A collection of key economic and political figures that we believe help to frame how we got to where we are today.

Government fiscal and debt metrics are strong but pro-growth fiscal policy risks deterioration. At the point they are forced into using fiscal buffers, the market will have repriced the risk sharply.

  • In recent history, low Government debt levels and fiscal prudence have been relative strengths of Turkey.
  • Public debt has been stable and the government recognises fiscal responsibility is necessary to offset structural weakness in other parts of the economy.
  • This, in theory, gives the government space to borrow if required to meet contingent liabilities, however the International Monetary Fund (IMF) recently highlighted that contingent liabilities of Public - Private Partnership (PPP) could be ~10% of Gross Domestic Product (GDP).
  • The banking system is estimated to require capital of ~10% of GDP in the event Non-Performing Loan (NPL) stress.
  • Prudent fiscal policy is required to sustain longer-term inflows as fiscal sustainability means predictability in fiscal policy.
  • Fiscal trajectory is negative as government focusses on a politically motivated spending led growth strategy. Growth reached 7% in 2017 and is putting pressure on the economy.
  • Loose fiscal and monetary policy in an economy at risk of overheating are leading to a potential hard landing for Turkey.

Loose financial conditions allowed Turkey to access external financing without addressing structural issues. As a result inflation as spiked sharply and:

  • Turkey’s structural weaknesses make it one of the most vulnerable economies in emerging markets (EM) as they have:
    • Low Foreign Currency (FX) reserves
    • A large current account deficit and short term external liabilities
    • Unanchored inflation expectations
    • A large corporate net FX exposure
    • Institutional weakness, of which lack of central bank independence is critical
  • Erdogan’s unorthodox economic policies and apparent unwillingness to address the underlying issues are exacerbated by limited buffers to absorb shocks.
  • The current account deficit is one of the highest in EM and they have the largest negative Net International Investment Position (NIIP) position in the EM peer group. NIIP has deteriorated from 49% of GDP in 2012 to 62% in 2018.
  • The inflation target is 5% but forward inflation expectations are at their highest levels at 16+%
  • High inflation erodes real returns on Turkish assets and constrains portfolio inflows. 

Given Turkey’s large external financing needs and minimal reserve buffers, Turkey is vulnerable in a post-QE world. Will Turkish banks need to rollover loans to European banks?

  • The gross external financing requirement of $230bn is the sum of short term foreign debt and the current account deficit, i.e. funding needs for the next 12 months. This consists of $175bn of short term debt repayments and ~$55bn current account. A 30% depreciation in Turkish Lira (TRY) increases this number by USD66bn.
  • Even after excluding items such as trade credits and non-resident deposits (approximately a third of total number), there is still a need for ~$12bn monthly external refinancing.
  • The net FX position measures corporate FX assets minus liabilities. This reveals a significant exposure to FX debt. If a corporate is not earning FX (via exports or $ linked revenues) TRY depreciation weakens their ability to repay interest/debt. There have already been several big ticket debt restructurings recently.
  • However the short term net FX corporate position is +USD6bn indicating that short term pressures are not as acute.
  • Mitigating factors are:
    • Natural FX hedges of the largest borrowers
    • Off balance sheet hedging
    • Foreign deposits of owners can be repatriated
    • Government legislation to limit small and medium size enterprise FX borrowings
  • However given net reserves of only $34bn and a weak external backdrop (for example 2 year US tsy yields at 2.6%) the risks of a sharp TRY devaluation and a funding crisis are meaningful.

Turkey’s reliance on short-term external funding exposes it to reversals in investor sentiment and Fed rate hikes.

  • The other key issue is that external imbalances were funded in large part by portfolio inflows. A significant portion of these are “hot” money that are highly sensitive to global market conditions. This is evidenced by portfolio inflows which so far in 2018 have been zero, compared to IMF estimate of 50%.
  • Foreign Direct Investment (FDI) was close to zero in January and February 2018 (versus 0.9bn 2017) highlighting weak FDI flows. This is also an indication of lack of private investment depriving Turkey of a source of “good” funding.
  • Given the lack of FX reserve buffers and the political and economic sensitivity to FX rates, the main policy lever left is interest rates.
  • The Central Reserve Bank of Turkey (CBRT) responded to TRY weakness with a 525bp hike in rates since November 2017, but inflation is also likely to jump to 16% leaving ex-post real rates of 1.5% that are low relative to EM peers.
  • The first MPC meeting after Presidential elections were expected to hike in order to contain rampant inflation, but were kept on hold.
  • The Government has effectively refused to use interest rates as a policy tool to contain inflation.

