Turkey is at the top of investors’ worry list this week, and justifiably so.
The lira’s ongoing collapse (which culminated on Wednesday in the worst day for the currency since the coup attempt after an overnight slide triggered by stopped-out retail traders in Asia crystallized later in USDTRY surging towards 5.00) seems to be spilling over and affecting risk appetite more generally.
This was always the risk. Obviously, Turkey is an idiosyncratic story about Erdogan’s lunacy, but when it comes to emerging markets, there’s always idiosyncratic, country-specific risk. The question is whether external shocks (e.g., a stronger dollar and rising U.S. yields) will expose those risks and whether, once exposed, those vulnerabilities will catalyze an episode acute enough to cause contagion.
On Wednesday, we got a taste of how that can play out when the TRYJPY collapsed. Here’s Bloomberg’s Mark Cudmore:
The Turkish lira dominates again — slumping several percent rapidly in early-Asia trading as Japanese retail TRY/JPY positions were stopped out. The combination of that yen boost and the broader hit to sentiment weighed on Japanese stocks, and soon the whole region was trading poorly.
Of course not everyone is convinced of the potential for turmoil in Turkey to materially dent the broader EM complex, let alone spill over into developed markets. The skepticism implicit in that assumption might be misplaced.
For their part, Barclays is out with an expansive new take on why “this time looks different for Turkey”. And while it doesn’t speak much to the potential for knock-on pain, it does suggest the country is in more trouble than a lot of folks are letting on.
“Turkey’s current account (C/A) deficit is one of the largest in EM at 6.5% of GDP (excluding gold trade this reduces to 4.9%),” Barclays writes, adding that “if the annualised C/A deficit stays within USD50-55bn over the coming months, external financing of as much as USD4-5bn would be needed each month [and] in 2017, only 17% of the C/A deficit was financed by net FDI compared with a c.40% average during 2003-2011.”
The bank goes on to warn that Turkey has some USD182 billion of maturing external debt in the next 12 months, amounting to more than 20% of GDP, up 5 percentage points since 2011.
Barclays then states the obvious, which is that investor perceptions of the country’s fractious relationship with the EU (a relationship that deteriorated meaningfully during the refugee crisis) will invariably affect folks’ willingness to roll their debt.
In the same vein, the bank reminds you that the difference between investors demanding more compensation for taking credit risk and actual roll-over risk (i.e., the risk of people being unwilling to lend) is “fluid”:
Thus far, there have not been any signs of stress in debt rollovers (Figure 4 and Figure 5), suggesting that Turkey is likely facing re-pricing risk (ie, a debt rollover at higher interest rates) rather than roll-over risk. However, the distinction between mere re-pricing and true roll-over risk is fluid. Still, the USD12bn in monthly external refinancing needs (assuming a full rollover of trade credit and non-resident deposits) leaves Turkey quite vulnerable to sudden shifts in capital flows, in our view.
Yes, “sudden shifts in capital flows” which become more likely in the event the market loses confidence in the executive’s mental stability and which become even likelier still in the event mental instability manifests itself in efforts to commandeer the central bank.
Turkey also stands out in terms of private sector leveraging trends within EM (the BIS studies indicates a positive credit gap for Turkey as well; Figure 6). The rising private-sector debt-to-GDP ratio, led by the corporate sector, is also partly due to a ‘deepening’ of the financial sector. Nevertheless, increased corporate sector leverage makes Turkey more vulnerable to an external shock, especially when combined with accumulated stress on balance sheets due to persistent TRY depreciation. Turkey’s gross-external-debt-to-GDP ratio has increased by c.11pp to 53% since end-2014, led by the private sector but also due to a smaller GDP in USD terms. Since end-2014, Turkey’s private-sector-debt-to-GDP ratio increased by c.13pp, which contrasts with the situation in its peers such as Brazil and India (Figure 6 and Figure 7).
Well what about reserves? Or, more to the point, assuming Erdogan intends to defend his self-declared status as “the enemy of interest rates” and assuming he is indeed serious about triumphing over those same interest rates which, according to him, are “the mother and father of all evil“, does Turkey have any other means of defending itself? Here’s Barclays on that:
Net FX reserves are low: The CBT’s gross reserves (including gold) are small on a net basis (adjusting for FX liabilities including FX RRR and ROM), which limits the central bank’s ability to utilise its FX reserves to alleviate the depreciation pressures on the TRY against the backdrop of large external funding needs and risks of ‘potential’ capital outflows. Net reserves are about USD34bn, according to our estimates, compared with the 2013 average of USD43bn when the CBT sold USD18bn FX in H2, and an additional c.USD6bn in January 2014 (of which, USD3.2bn was direct FX intervention) ahead of the emergency rate hike on 28 January 2014.
We think the relatively low level of FX reserves has shifted the markets’ focus to the CBT’s willingness to defend the exchange rate though the interest rate channel.
And see that last bolded passage is a problem, because it means the market is squarely focused on the most negative aspect of this entire debacle, which is the central bank’s lack of independence.
The further into this you look, the worse it gets. According to Bloomberg, Turkish corporates are going to need to dig around in the couch cushions (or maybe the “Ottoman cushions” is better) for “an extra ~600 million lira to pay foreign-currency notes maturing in the next few months due to [the] currency collapse.”
Bloomberg also flags a surge in the cost of protection on Turkish bank debt.
Now with that in mind, let’s go back to Barclays:
As the corporate sector receives the bulk of its FX loans from domestic banks, TRY depreciation ultimately heightens the FX exposure of the banking sector. Domestic banks accounted for 64% of corporate FX borrowing in 2017 (27% in 2008), which was reflected in the banks’ increasing reliance on external funding (Figure 15). As of Q1 18, the share of banking sectors’ external liabilities in total liabilities had risen to 22% from 12% in 2008. Continued TRY weakness could lead some corporates to delay repayments or default on FX debt, which would ultimately weigh on banks’ capital ratios and lead to a tightening in lending conditions.
So you can see how this has the potential to spiral out of control as the whole thing becomes one giant, self-fulfilling prophecy.
Is there any good news? Well, not really. But Barclays does note that foreign ownership of local bonds and equities isn’t “excessive”, which would appear to limit the scope for a rout tied to capital flight.
Finally, for those wondering about the history of the lira and the evolution of monetary policy, here’s a handy chart from Barclays that shows you how acute runs on the currency have forced CBT’s hand in the past:
As ever, it all depends on the whims of a man who has variously promised to fight tooth and nail against the “scourge” of higher rates. The more power he has, the more impotent the central bank will ultimately be.
But as noted on Tuesday, you can trust him. He knows what he’s doing…