13 September MPC meeting in light of the inflation data. We however do not foresee a ‘Argentina scenario’ of an aggressive hike and we think that the government opts to only hike rates in line with inflation (around 200bp on 13 September). Thereby they will continue to disappoint investors, who feel the central bank should take the drop of the lira into consideration by setting interest rates.

If there is further pressure on the lira, we anticipate that the CBRT will not increase interest rates but only set the funding requirements to the late liquidity window, which would effectively mean a further rate hike (300bp above the benchmark one-week repo rate). They may also take other measures to limit FX swap transactions, for example by capping currency swap transactions in which banks can engage as a percentage of shareholder equity. All in all, we think that rising rates in line with inflation, reintroduction of the corridor system and more actions by the CBRT to discourage short-selling won’t be enough to curb the fall of the lira, in part because of the one-off nature of some of these policy instruments.

3. Turkey will explore all other options before knocking on the IMF’s door

Turkey is not likely to request support from the IMF in the near future. First of all, Erdoğan will not agree to the conditions the IMF will attach to a loan, as these will certainty entail higher interest rates and an independent central bank. Furthermore, Erdoğan took much pride in paying off the IMF loans in 2013. If Turkey ultimately needs IMF support, we think the Monetary Fund will be open to negotiations. While the US can effectively block IMF financial support to Turkey (because such a decision must be approved by an 85% majority and the US has 17% of the votes) it would be an unusual political statement to do so.

4. We do not expect a consortium of countries to cover Turkey’s full funding shortage

Qatar has provided USD 15bn to Turkey, but only USD 3bn is cash funding. As explained in our previous Turkey Watch: Turkey saga continues, we expect neither other GCC countries, nor Russia or China, to solve the funding shortage. There is speculation that Germany is considering different options to provide financial aid to Turkey, including a coordinated European bailout. We feel this is unlikely, as it would cause significant resentment among voters in Germany and other European countries. According to EU officials, a bail-out would also require the involvement of the IMF, which would be politically difficult for Turkish policymakers. Germany may provide a bilateral loan to Turkey, but conditions at this point are still very uncertain.

5. Turkey will face balance of payments issues (especially the non-financial private sector), but the government will be able to repay its foreign debt

As explained in our Turkey Watch: TRY to recover, we still believe that the government will be able to repay its short-term financial obligations (short-term debt and principle payments). The private sector – not the government (as is the case for Argentina) – is the largest foreign currency borrower. According to the IIF, the non-financial corporate sector has built up substantial external debt in the past decade, from 30% of GDP in 2007 to 65% of GDP in 2018. Central bank data shows that in Q2 2018, USD 147bn of the USD 180bn in short-term debt was held by the private sector. The largest part is owned by banks (USD 81bn) and around USD 64bn is owned by the non-financial sector. Approximately USD 32bn of the total short-term debt is held by the public sector, largely by state-owned banks. This brings the external short-term obligations of the Turkish government to USD 4.3bn, a manageable amount. The official reserves stand at around USD 100bn, according the CBRT July figures.

Base case scenario: a deep recession

In light of all this, lira weakness is not over yet as capital outflows will continue. This could result in a further drop in the currency of around 20%, which means a USD/TRY of around 8.2. We expect inflation to trend upwards in the coming months, from a current level of around 18% to 21% at the end of this year. While declining consumption will push inflation down, higher import inflation will partly reverse this trend. We expect inflation to come down to 8% end-2019. According to the IIF, the drop in credit this quarter is even bigger than during the crisis in 2008/2009. This will weigh on activity, as Turkey’s growth is largely stimulated by credit growth. Imports will decline on the back of lower consumption and production. Exports may increase because the lira made Turkish exports relatively cheap for the rest of the world. However, as Turkey has a large import component in its exports and is dependent on oil and commodity imports, we do not expect the current account to turn positive.

Lower growth and a weaker currency, on balance, will make it difficult for certain companies to fulfill their external debt obligations. The non-financial corporate sector is directly in the line of fire and we expect restructuring and default rates to rise substantially. In particular, companies with large foreign currency debt, but that only receive part of their earnings in foreign currencies, will be under pressure. Most likely this will lead to a more abrupt and more pronounced contraction of the economy. In light of these factors, we expect Turkey to face a recession in 2019. We therefore adjust our growth forecast from 2% yoy to -3% in 2019.

Spill-over effects to the banking sector

So far, Turkish banks have held up well. Banks are well-regulated, although we have seen some regulatory forbearance slipping through in the last months. Capital adequacy ratios have been well above the 12% required by the regulator and repayments on restructured loans are around 80%. Still, under our current base case scenario, Turkish banks will also be impacted.

The tougher economic circumstances, tightening financing conditions and the weakening of the lira will further increase pressures on domestic borrowers with foreign currency debt. While current NPL ratios are still low (around 4%), they do not present a good picture of the asset quality because of regulatory forbearance. While Turkish banks are partly shielded from the sharp lira depreciation thanks to high FX reserves, it will be harder for them to attract foreign capital and swap it into lira loans, which will result in lower profitability.

FX funding problems at banks will increase

Turkish banks are reliant on foreign currency funding. A large part of banks’ FX funding comes from domestic FX deposits. However, Moody’s estimates that around USD 77bn of the FX funding of banks needs to be refinanced in next 12 months. The banking sector holds around USD 50bn in liquid FX assets and has an estimated USD 57bn reserves at the CBRT under the ROM mechanism, which they cannot fully withdraw under the current regulation. Banks are at risk both on the asset and the liability side. On the asset side, corporates will have to restructure their foreign currency loans, so there will be a deterioration in the FX asset quality. On the liability side, FX funding from foreign investors may dry up (or not be rolled over) and domestic deposit holders of FX deposits (estimated around 40% of total deposits) will start to withdraw their money. Banks that have a foreign parent, such as YapiKredi, Garanti, Finansbank and DenizBank are partly shielded from this FX liquidity risk. That said, banks will be forced to deleverage or may apply external funding from the CBRT or government.

Government’s fiscal position will worsen

Given the deteriorating economic conditions, some banks and corporates may request government support. The government already has some contingent liabilities due to the Credit Guarantee Fund (CGF). We estimate that around 13% of the total loan books of banks are covered by the CGF. Trade, manufacturing and construction account for more than 80% of the guarantee-supported loans, and these sectors are traditionally sensitive to economic cycles. Turkey has some fiscal space to cushion negative shocks, as the fiscal deficit stands at around 3% of GDP and government debt is 30% of GDP. As a result, the general government primary deficit is expected to increase to 4% in 2019 and the government debt dynamics are likely to deteriorate.