The banking sector has started to feel the stress and although they are in theory FX “hedged” they are still exposed through FX lending to corporates.

  • The banking sector has traditionally been strong with high Capital Adequacy Ratio (CAR), low NPL’s and strong profitability.
  • However amid rapid TRY depreciation Turkish banks have experienced deterioration in asset quality, as evidenced by several recent high profile and big ticket debt restructurings.
  • Fragile sectors are construction, utilities and energy. Large corporate restructurings include OTAS (telecoms), Dogus (diversified), Yildiz (consumer), Gama (diversified) and Bereket (energy).
  • Although the traditional measure of NPL’s remain low at 3%, stage 2 NPL’s (a broader and more relevant measure) are 8+%.
  • TRY depreciation will also negatively impact CAR ratios to the tune of 30bp to 90bp however this is likely to be partly offset by positive impact of the government Credit Guarantee Fund as these loans have zero risk weighting.
  • Loan to deposit ratios are very high. Reflecting a structural position whereby Turkish banks borrow in USD markets and lend locally in TRY. However the net open FX position of the banking sector is relatively low as they use off balance sheet derivatives to hedge.
  • A key issue is Turkish banks rolling over loans. Typically the Turkish corporates borrow FX from local banks, and local banks borrow FX from foreign banks through bonds and loans. Given the political and economic noise there is a risk that loans are not rolled and this maybe a key trigger for a shutdown in liquidity. However these wholesale loans are private and bilateral and therefore hard to find detailed information. 

US Fed hiking cycle, higher oil and USD strength are all putting pressure on Turkey as evidenced by TRY being the worst performing currency.

  • The global backdrop rising US rates, stronger USD and higher oil all lead to TRY weakness and further risks to the ability of Turkey to access external funding.
  • With a Fed hiking cycle taking US 2year treasury rates to 2.5% Turkish assets look less attractive.
  • Turkey is an energy importer and a large part of the current account deficit is oil. The oil price in TRY is at all-time highs (including 2008 when oil prices peaked at $140).
  • USDTRY started the year at 3.8 and spiked to 4.9 intraday (+29%) until the CBRT hiked rates. 

Investors in EM like “convergence stories”. However Turkey has gone from EU convergence to divergence as an increasingly anti-West and Russia aligned strategy is followed. Sanctions are a risk. 

  • A “numbers” approach does not lend itself to analysis of politics. However:
  • The recent referendum in Turkey resulted in an Executive President system and effectively gave Erdogan “infinite” powers and he is now able to rule by decree. In theory, Parliament has some blocking powers but Erdogan also holds a majority in parliament.
  • From being an EU ascension candidate Turkey has become increasingly isolated from the West in general as it pursues a domestic agenda that is populist and at odds with US policy.
  • Turkey is at risk of sanctions from the US on multiple fronts and also there has been a dangerous shift of Erdogan into Russia’s sphere of influence.
  • Turkey is purchasing a sophisticated Russian missile system (S-400). As a result, the US Senate has blocked the sale of F-35 “stealth” jets to Turkey and sanctions are being considered.
  • The move towards Russia can also be seen in projects such as the Turkstream pipeline, which aims to bypass Ukraine and is seen as a key project to increase Russia’s power in the region.
  • Pastor Brunson, a US citizen, was arrested as a bargaining chip for the extradition of Gulen, a Turkish Cleric living in the US, who was accused of orchestrating the 2016 coup attempt in Turkey. The US Senate has called for sanctions.
  • The deputy general manager of Halk Bank was convicted of Iranian money laundering and imprisoned in the USA. The trial suggested that responsibility led all the way to the top. The fine has not been decided as yet however estimates range upwards from $1.1bn.
  • Iran is the second largest exporter of oil to Turkey accounting for ~25% of oil imports. The US has indicated it is less inclined to offer waivers as it has done in the past, given Trump’s more hard-line approach. So far, Turkey have described Iran as a “brother nation” and refused to stop the imports.
  • Turkish troops were deployed in Northern Syria to fight US supported Kurdish militia known as YPG. Turkey considers YPG an offshoot of the “terrorist” PKK organisation but the US needed them as the only effective force against ISIS. Military conflict between two NATO members was at one point a possibility.

 

Source for data: IMF 2018 ARTICLE IV CONSULTATION—PRESS RELEASE; STAFF REPORT; AND STATEMENT BY THE EXECUTIVE DIRECTOR FOR TURKEY.

The figures above are correct as at August 20 2018 and are subject to change with market movements.

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