Turkish policymakers continue to stumble. The ban of three foreign banks from trading lira was quickly reversed, adding to the sense of disarray. Indeed, this feels like a rerun of the last lira crisis back in August 2018. Surprisingly little has changed fundamentally in the nearly two years that have passed, as officials have largely refrained from taking any significant actions except those that make it even harder to invest in Turkey. Turkey used to be the darlings of EM. Now, we fear it will end up being like Argentina, where it will take a generation for foreign investors to return.
Turkish regulators banned three major foreign banks from trading lira last week. Why? Reportedly for failing to fulfil their liabilities in lira transactions with local banks and taking “manipulative” positions against the currency. These are some of the biggest FX banks in the world and so this will of course lead to unintended consequences. Indeed, FX liquidity quickly dried up, leading to wider bid/ask spreads.
The move came hours after regulators were given more authority to prosecute alleged market manipulation. Indeed, the definition of “manipulative” was expanded to include trades that generate “misleading pricing” or keep asset prices at “abnormal or artificial” levels. Obviously, there is a lot of leeway here but the net impact is that it will a chilling impact on FX trading.
After a couple days of erratic market conditions, Turkish policymakers reversed the ban before trading began Monday. True to form, President Erdogan claimed Turkey was under attack from foreign forces. The reversal does nothing to reverse the damage done to investor confidence. If anything, the utter unpredictability makes things even worse.
This isn’t the first time authorities have tried to strong-arm financial institutions and it won’t be the last. However, the big difference this time is that foreign banks were being directly targeted. In the past, the authorities leaned on the local banks to change their trading relations with foreign banks. For instance, the central bank last year limited the amount of lira swaps that local banks could do with foreign counterparties.
Will there be any significant impact? It may have a temporary one, but not a lasting one. The knee-jerk reaction has taken USD/TRY from the all-time high near 7.27 last week to back below 7.0. Yet the external environment argues for further lira weakness. Removing counterparties will solve nothing. Period. Every country is grappling with the pandemic, with EM particularly vulnerable due to the reliance on global growth and foreign capital flows. Both have turned very negative for EM and so lira weakness is to be expected. On top of that, the central bank is cutting rates aggressively. All signs point to resumed lira weakness ahead.
Indeed, the moves will likely exacerbate the problem by driving foreign investors further away. Turkish policymakers are completely misreading the situation. It’s not speculators that are the problem. It’s the policymakers that are the problem. Simply put, they have relied too much on unorthodox policies that are opaque and unpredictable. Real money foreign investors want transparency and predictability and if they don’t get that in Turkey, they will go elsewhere.
Reports suggest Turkey approached the US about a dollar swap line. We doubt Turkey will be granted one in this current environment. Turkey’s relations with the West and particularly the US have frayed in recent years. It pays to have good friends in times of need but Erdogan has basically self-isolated in recent years, preferring to throw in his lot with Russia regarding the Syrian situation. With oil prices depressed, Russia is in no position to help Turkey now, to state the obvious.
We think Turkey will only go to the IMF as a very last resort. Despite first embracing economic liberalization, President Erdogan has since turned away from orthodoxy. The IMF would likely prescribe greater central bank independence coupled with fiscal tightening and no FX intervention, which we consider deal-breakers for Erdogan. Yet market turmoil may eventually force him to go cap in hand to the IMF. We believe that conditions for EM remain unfavorable, with greater stresses to come for idiosyncratic risks like Turkey, South Africa, and Brazil. Turkey is simply not prepared (or able) to go it alone.
Investors should be prepared for the possibility of strict capital controls. This is not our base case, but the odds are clearly rising with each desperation move that Turkey takes. When a country is running unsustainable policies, capital controls are often the only way to square the circle.
This is a variation on Robert Mundell’s so-called “Impossible Trinity.” Mundell showed that it is impossible for a country to simultaneously have a fixed exchange rate, allow free capital flows, and run an independent monetary policy. A country can only have two of the three. While Turkey no longer has a fixed exchange rate, it is trying to influence it even while allowing free capital flows and cutting rates independently.
