More Trouble Ahead for TRY as Central Bank Meets Thursday

Turkey’s central bank meets Thursday and is expected to keep rates steady. There is a slight chance of a hawkish surprise, but not enough to turn the tide of deteriorating fundamentals. Confidence in policymaking remains low even as the economy is in recession, and so we expect Turkish assets to continue underperforming.

POLITICAL OUTLOOK

Treasury and Economy Minister Albayrak presented a disappointing economic plan this month. With foreign investor sentiment remaining weak after the pre-election swaps fiasco, Albayrak needed to go big. He didn’t. His presentation was vague on many details, leaving investors underwhelmed.

As part of the plan, the government will inject fresh capital into state-owned banks. The government announced today plans to issue EUR3.7 bln ($4.2 bln) of bonds and the proceeds will be used to recapitalize the state banks. The government will also create two funds to take on bad loans.

This is Turkey’s first banking bailout since the 2000-2001 crisis (see A Brief History Lesson below). For the most part, the current moves seem engineered to maintain a credit-fueled recovery rather than push through much-needed structural reforms. Back in 2001, the bank bailout went hand in hand with serious reforms that were required then by the IMF. Without the IMF looking over its shoulder now, Turkey is trying to take the easy way out. We think this is destined to fail.

At this point, we do not believe Turkey will go to the IMF for help. The strict conditionality is simply a deal-breaker for Erdogan, who bristles at being told what to do. Rather, we expect Turkey would go to either Russia or China for help. While any bilateral aid would come with strings attached, it would not be as tough as anything the IMF would require.

Local elections were bad news for Erdogan and his AKP. In the last local elections in 2014, the AKP won control of both Istanbul and Ankara and so these races were key. It appears that the opposition CHP narrowly won the vote in Istanbul, but THIS is being disputed by the AKP. The election board just rejected one AKP claim for a new vote but is still considering another. The opposition had a larger margin of victory in Ankara.

Cracks may be appearing in the ruling AKP. Former Prime Minister Ahmet Davutoglu warned that the party “must face the reality of decreasing public support” due to “arrogant” policies.  Davutoglu is still a member of the AKP but is no longer an MP. Before getting too excited about this, we think Erdogan maintains an iron grip on the party, at least for now.

Lastly, Turkey is one of the countries granted waivers to buy Iranian oil. With the US letting those waivers expire May 2, Turkey will feel the pinch, regardless of whether it defies the US or not. The nation imports all its oil and higher prices will lead to wider trade and current account deficits ahead. Note that China and Turkey have said they will continue to buy Iranian oil.

 

A BRIEF HISTORY LESSON

Turkey experienced a severe financial crisis from 2000-2001. The seeds were planted by the 1997-1998 Asian crisis. Even though that had largely ended by 1999, Turkey continued to have trouble attracting foreign capital flows as it moved into 2000. 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. That program was augmented again by $8 bln in May 2001 to bring the total package up to $19.5 bln.

Ahead of the crisis, Turkey’s banking system suffered from systemic weaknesses. The industry had been deregulated without introducing sufficient regulatory oversight or supervision. The four largest state-owned banks accounted for around 30% of the entire banking sector, and they were increasingly relied upon to finance government spending.

Furthermore, the banking system was highly dependent on foreign funding. Besides this currency mismatch, the system also faced a large structural maturity mismatch by being too reliant on short-term financing. Thus, one major bank facing a cut-off in interbank funding quickly turned into a system-wide liquidity crisis. This in turn morphed into a currency crisis.

After the lira’s crawling peg broke in February 2001, the lira weakened nearly 60%. Inflation spiked, the recession deepened, and these factors all caused a series of bank failures. It was then that Turkish policymakers were forced to bail out the banking system. The so-called Banking Sector Restructuring Program (BSRP) was introduced in May 2001 with the aid and blessing of the IMF. That program totaled $77 bln, with $22 bln going to state-owned banks.

The economic chaos of 2000-2001 paved the way for the landslide election victory by Erdogan’s AKP in November 2002. Believe it or not, the AKP introduced significant structural reforms after it took over. These 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 approved another $16 bln standby program for Turkey in February 2002, before the AKP came into power. The AKP 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 sought IMF help since.

 

ECONOMIC OUTLOOK

The economy is in recession. The IMF expects GDP to contract -2.5% this year before growing 2.5% next year and 3.6% in 2021. GDP contracted -1.6% q/q in Q3 and -2.5% q/q in Q4, the first back to back drops since 2008-2009. Data so far in Q1 suggest the slowdown has intensified and so we see downside risks to the GDP forecasts. Commercial bank loans are contracting y/y in both nominal and real terms. NPLS are rising steadily and likely to spike as the economic slowdown deepens.

Price pressures are high and likely to move higher. At this point, the 3-7% target range has been rendered meaningless. CPI rose 19.7% y/y in both February and March. While down from the 25.2% peak in October, inflation is likely to move higher again. The lira was down 4% last month and has tacked on another 4.5% loss this month. Oil prices are moving higher, and so all things point to further acceleration in CPI inflation. April data will be reported May 3.

