Question? What’s your general take on the Turkish macro/policy story
Answer: I am probably more worried now on the Turkey story than at any time apart from perhaps the 2000/2001 crisis.
Turkey’s vulnerabilities are well known – a structural current account deficit and reliance therefore on foreign financing. In 2020 the current account deficit amounted to around $35.6bn. Short term debt amounts to around $180bn, so that suggests a gross external annual financing need of around $215bn. This year the current account deficit has contracted given the weaker lira and a decline in gold purchases, but it is still likely to be $10-15bn for the full year in 2021, and best case close to balance in 2022. This still leaves the $180bn in short term debt to cover on annualised basis, and financing needs increase if we see dollarisation from locals and continued capital flight from foreigners. Set against this is net FDI which has failed to reach beyond $10bn since 2016, and looks unlikely to extend much beyond $6bn for the full year in 2021. Barring reserve intervention, Turkey needs foreign capital inflows to over its external financing needs.
Quite a lot of short term debt consists of trade credits which are very rollable, and Turkish banks and corporates have done relatively well at rolling their external liabilities – largely as they have long standing international banking relationships which have weathered numerous crisis in the past. But still it’s a constant threat/pressure rolling these credits, while also suffering flight from dollarisation portfolio outflows. The latter has slowed somewhat in recent years as the stock of foreign holdings of debt and equity are down to under $30bn, the lowest level in over a decade, and less than 30% of the peak. So there is less portfolio money to leave. In recent years FX deposits have increased around $20bn a year, so this still leaves the gross external financing requirement at around $200bn.
Set against the above, gross FX reserves stand at around $120bn, after another bout of FX intervention in recent weeks, likely to have amounted to around $6bn. Gross reserves sound a lot but net of liabilities, including FX RRRs, swaps, et al, the CBRT’s net reserve position is thought to be significantly negative, likely upwards of $50bn. The CBRT can intervene in theory drawing down gross reserves, but only likely pushing net reserves further into negative territory – spending other peoples’s money.
Central banks never like to run large negative reserve positions as it implies a fundamental lack of credit worthiness and risks a broader loss of confidence in the macro financial position. The banking sector is still relatively flush with dollar liquidity, because so far dollarisation has been captured by the banking sector, and then by the CBRT. But what happens if the population’s fundamental trust in the CBRT and the banks lapses, is there enough FX liquidity in the banking sector and CBRT to cover a run on FX deposits in the banks, likely not. This could quite easily end up in a Lebanon style scenario.
Question? Can Erdogan’s New Economic Model work?
Answer: Well it is probably useful first to describe what that model is. And let’s be direct here, I think the starting point is Erdogan’s ideological aversion to interest rates, based on his religious beliefs in the injustice of usury. Ex-poste his advisers have tried to fit an economic plan or model around it. But the plan or model seems to be to make the currency as cheap as possible to move the current account into surplus, to reduce the external financing gap, and to try and use the cheap currency to attract FDI, which the hope is will also cut the external financing gap.
That all sounds well and good, but the sheer extent of the exchange rate adjustment we have seen – two thirds year to date creates a number of risks. First, an exchange rate/inflation spiral. Exchange rate pass thru to inflation was already likely high in Turkey, but has likely risen over recent months to something like 40-50%, which means that the benefit of any nominal depreciation quickly gets eaten away by higher inflation, limiting the beneficial impact on the current account. This suggests the lira will have to continue to devalue to keep the competitiveness gains.
Second, sheer uncertainty on the exchange rate and inflation front – inflation likely will peak at over 50% YOY over the next few months – makes it very difficult for business to plan and invest. Will foreign direct investors really commit to Turkey when the economic outlook is now so uncertain – talk of capital controls as one option to stem FX depreciation? Third, with the lira rapidly losing its value the fear is continued dollarisation, and the risk that there might also be a loss of confidence in banks, bank runs resulting which will take the BOP crisis to a new level, likely a systemic banking and credit event.
And ultimately Erdogan is saying that he is taking interest rates out of the tool kit for managing the macro economy, then how can locals and foreigners have any real confidence in the ability of the Turkish authorities to stabilise the macro? This just leaves fiscal policy and macro financial policy. And there is a reason why no other G20 economy has thrown out interest rates from the economic policy tool kit – it’s because likely any such policy would simply not work.
Simply put; why should anyone hold lira, when inflation is currently 20%, but likely rising to 50%, while policy rates are just 14%, and deposit rates are close to that level. Holding lira will see one’s wealth erode over time and quickly. The temptation will be to sell lira as quick as one can, to avoid the impact of inflation. We have seen this story play out many times in EM – from Argentina to Venezuela. It never ends well.
So simple answer: I just cannot see Erdogan’s New Economic Policy working. Indeed, it’s a hugely risky policy which likely will fail but could well push Turkey into a systemic crisis where a balance of payments crisis results in a devaluation/inflation spiral, risks bank runs, a banking and perhaps even a credit and sovereign debt crisis. It could get really ugly.
Question? Well we have been here before with this interest rate policy and devaluation risk, but back in 2012/13, 2015, and 2018, and again in late 2020/21 Erdogan eventually did the right thing, and moved back to some form of orthodoxy, eventually raising rates. Won’t he do it this time?
