Lessons from the Past for Turkey

The Turkish lira continues to tumble as officials refrain from taking any significant actions. We look at two of Turkey’s past crises to gauge the economic toll that this current crisis is likely to take.

POLITICAL OUTLOOK

The current economic team is in over its head. Finance and Economics Minister Berat Albayrak has offered nothing except vague platitudes for the markets. Over the weekend, Albayrak said that the government has prepared an “action plan” to help Turkish markets. However, nothing was done except two minor measures on FX swaps and reserve requirements. Albayrak pledged not to seize any foreign currency deposits of its residence or forcibly convert them to liras.

President Erdogan must reestablish credibility with the markets. Kemal Dervis, Mehmet Simsek, and Ali Babacan are all well-respected names from the past. Nowadays, there are simply no officials in the cabinet of this stature. Turkey needs officials with experience navigating global financial markets to step to the forefront. Erdogan must also make a stronger statement on central bank independence.

Turkey’s relations with the West must be repaired. Erdogan has not exactly endeared himself to the Western powers. Yet his recent threats to form new alliances ring hollow. He cannot really rely on aid from Russia given that country’s precarious position. China too has its plate full with its own economic concerns and not in any position to offer significant aid. It was reported that Albayrak met with his Kuwaiti counterpart over the weekend to request aid but nothing has been forthcoming yet.

We think Turkey will only go to the IMF as a last resort. Despite first embracing economic liberalization, he has since turned away from orthodoxy. The IMF would prescribe greater central bank independence coupled with monetary and fiscal tightening, which we consider deal-breakers for Erdogan. Yet market turmoil may eventually force him to go cap in hand to the IMF. We believe the current EM sell-off still has legs, with greater stress to come for Turkey. It is simply not prepared (or able) to go it alone.

 

A BRIEF HISTORY LESSON

Turkey lurched from crisis to crisis throughout the 1990s. The nation experienced growing economic balances after liberalizing the current account in 1989. Commercial banks engaged in heavy offshore borrowing, and inflows of foreign capital allowed the government to run huge budget deficits of over -10% of GDP in the years before 1994. Even with access to foreign capital, the central bank was still printing money to fund these deficits. The resulting high inflation led to an overvalued exchange rate and growing current account deficits.

These imbalances came home to roost. FX intervention and rate hikes were not enough to stem the capital flight in 1993, much of it domestic. In January 1994, the lira was devalued and fell over 60% against the dollar through April before stabilizing near the lows. That year, inflation spiked up to over 100% while the economy contracted -5%.

An IMF standby arrangement was reached in July 1994. Key provisions included sharp increases in administered prices, cuts in government spending coupled with tax hikes, and privatization of state-own enterprises. The economy quickly bounced back, growing 6.6% in 1995 and 7.5% in 1997.

Turkey then experienced an even more severe financial crisis from 2000-2001. The seeds for this crisis were planted by the 1997-1998 Asian crisis. Even though that crisis had largely ended by 1999, Turkey did not really change its business model after the previous crisis. Still heavily reliant on foreign capital, Turkey had trouble attracting inflows going into 2000. The earthquake of August 1999 didn’t help matters, nor did an overvalued lira. To address the growing problems, the IMF approved a supplemental $7.5 bln package in December 2000 on top of the $4 bln standby that had been approved in December 1999.

As with so many EM crises, Turkey’s 2001 crisis had both banking and currency aspects to it. After the new government came into power in December 1999, policymakers introduced a crawling peg regime in an effort to anchor inflation and inflation expectations. Crawling exchange rate pegs were in vogue at the time for many of the CEE countries as they transitioned to market economies after the fall of the Iron Curtain. However, they rarely addressed the problem of chronic overvaluation.

Ahead of the 2001 crisis, Turkey’s banking system had systemic weaknesses. It had been deregulated without introducing sufficient regulatory oversight or supervision. Furthermore, the banking system was highly dependent on foreign funding, and faced a largest structural maturity mismatch as well as heightened currency risk. Thus, when one major Turkish bank faced a cut-off in interbank funding in late 2000, this quickly turned into a system-wide liquidity crisis as we entered 2001.

This in turn morphed into a currency crisis, helped by a healthy dollop of political risk. In February 2001, Prime Minister Bulent Ecevit and President Ahmet Sezer had a highly publicized feud regarding corruption. This fed into concerns that political instability was picking up which might lead to a potential government collapse. The bank tried to prop up the lira but by then, the writing was on the wall.

After the crawling peg broke in February 2001, the lira weakened nearly 70% in the coming months. Inflation spiked and the recession deepened, and this led to a series of bank failures. During the 199-20010 period, the Savings Deposit Insurance Fund (SDIF) rescued 18 banks in total, equal to about 12% of total assets in the banking sector. Loans contracted by nearly -30% during the crisis while NPLs surged. Due to large-scale losses by the state banks and the costs incurred by the SDIF, the budget deficit blew out in 2001.

Work to repair the banking sector was undertaken immediately by Banking Regulation and Supervision Agency (BRSA). Four areas of focus were restructuring state banks, resolution of the banks taken over by SDIF, strengthening the private banks, and improving the regulatory framework. Most importantly, a sovereign default was avoided. In June 2001, the government arranged a voluntary debt swap. The year after that, a voluntary debt swap was arranged for Turkish corporates.