To put things into perspective, the lira has weakened 15% year to date and around 25% since the beginning of 2019. As such, we are not yet approaching the magnitudes seen during the 1994 (60%) and 2001 (70%) crises (see Brief History Lesson at the end for more details). The biggest difference is that the lira is no longer pegged and so risks of FX overshooting is much more limited. We have always felt that a floating exchange rate acts like a shock absorber. While a 25% 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 faces a deep recession this year. The IMF is forecasting a contraction of -5% this year followed by 5% growth next year. During the 1994 crisis, the economy contracted -5% that year. During the 2001 crisis, GDP contracted -5.9% that year. Both times, the central bank followed orthodox policy and hiked rates to defend the lira. The higher rates have to go and the longer rates have to stay high, the greater the economic costs. Today, we are seeing a much more unorthodox policy framework, to put it mildly. Regardless, bank loans are likely to contract and NPLS are likely to spike.
Price pressures remain stubbornly high and likely to rise 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. After the last lira crisis in 2018, inflation spiked as high as 25.2% y/y that October before falling back. Inflation remains elevated, however, with CPI rising 10.9% y/y in April, the lowest since November but still well above the 3-7% target range.
The Turkish central bank’s latest inflation report seems too optimistic. The bank cut its inflation forecast for this year from 8.2% to 7.4% and pencilled in a further decline to 5.4% in 2021. With the lira down nearly 16% so far in 2020, there are clear upside risks to inflation going forward. Note PPI rose 6.7% y/y in April, also the lowest since November. Keep an eye on PPI for signs of inflation pass-through from the weak lira.
Can the central bank continue to cut rates? Yes, and that’s what its updated forecasts say. It’s clear that the bank intends to take unorthodox measures to support the lira even as it continues to cut rates. The bank has already cut the policy rate from 24% in June 2019 to 8.75% currently. Next policy meeting is May 21 and another cut is expected.
Despite the downturn, the external accounts are likely to worsen. 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. Both improvements came from a collapse in imports due to deep recession. Now, the current account is moving from surplus back into deficit over the last four months and this is another rising vulnerability for Turkey.
Foreign reserves have dropped steadily over the course of the year. In December, reserves peaked at $81.2 bln but have fallen steadily since to $52.7 bln in April and $51.5 bln in early May. This is the lowest level since 2006 and explains recent weakness. Reserves only cover about 2.5 months of imports and are equivalent to less 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 about $25.2 bln in April and shows even greater external vulnerability. That is why the authorities are trying to clamp down on lira trading, as further FX intervention is becoming unsustainable due to the low level of reserves.
The lira continues to underperform. In 2019, TRY fell -10% vs. USD and was ahead of only the worst EM performer ARS (-14.5%). So far in 2020, TRY is -15% and behind only the worst EM performers BRL (-32%), ZAR (-24%), MXN (-22%), RUB (-16%), and COP (-16%). Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect underperformance to continue.
Turkish equities are outperforming after a weak 2019. In 2019, MSCI Turkey was -20.5% vs. -17.5% for MSCI EM. So far this year, MSCI Turkey is -0.5% YTD and compares to -4.5% YTD for MSCI EM. With the economy going into recession on such weak footing, we expect Turkish equities to start underperforming. The banking sector remains particularly vulnerable. Our EM Equity Allocation model has Turkish equities at UNDEREWEIGHT and so we expect underperformance to continue.
Turkish bonds have underperformed. Despite sizable rate cuts, the yield on 10-year local currency government bonds is +84 bp YTD and is behind only the worst EM performer Brazil (+154 bp). With inflation likely to move higher and the central bank perhaps forced to pause its easing, 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 limited access to foreign currency to service its external debt, Turkish corporates and banks are finding it to be nearly third more expensive to service their external obligations now compared to the start of 2019 due solely to currency weakness.
Our own sovereign ratings model shows Turkey’s implied rating fell a notch to B/B2/B. This means Turkey faces strong downgrade risks to its actual B+/B1/BB- ratings.
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.