Turkey faces corporate debt spiral unless it raises rates

Turkey’s central bank faces a stark choice on Tuesday: raise interest rates to stabilise the economy or spark a sell-off in the lira that could push indebted Turkish firms over a cliff edge.

The situation for Turkey’s economy could hardly be more critical as policymakers hold their first meeting since Turkish President Recep Tayyip Erdoğan’s re-election last month.

The central bank will probably hike ‘its benchmark interest rate of 17.75 percent by 100 to 125 basis points, according to predictions by major banks including JPMorgan Chase and Nomura. But analysts say the risk that the bank decides not to increase rates at all are significant.

Reports of large Turkish firms applying for bankruptcy protection resurfaced this week after the lira fell to fresh lows against the dollar. Corporates owe more than $220 billion in unhedge foreign debt that is becoming increasingly expensive to repay. 

Fresh troubles for Turkish firms came as the International Monetary Fund reiterated that Turkey’s $880 billion economy is in danger of overheating. The statement came a few days after Fitch cut the country’s sovereign debt further into junk territory, citing the same concerns. 

While the central bank is likely to understand the dangers of a possible Turkish corporate debt crisis and raise interest rates, such an outcome is by no means assured.

In May, Erdoğan said he would take more control of monetary policy should he win the election. He shocked investors by explaining in detail why interest rates should be lowered to slow inflation, arguing against conventional economic theory that lower rates encourage more inflation.

Should the central bank fail to raise interest rates as expected, the lira would weaken significantly again, putting severe pressure on companies’ balance sheets, said Inan Demir, an economist at Nomura, who is expecting a rate hike of 125 basis points.

“The burden on the corporate sector would become almost unbearable and we would see more and more restructuring requests that would weigh on the banking sector balance sheet,” he said. 

“Most banks and corporates need to roll over substantial amounts of external debt… Creditors may grow even more concerned, so we may find ourselves in a vicious circle where lira weakness leads to private sector balance-sheet concerns which leads to a slowdown in foreign lending, which then goes on to create further lira weakness.”

Turkish firms including Dogus Group, run by billionaire Ferit Sahenk, have already applied to banks to renegotiate billions of dollars in foreign currency loans. Some estimates put the total at more than $20 billion, not including the loans held by small and medium-sized enterprises, who tend not to report their plans publicly. Power companies, the remit of newly-appointed economy chief Berat Albayrak in his previous role as energy minister, have particular financial difficulties due to government price caps and the substantial loans they took on for asset purchases.

But suspicions that Erdoğan is intent on suppressing interest rates and putting economic growth ahead of currency strength and inflation aren’t going away. 

On July 8, the president tightened his hold on the central bank, making himself responsible for appointing the bank’s governor and his deputies. He also reduced their terms in office to four years from five. Ugur Gurses, perhaps Turkey’s most well-known writer on the economy, resigned from Hurriyet, a leading Turkish daily, on Monday after criticizing Erdoğan’s decision. 

Cemil Ertem, Erdoğan’s chief economic adviser, stirred concerns further on Thursday. Writing in an opinion piece for the Milliyet newspaper, Ertem stated that Turkey would push ahead with a program of economic growth that would also boost employment, slow inflation and narrow the current account deficit. 

Policymakers were forced to belatedly raise interest rates by 425 basis points to 17.75 percent in two hikes in May and June after Erdoğan’s comments on interest rates helped push the lira to a record low of 4.92 to the dollar. Erdoğan’s approval was sought before the rate hikes were made, according to news reports at the time.

The monetary tightening appeared to work at first, strengthening the lira, until the Turkish Statistical Institute said inflation surged to 15.4 percent in June from 12.2 percent the previous month. 

The lira sold off again earlier this month, reaching a fresh all-time low of 4.98 per dollar, after Erdoğan appointed Albayrak, his son-in-law, as chief of the Treasury and Finance Ministry.

Premature monetary easing would be “suicidal and is out of the question”, JPMorgan economist Yarkin Cebeci said on Friday, predicting a rate increase of 125 basis points.

“There is, however, the risk that the central bank remains on hold or delivers just a symbolic cut. In such a scenario, we expect the credibility erosion to continue and the pressure on the lira and hence on the central bank to increase significantly,” he said.

Even with a rate hike of 100-125 basis points, the positive impact on the lira and inflation may be limited at best.  

Before the central bank’s first rate hike in May, inflation was 10.85 percent and the benchmark interest rate was 13.5 percent, a margin between the two of 265 basis points. 

The 300 basis-point hike in May increased that margin to 565 basis points. 

Even though the central bank’s second rate hike of 125 basis points in June took the benchmark to 17.75 percent, by that time inflation had increased to 12.15 percent. That meant that, despite the rate increase, the margin between the benchmark and inflation narrowed slightly to 560 basis points.    

And then as June inflation surged to 15.4 percent, the gap between the benchmark and inflation eroded by more than half to 235 basis points, less than the margin that existed before the program of rate hikes began in the first place.

To strengthen the weight of interest rates on the lira and inflation to previous levels, the central bank should hike rates by 325 basis points to 21 percent, effectively restoring the margin that the rate hikes in May and June had created. 

But it would be politically impossible for the central bank to do so.

In July, inflation is expected to accelerate to 16 percent, or perhaps higher, as the impact of the lira’s decline on prices persists. Inflation may increase again in August. Therefore, it is very likely that the central bank will come under pressure to raise rates again should it increase them on Tuesday.

For a more modest rate hike of some 125 basis points to have a meaningful impact on inflation and general sentiment toward the lira, it would need to be accompanied by serious action by the government, therefore an acceptance by Erdoğan of lower rates of economic growth. 

Erdoğan and Albayrak should strengthen the central bank’s hand with their own tighter policies, namely cuts in expenditure to reduce the budget deficit, which is set to widen to about 3 percent of GDP because of election spending.

Upon his appointment, Albayrak pledged to slow inflation to single digits and take measures on the budget, including setting firm spending targets, but he provided almost no details of the exact steps that the government would take to achieve those goals.

Demir puts the chances of a rate hike by the central bank at 60-65 percent.  

“I think, may be hopefully, that the central bank does recognize the costs associated by not hiking the policy rate and they will go for a hike,” he said. “If they don’t hike, I think markets will assume the worst about upcoming policy decisions in Turkey.” 

The opinions expressed in this column are those of the author and do not necessarily reflect those of Ahval.

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