The central bank meets Thursday. No change in official rates is expected, though one lone analyst sees a 150 bp hike. For now, we expect the bank to rely on stealth tightening, as it did just before the local elections. Then, the central bank suspended all funding at the 1-week repo policy rate of 24% and shifted it to the overnight lending rate of 25.5%. After the election, the bank went back to offering funds to commercial banks at the 24% policy rate. The offshore swap market has also normalized since the election.

With the lira under steady pressure, the case for easing is no longer there. Instead, the conversation must shift to one of tightening. The more the lira weakens, the more likely tightening becomes. As the first line of defense, we expect more stealth tightening that raises the average cost of funding for banks first back to 25.5% and then to the 27% Late Liquidity Window Rate. We expect explicit rate hikes later this year.

The central bank’s next quarterly inflation report is due out April 30. In the last report released January 30, the central bank cut its inflation forecasts for 2019 and 2020 to 14.6% and 8.2%, respectively. These inflation forecasts should be raised significantly in the April report and could hold some clues to monetary policy going forward. The next meetings after this Thursday’s are June 12 and July 25.

The external accounts are improving sharply. The 12-month total trade deficit has narrowed nine straight months, with imports contracting y/y since June. Furthermore, the monthly current account readings moved into surplus for four straight months before moving back to deficit since December.

The IMF sees the current account moving to surplus of 0.7% of GDP this year from -5.7% in 2018 before moving back to a modest deficit of -0.4% next year. Note that 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.

Gross foreign reserves fell sharply ahead of the local elections but have since recovered. Or so it seems. Reserves were $79.1 bln in February but then fell to $71.4 bln in mid-March. Reserves have recovered to $76.7 bln in mid-April. At this level, they cover less than 3 months of imports and are equivalent to about 40% of the stock of short-term external debt.

Usable reserves net out commercial bank FX deposits at the central bank. These hit a new low of $24.7 bln in mid-March before recovering to $28 bln in April. This still shows even greater external vulnerability. Lastly, Turkey’s Net International Investment Position is still a rather high -46% of GDP.

Press reports suggest usable reserves are much lower than reported. The central bank reportedly engaged in some currency swaps with commercial banks to inflate its foreign reserves. Rather than the $28 bln being reported for usable reserves, reports suggest that the true number was below $16 bln. Frankly, both numbers are simply awful. However, the real takeaway is that the institutional framework appears to be breaking down further in Turkey.

 

INVESTMENT OUTLOOK

The lira continues to underperform. In 2018, TRY fell-28% and was behind only the worst performer ARS (-50.5%). So far in 2019, TRY is the second worst EM performer at -9.5%, ahead of only ARS (-11%). Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect this underperformance to continue.

USD/TRY is trading at its highest level since January 3, having broken above the more recent high near 5.8450 from March 22. The January high near 5.88 is the next big target but looking farther out, the recent break of a key retracement objective near 5.81 sets up a test of the October 4 high near 6.2280. A break of the 6.19 area would set up a test of the August 30 high near 6.8425.

FX policy has become unpredictable and that’s going to scare off foreign investors. Offshore liquidity dried up ahead of the elections, driving offshore interest rates sharply higher. Onshore banks were not providing any offshore liquidity, which we think was likely done at the behest of the government seeking to punish short TRY positions. Overnight rates spiked to over 1000% before normalizing.

While this may have had a short-term positive impact, the longer-term impact is clearly negative.  To us, this move was akin to capital controls and so foreign investors must think twice about whether they want to be active in a country that makes it nearly impossible to effectively hedge or exit real money positions in lira-denominated assets.

Turkish equities are still underperforming. In 2018, MSCI Turkey fell -20.5% and compared to -17.4% YTD for MSCI EM. So far in 2019, MSCI Turkey is up 4.4% vs. a 14.3% gain for MSCI EM. With growing risks of a protracted recession on top of further monetary tightening, we expect Turkish equities to continue underperforming. This supports the VERY UNDERWEIGHT in our EM Equity Allocation model. The banking sector remains particularly vulnerable.

Turkish bonds are underperforming. The yield on 10-year local currency government bonds is +139 bp YTD and is the worst EM performer. With inflation likely to move higher and the central bank eventually forced to tighten further, we think Turkish bonds will continue to underperform.

Our own sovereign ratings model showed Turkey’s implied rating steady at B+/B1/B+ after rising a notch last quarter. We think Turkey faces very strong downgrade risks to its B+/Ba3/BB ratings. What happens going forward will depend on how long the current slowdown persists, as a protracted recession will hurt many of Turkey’s already poor credit metrics.

Moody’s weighed in recently and it wasn’t good. It said that the reform program recently outlined by Albayrak provided little detail in several important policy areas as well as the actual timetable. The agency added that Turkey’s significant structural problems remain in place.