The economic chaos of 2000-2001 paved the way for the landslide election victory by Erdogan’s Justice and Development Party (AKP) in November 2002. At that point, Erdogan was banned from politics for reciting a religious poem and so Abdullah Gul became Prime Minister. Erdogan then took over in March 2003 after his ban was overturned. He’s never looked back.

Once upon a time, Erdogan followed orthodox economic policies and stuck to a well-trodden secular path. When the AKP took over, it introduced significant structural reforms that included a new law on Foreign Direct Investment (FDI), privatization of state-owned enterprises (SOEs), and corporate tax cuts. These measures helped the Turkish economy recover from the crisis and take off, with growth averaging nearly 7.5% from 2003-2007.

The IMF had approved a $16 bln standby program for Turkey in February 2002, before the AKP came into power. Turkey stuck with that program, and a new $10 bln standby was reached in May 2005 with the Erdogan government. This one was successfully completed in 2008, and Turkey has not needed IMF help since then. Until now.

 

ECONOMIC OUTLOOK

To put things into perspective, the lira has weakened about 50% since last September. As such, we are approaching the magnitudes seen during the 1994 (60%) and 2001 (70%) crises. The biggest difference is that the lira is no longer pegged. We have always felt that a floating exchange rate acts like a shock absorber. While the 50% loss in the lira is causing stresses in Turkey, it is much less disruptive than a broken peg. Even if the lira goes on to weaken further, the stepwise nature does give domestic agents some time to adjust. That’s pretty much it for the good news.

With regards to the bad news, the economy is in danger of a hard landing. After the 1994 crisis, the economy contracted -5% that year. After the 2001 crisis, GDP contracted -5.9% that year. The higher rates have to go and the longer rates have to stay high, the greater the economic costs. As such, we see rising risks of a deep recession in 2019. Bank loans are likely to contract and NPLS are likely to spike.

Price pressures remain high and likely to rise further due to the weak lira. After the 1994 crisis, inflation spiked to 106% that year. After the 2001 crisis, inflation remained high at 54.4% that year. CPI rose 15.8% y/y in July, the highest since October 2003 and well above the 3-7% target range. With the lira down nearly 30% so far in August, there are clear upside risks to inflation going forward. Note PPI rose 25.0% y/y in July, the highest since July 2003, which also portends further acceleration in CPI inflation.

Before things went pear-shaped, we had thought a rate hike to 25% would be a good first step in stabilizing sentiment. That is no longer the case. Now, we think rates would have to rise to at least 35% to make a bold statement to the markets. How far rates eventually need to rise depends in part on sentiment and how high inflation spikes. Argentina, which hiked rates to 40% this year, was forced to hike rates again today to 45% despite taking all the right measures and getting an IMF program in place.

The external accounts are likely to improve. After the 1994 crisis, the current account moved from a deficit equal to -3.6% of GDP in 1993 to a surplus equal to 2% of GDP the next year. After the 2001 crisis, the current account moved from a deficit equal to -3.7% of GDP in 2000 to a surplus equal to 1.9% of GDP the next year.

Foreign reserves have dropped steadily over the course of the year. In January, reserves were $91.4 bln but have fallen to $78.3 bln in July. They cover about 3 1/2 months of imports and are equivalent to about a third of the stock of short-term external debt. However, usable reserves (which net out commercial bank FX deposits at the central bank) were only about $27.9 bln in July and shows even greater external vulnerability. Thus, FX intervention is off the table.

 

INVESTMENT OUTLOOK

The lira continues to underperform. In 2017, TRY fell -7% vs. USD and was ahead of only the worst EM performer ARS (-14.5%). So far in 2018, TRY is -46% and is the absolute worst performer. The next worst are ARS (-38%) and BRL (-15.5%). Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect underperformance to continue.

Turkish equities are underperforming after a stellar 2017. In 2017, MSCI Turkey was up 44% vs. 34% for MSCI EM. So far this year, MSCI Turkey is -21% YTD and compares to -10% YTD for MSCI EM. With growing risks of a hard landing, we expect Turkish equities to continue underperforming. The banking sector remains particularly vulnerable.

Turkish bonds have underperformed. The yield on 10-year local currency government bonds is +1018 bp YTD and is the absolute worst EM performer. The next worst is Argentina at +363 bp. Shorter-dated paper has fared even worse as a result of the 17.75% policy rate. With inflation likely to spike higher and the central bank likely forced to tighten policy further, we think Turkish bonds will continue to underperform.

Turkey’s external debt metrics are much worse now than they were in either 1994 or 2001. External debt as a share of both GDP and exports is higher now, as is the ratio of short-term external debt to foreign reserves. By any metric, Turkey’s external vulnerability is at an all-time high. While the sovereign has access to foreign currency to service its external debt, Turkish corporates and banks are finding it basically twice as expensive to service their external obligations.

Our own sovereign ratings model showed Turkey’s implied rating rose a notch to B+/B1/B+, reversing last quarter’s drop. However, we still think Turkey faces strong downgrade risks to its BB-/Ba2/BB ratings. Fitch has already warned that unhedged external debt obligations will weaken the nation’s credit metrics, and downgraded Turkey a notch last month and kept the outlook negative.