The outlook for Turkish lira is not bright yet
The lira has gained after the Turkish central bank hiked rates by 625 basis points last month to 24 percent and the government announced its three-year New Economic Program (NEP).
There is also rising optimism for the release of U.S. Pastor Brunson on Oct. 12. Local lender Akbank has secured a critical syndicated loan of almost $1 billion following a worrisome delay.
Investors were concerned that Turkey’s currency crisis, which had melted away some 40 percent of the lira’s value year-to-date, meant banks would struggle with foreign financing. But now Akbank's successful rollover is seen as a positive sign; disregarding the fact that the premium cost of the loan has doubled compared with similar borrowing in March.
Hence, the Turkish lira has strengthened almost 4.5 percent over the past week. Along with the surge in the currency’s value, the premium on Turkey’s five-year credit default swaps (CDS), which reflects the costs of insuring Turkish sovereign debt against non-payment, eased to 365 basis points from a peak of 500 basis points in August.
So, now the question is of course whether the Turkish lira, which closed Friday at 6.05 per dollar, can keep appreciating, hence easing, at least in part, the burden on companies who have accrued hundreds of billions of dollars in foreign currency debt. Furthermore, one must ask whether the lira’s newfound strength will be lasting enough to reverse a surge in inflation.
To make a conclusion, there are several factors at work. Let’s start with politics.
Turkey-U.S. relations have always been important. President Donald Trump imposed sanctions on two Turkish ministers in August for their role in the internment of Brunson. The fate of the detained Pastor will set the tone of future relations. Last week’s unexpected comment by U.S. Secretary of State Mike Pompeo that Brunson could be released soon was not reiterated by officials at the State Department. One official, in fact, said Pompeo had no new information regarding Brunson’s detention. The secretary has now said that the U.S. may hold more talks with Turkey.
To make matters more intriguing, during a visit to New York for last week’s United Nations summit, President Recep Tayyip Erdogan stressed that Turkey’s courts were immune from political interference and are free to decide on the fate of Brunson, who is accused of secret ties to terrorist groups in Turkey. Given the common understanding in Turkey that the president does indeed meddle in court decisions at times, his announcement boosted the lira further because his tone was interpreted as a twisted way of saying that Brunson would be set free from house arrest. Adding to the intrigue though was an announcement from Brunson’s lawyer that he was not hopeful for his release.
Apart from the Brunson’s detention, which many see as a move by Erdogan to persuade the United States to extradite Turkish cleric Fethullah Gulen, who resides in Pennsylvania and is accused of masterminding a failed military coup in 2016, there are division between Turkey and the United States over Syria as well. Erdogan, while almost ignoring Russian cooperation with the Syrian Kurds in its fight against the Islamist opposition, is adopting a tough tone when it comes to the United States and its alliance with the Kurdish PYD/YPG militant groups, threatening to forcefully impose “safe zones” in PYD/YPG populated territory east of the Euphrates.
Then there is Iran. Turkey is refusing to comply with fresh U.S. sanctions on the Islamic Republic. The European Union is planning to launch a “backdoor approach” in continuing its trade with Iran and Turkey will of course be no different. Yet, Trump’s repeated threats to impose sanctions on countries who have close ties with Iran – Turkey indeed does -- is set to make some investors cautious about putting money into the country.
Thus, even if Brunson were released at the next court hearing in mid-October, which would undoubtedly unleash a short rally in the lira, other major factors continue to hurt relations between Washington and Ankara and will exert downward pressure on the lira well into next year.
Meanwhile in economics, investors will be following very closely the government’s so-called “stress test” of Turkish banks and possible financial support for troubled lenders.
With the lira’s depreciation, the long-term debt repayments of banks of some $24 billion now equate to some 145 billion liras compared with 98 billion liras in January. Yes, the successful Akbank rollover will set the tone for debt issuances of remaining banks, yet the pain of rising costs is here to stay just as the economy is entering a period of contraction. Banks will be able to raise funding at higher cost, yet the deteriorating growth outlook and weaker lira will no doubt impact the approach of investors and overseas banks to reviewing and contributing to rollovers of syndicated loans.
Turkish banks are not expected to face serious rollover problems in the coming months, but the fate awaiting Turkish corporates is very different. With approximately 40 percent of domestic corporate loans denominated in foreign currency, the lira’s 40 percent value loss year-to-date hinders the repayments abilities of such borrowers. Even local currency debt is becoming tough to repay with skyrocketing variable lending rates now at some 30-35 percent annually. As for consumers, who are not allowed to accumulate debt in hard currency, rising interest rates, especially after the big Sept. 13 rate increase by the central bank, make borrowing that much tougher to sustain.
Furthermore, the lira’s meltdown has led to a series of ratings downgrades by the three major credit rating agencies for both Turkish sovereign and corporate debt. These cuts threaten the credit profiles of the banking sector. Just recently S&P Global Ratings announced that the percentage of problem loans in the Turkish financial system could increase to 15 percent within the next 24 months from 3.02 percent at the end of 2017. Banks’ exposure to risky sectors hit hardest by the lira’s depreciation, such as construction, energy, and project finance, have already resulted in a freeze in daily banking sector activities.
Overall, as calm as things may look, the economic situation in Turkey is more unstable than it appears. Slowing economic growth will turn into contraction while inflation is set to accelerate further in what is defined as “stagflation”. The lira’s weakness is not likely to turn into strength and higher interest rates are here to stay for some time. Concerns about banks' asset-quality, performance, capitalisation, funding and liquidity will remain prominent. And Treasury and Finance Minister Berat Albayrak’s repeated rhetoric that Turkey and its banks are not facing currency risk is obviously not helping.
The country needs swift measures to address banking sector problems and accelerating inflation. If such measures are not implemented quickly and effectively, today’s foreign financing shortages could spiral out of control and turn into a textbook balance of payments crisis at some point after the first quarter of 2019.
Investors seem to grasp these facts and the lira/dollar rate looks range bound at 6.00-6.25 for the next few months. But if the government does not act decisively on a myriad of economic and political issues and Turkey’s macro outlook worsens, as expected, then the odds are increasing that the lira will weaken towards somewhere between 7.5 and 8.5 per dollar in 2019.