The Turkish central bank meets tomorrow and is expected to hike rates 325 bp to 21%. The lira has stabilized since last week, after the bank pledged to act after the high August CPI print. However, the bank has tended to disappoint at every juncture during this crisis and we expect this streak to continue.
Finance and Economics Minister Berat Albayrak has offered nothing of substance since his conference call with market participants last month. Indeed, all he offered then were vague platitudes and promises but no details whatsoever regarding concrete action. Nothing has been done except some minor minor measures on FX swaps and reserve requirements.
President Erdogan has not yet reestablished 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. Albayrak has paid some lip service, but the fact that rates have not been hiked since June suggests a complete lack of central bank independence.
Meanwhile, President Erdogan just appointed himself chairman of Turkey’s sovereign wealth fund. He also jettisoned the entire management team. Zafer Sonmez, head of Turkey and Africa for Malaysia’s government investment vehicle Khazanah Nasional, was named general manager, while Treasury and Finance Minister Berat Albayrak and Erdogan’s son-in-law will sit on the board. The optics of this are bad, to state the obvious.
We continue to think that Turkey will only go to the IMF as a last resort. Despite first embracing economic liberalization, Erdogan has since turned away from orthodoxy. The IMF would prescribe greater central bank independence coupled with monetary and fiscal tightening, which we consider to be 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
In a previous piece (Lessons from the Past for Turkey), we discussed Turkey’s previous economic crises of 1994 and 2001. Here, we focus on the differing policy responses as well as the ensuing currency depreciation and spike in inflation during those episodes of market stress.
Due to a confluence of events, capital flight picked up in 1993, much of it domestic. The central bank governor resigned in July 1993 due to disagreements with the Prime Minister on the conduct of monetary policy. A ham-handed attempt by policymakers to control interest rates (sound familiar?) then followed. Facing a heavy debt servicing burden due to persistent budget deficits, the government tried to keep rates artificially low in 1993. Several debt auctions were canceled in Q4 2013, feeding into the negative market sentiment.
All these developments fed into the 1994 crisis. In January 1994, the lira was devalued and fell over 60% against the dollar through April before stabilizing near the lows. Inflation peaked at 131% in February 1995 and the recession was at its deepest in Q2 1994, when GDP contracted -11.3% y/y.
On the other hand, even a more orthodox approach did not guarantee success for Turkey. Turkey had trouble attracting inflows going into 2000. To address the growing problems in Turkey, 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.
Yet IMF aid and aggressive rate hikes were not enough to save the crawling peg, which was broken in February 2001. Before the peg broke, the policy rate was hiked to 100% and overnight interest rates spiked to nearly 5000%. After the crawling peg broke, the lira weakened nearly 70% in the following months. Inflation peaked at 73% in early 2002 and the recession was at its deepest in Q4 2001, when GDP contracted -10% y/y.
These previous experiences suggest that Turkey may be facing a no-win situation. In 1994, we saw that a mild policy response was not be able to prevent a deeper crisis. In 2001, we saw that an orthodox and aggressive response did not guarantee a positive outcome either. Whatever Turkey’s policymakers choose to do going forwards, it’s worth reminding ourselves that Turkey cannot escape the basic laws of economics. These laws will eventually dictate a significantly tighter monetary policy that will likely lead to deep economic contraction.
The lira has weakened about 46% 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 46% 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 greater 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. In real terms, bank loans are already contracting y/y. Eventually, NPLS are likely to spike.
The IMF expects GDP growth of 4.4% this year and 4.0% next year vs. 7.4% in 2017. GDP rose 5.2% y/y in Q2, which was the slowest since Q2 2017. Data so far in Q3 suggest the slowdown has intensified in Q3. Given all that we know right now, we see downside risks to these growth forecasts.
Price pressures remain high and likely to rise further. CPI rose 17.9% y/y in August, the highest since September 2003 and well above the 3-7% target range. With the lira up around 3% so far in August, there is some slight hope that inflation readings might stabilize a bit. However, we note that PPI rose 32.1% y/y in August, the highest since May 2003. This portends further acceleration in CPI inflation.
The central bank’s inflation forecasts have been revised but remain way too low. End-2018 inflation is now seen at 13.4% y/y vs. 8.4% previously. With only four months to go, we think inflation will end the year closer to 23.4% than to 13.4%.
Before things got out of hand, 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 eventually rise to 30-35% to make a bold enough statement to the markets. Argentina, which hiked rates to 40% in May, was forced to hike rates again to 45% and then again to 60% in August despite taking all the right measures and getting an IMF program in place.
Expectations for tomorrow are all over the place. At the extremes are 2 analysts looking for no change and 1 looking for a 725 bp hike to 25%. Median forecast is a 325 bp hike to 21.00%, which would basically mirror the disappointing 300 bp hike from the bank back in May. The bank has tended to disappoint at every juncture during this crisis, and we expect the same tomorrow. We think that even a consensus 325 bp hike would be taken as a green light to sell the lira again.
It’s worth noting that the bank has undertaken stealth tightening. In August, the bank pushed commercial banks out of borrowing at the 1-week repo rate of 17.75% and forced them to obtain funding at the Overnight Lending Rate of 19.25%. This is where the average cost of funds has stood since mid-August. Strangely enough, M3 growth is accelerating and grew a whopping 35% y/y in August. This makes no sense and bears watching.
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. The 12-month total trade deficit has narrowed two straight months, with imports contracting y/y in both June and July.
Foreign reserves have dropped steadily over the course of the year. In January, reserves were $91.4 bln but have fallen to $70.4 bln in August. They cover barely 3 months of imports and are equivalent to a little more than 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 $26.2 bln in August and shows even greater external vulnerability. Lastly, Turkey’s Net International Investment Position is a whopping -60% of GDP.
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. Its negative NIIP is also larger now. By any metric, Turkey’s external vulnerability is at an all-time high.
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 -40% and is behind only the worst performer ARS (-51%). 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 -22% YTD and compares to -13% YTD for MSCI EM. With growing risks of a hard landing, we expect Turkish equities to continue underperforming despite a NEUTRAL weighting in our EM Equity Allocation model. The banking sector remains particularly vulnerable.
Turkish bonds have underperformed. The yield on 10-year local currency government bonds is +802 bp YTD and is the absolute worst EM performer. The next worst is Argentina at +747 bp. Shorter-dated paper has fared even worse because of the 17.75% policy rate. With inflation likely to move higher and the central bank eventually forced to tighten policy further, we think Turkish bonds will continue to underperform.
Our own sovereign ratings model showed Turkey’s implied rating fell a notch to B/B2/B, reversing last quarter’s rise. We still think Turkey faces very strong downgrade risks to its B+/Ba3/BB ratings. Fitch has already warned that unhedged external debt obligations will weaken the nation’s credit metrics, and downgraded Turkey a notch in July and kept the outlook negative. On August 17, S&P downgraded Turkey a notch to B+ and Moody’s did likewise to Ba3. Like Argentina, what happens going forward will depend on how long the current market turmoil drags on, as a deep recession will hurt many of Turkey’s already poor credit metrics.