Answer: Yes, he has always done the right thing in the past, eventually, but it feels different this time around. First, he has few orthodox thinkers left around him, having sidelined the likes of Babacan, Simsek, Agbal, and lately Elvan. I don’t think there is anyone left around Erdogan willing to tell truth to the boss. Those remaining just seem set on pandering to Erdogan’s ego for their own career progression. I doubt then he will be given the right advice at the right time. Second, I think Erdogan believes all this stuff, and is set on proving everyone wrong. He seems to have dug himself into a hole from which there is little hope of speedy extraction. It’s a case of “Erdogan unchained”.
Third, and listening to Erdogan’s rhetoric he is already seeming to set up fall guys if he ends up screwing the economy totally up – it will be the foreign speculators and investors which launched an interest rate war on Turkey. He will blame someone else and then run in the election on a nationalist ticket which attacks foreigners for their part in any Turkish economic crisis which resulted. His rhetoric does not appear to be one of a person getting ready to do an about turn. It feels like full steam ahead.
Question? Do you fear a systemic crisis in Turkey?
Answer: Well Turkey has well known strengths, including strong corporates and banks, well used to market volatility and living in an environment of high inflation and depreciation. The population are also well versed in these kind of situations. Banks are generally well run and have a strong risk management culture, they saw this coming and hence they built up their defences. Yes interesting that back in 2017/18 and the last big lira sell off, the question was at what level would corporate and banks get into difficulty with their FX liabilities. Interestingly this time around as the lira has gone thru 8, 9, 10 and now 17, almost 18, FX debtors seem remarkably sanguine. I think this relates to the fact that they saw this coming and either FX debtors are either exporters and naturally hedged or have built up FX buffers. But I am sure there will be a level for the lira at which questions will be asked about the ability of FX debtors to pay. Is that 20, 25 or 30, I simply don’t know. But the level at which the lira is devaluing, almost 30% over the past month, suggest that these levels might well be hit. So a credit event cannot be ruled out.
But I would watch for the behaviour of depositors. So far they have been dollarising but moving from lira to FX deposits in the banks. They have thus far trusted their banks. I think this relates to the success of the 2000/01 IMF inspired reforms which cleaned out the Turkish banking sector root and branch. But if confidence in the CBRT completely evaporates, with worries about the net reserve position of the central bank, it is unite possible we could see deposit flight and this would turn this crisis into a totally different animal, and more of a systemic style crisis.
Question? What do you make of the new FX indexed deposit scheme (DCM) ?
Answer: Interesting, and it came just at the right time in terms of seemingly shoring up confidence of the deposit base, as there were just beginning to be signs of potential bank runs this week – increased demands for physical cash from depositors. Thru this move Erdogan showed he recognised the seriousness of the problem, and affirmed his commitment to markets, and not capital controls albeit also not interest rate policy. It might hold deposits in the banking sector for a while, and might slow lira depreciation. But it does not really address the core of the problem which is an economy running too hot, high inflation and a large external financing gap. Policy makers need to accept a period of slower growth to help disinflation. But with elections due in the next 18 months or so, and Erdogan lagging in the polls, this seems unlikely.
Indeed, listening to Erdogan’s speech on December 20, he talked about boosting the credit guarantee scheme, and we have seen a big hike in the minimum wage. The DCM might actually further boost credit as banks might further reduce deposit rates, and the CBRT might feel emboldened to further cut policy rates. The DCM also implies more pressure on the fiscal balance, as the budget will have to bear the brunt of compensating depositors for FX depreciation. And in all this I don’t really see a strategy to fight inflation. In the near term, given exchange rate pass thru baked into the system, inflation could hit 50% YOY, this will erode the benefits of the nominal depreciation, as will the rally seen over the past 24h, unless we see a resumption of nominal depreciation, any benefits from the current account will erode. What seems likely here is election economics, fiscal and monetary loosening, more growth, sustained inflation and continued devaluation – which will now feed into a wider budget deficit, and weaker sovereign balance sheet. Turkey’s credit worthiness is being eroded by all this.
Question? What is your call for elections?
Well, they have to be held I guess by mid 2023. I am not a big fan of the early election thesis. At the moment Erdogan is lagging in the polls so I don’t get why he would go early. He will call elections when he thinks he can win. I expect the next 12-18 months to see economic policies rolled out which he think will win, that means a credit boom, the higher minimum wage, higher public sector salaries and benefits payments. All this will be pro growth, bad for inflation, the balance of payments and likely the lira.
Question? Can Erdogan win?
Answer: Absolutely, but this will be Erdogan’s toughest election battle ever. The population are suffering economic pain and the opposition are the most United we have ever seen them. But Erdogan is a great campaigner and lives for elections. For me it is a 50-50 call.
An important question is what will happen in a contested election, and how far election rules will be bent to ensure an election victory. Herein, Erdogan has the advantage of being in power, and having all the levers of government on his side.
I guess the other question will be at what cost another Erdogan victory. What shape will the economy and Turkish democracy be thru this process. I assume the sovereign balance sheet will be much weaker, and if he wins the question is will he continue with the unorthodox policies or will he understand that he needs to steady the boat, and consolidate with more prudent policies. Will he? Or is his low interest rate mantra here to stay. I fear it is which means if he wins, Post election, the Turkish economy might veer from one crisis to another.
** Please note that any views expressed herein are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at BlueBay, or the views of the firm as a whole. In addition, these conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment. No representation or warranty can be given with respect to the accuracy or completeness of the information. Charts and graphs provided herein are for illustrative purposes only.
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