Turkey Watch: stimulus at the expense of stability

by: Anke Martens , Georgette Boele

In this publication: Turkey started the year on an optimistic note, but Covid turned the tide. The current account shifted into deficit and the budget deficit widened. At the same time, real interest rates quickly turned negative,   while risk perception increased and capital flowed out, so that reserves fell and investors shied away from the lira. Increasing interest rates meets political opposition, contributing to our expectation of more lira weakness.

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Turkey started the year on an optimistic note, but Covid turned the tide

After currency turmoil and economic downturn between mid-2018 and mid 2019 the Turkish economy had finally returned to growth in 2H19. GDP still grew 4.5% yoy in the first quarter of the current year, even as other emerging and advanced economies were already hit by the covid-19 pandemic. This resilience was due to robust domestic consumptive demand, helped by accommodative policies. In the second quarter, however, the tide turned and Turkey’s GDP shrank 9.9% yoy, the fastest decline since 2009. While PMI started signalling a bit of recovery (from very low levels) from June, we still expect real GDP to shrink 4.5% for the year as a whole. This compares to a pre-Covid positive growth expectation of about 4%.

The current account shifted into deficit while the budget deficit widened…

Amid the crisis, the external position has started to deteriorate. The current account stood at a deficit of USD19.7bn in 1H20, from a surplus of $8.7bn in 1H19, driven by remaining comparatively strong credit growth driving domestic demand, while import demand of the eurozone collapsed and tourism revenues tanked. Lower prices of energy imports provided some offset, but the current account is expected to stand at a deficit of 2.5% of GDP for FY20, compared to a 1.2% surplus in 2019. The budget balance was also hit by the crisis. Amid shrinking fiscal revenues and stimulus, the budget deficit is estimated to increase sharply to about 6% of GDP this year, from 2.9% in 2019. Government debt is estimated to increase from 31% in 2019 to 39% in the current year. Fortunately, this is still a relatively low level.

At the same time, real interest rates quickly turned negative…

Emerging markets globally have been decreasing their interest rates to counter the covid impact on their real economies. Turkey was already doing that at the time that the crisis hit. The policy interest rate has been falling since July 2019 from a high of 24%, to 12% at the end of 2019 and 8.25% since May of this year. Inflation did not come down at the same pace, however. As a result, the real interest rate has decreased from highs of around 8% in the summer of 2019, to around -3% currently. These rates make the currency less attractive to investors.

.. while risk perception increased and capital flowed out

Sovereign CDS spreads, an indication of how the market sees country risk, have more than doubled since the beginning of the year, and spreads are currently at or around the highs seen in the third quarter of 2018. Due to the increased risks, Fitch attached a negative outlook to its BB- sovereign rating in August, citing weakening of the external position and weak monetary policy credibility. Capital outflows were visible in many emerging markets globally (the “sudden stop” in March, in which non-resident portfolio outflows from EMs surpassed anything seen previously, was unparalleled).

…. so that reserves fell and investors shied away from the lira

The lira weakened in March and April, along with many other EM currencies, but at an above-average 11% against the USD. But when capital outflows lessened in many other EMs, they persisted beyond the initial COVID-19 selloff in Turkey. This was not visible in the lira exchange rate in June and July, as the central bank intervened heavily to support the lira. Since the start of August it appears to have abandoned the attempt, after which the lira resumed its decline. The Turkish lira has declined by 20% versus the dollar so far this year, making it one of the worst performing emerging market currencies. At the same time, gross foreign-currency reserves have fallen 40% since the start of the pandemic, leaving foreign-currency liquidity at a weak level. Turkey has relatively large external financing needs (external debt service is expected to stand at 49% of export revenues this year). The high external debt burden, which is for a large part in the hands of nonfinancial companies, has the potential to undermine bank asset quality. In combination with low reserves, it leaves Turkey vulnerable to shocks.

Increasing interest rates meets political opposition…

Increasing the main policy rate and thus supporting the currency may seem like an obvious path in the circumstances. However, the central bank under Governor Murat Uysal is under pressure to keep interest rates low, implementing policies supported by President Recep Tayyip Erdogan, who believes that high interest rates fuel inflation. So far, the central bank has dealt with this contradiction by tightening without increasing the main policy rate. Examples include halving the overnight borrowing limits of lenders and cutting liquidity limits to primary dealers to zero, and raising reserve requirements. The question is whether these back-door channels will be enough to stop the currency’s decline.

… contributing to our expectation of more lira weakness

Does the lira have room to recover in the near-term? We don’t think so as the dynamics will not change in the short term. The current-account deficit, fiscal deficit, weak growth and negative real yields, combined with domestic politics and concerns about the independence of the central bank are all negative for the lira. Foreign-currency reserves are low and there is not much room to intervene in currency markets to support the lira. We think at some point in time the central bank needs to take stronger action to stabilise the currency. So we expect more weakness in the near-term and some stabilisation followed by a recovery towards the end of this year and next year. This will also be the result of general dollar weakness.