Guldem Atabay
Sep 06 2018

Currency Crisis - a la Turca

Financial turmoil has been shaking emerging economies since the start of the year as rising interest rates for the dollar keep reducing the motive to search for yields in emerging economies. Thus, investors have become more wary about the effects of rising Fed interest rates on these fast-growing, but habitually fragile economies.

Again the “fragile five” of Turkey, Argentina, India, Brazil and Indonesia are under the spotlight. Argentina and Turkey stand out as the emerging economies where the imbalances are the biggest. The peso has lost more than half its value this year and the lira is not far behind.

Moreover, the economic crises in Turkey and Argentina have also been weighing on other emerging markets. The MSCI Emerging Markets index is now down around 15 percent from its peak earlier this year.

The weakening lira and weak policy action have prompted foreign investors to pull more of their money out of Turkey’s stocks and bonds. The flight of this capital only strengthens the lira rout and adds to the already existing pressure on the central bank to raise interest rates. In return, the outlook for growth looks dismal. Consumer price inflation is currently heading to above 20 percent by year-end and to more than 40 percent by next year. In other words, Turkey is about to enter a sharp stagflationary period.

The ghost of the 1997 Asian Crisis is returning to haunt us.

To recall, what triggered currency crises back then in Asia was not fiscal imbalances, but huge current account deficits financed mostly by foreign bank lending with short-term maturity. The domestic banks were able to lend aggressively because foreign banks and other investors readily provided these hastily expanding economies with liquidity assuming the exceptionally high growth rates would continue indefinitely. A high level of corruption, political risks and lack of leadership, which failed to address the problems of overheating economies and consequently weakening current accounts, also played a major role. When the Fed tightening began, such short-term financing began to retreat. Combined with currency pegs and a decade of significant bank lending to real estate companies in hard currency, voila! There was the Asian Crisis that shook the world between 1997 and 1999.

Nonetheless the situation in Turkey is a tad different from what began shattering the Asian giants back in 1997. At first sight though, the similarities do speak louder.

Turkey has a huge current account deficit to the tune of 6.4 percent of GDP. As FDI almost dried up over the past five years in particular, most of that gap has been financed by external borrowing: by banks and private sector non-financial companies. In figures, Turkey’s external debt totals some $450 billion, or some 50 percent of GDP, with the short-term portion accounting for a little more than 30 percent of that total at $150 billion dollars. Counting in the current account deficit, Turkey faces refinancing of a sizable $230 billion in the next 12 months and it is getting costlier by the hour. At the core of the problem lies the fact that out of this total of $450 billion, $336 billion is owned by the non-financial sector compared with their roughly $120 billion dollars in hard currency assets. With net foreign exchange reserves at the central bank of some $23 billion, pressure on the lira prevails.

Turkey’s indebted private sector companies are no doubt in trouble. In a recent Bloomberg Economics note, the additional debt burden of the 40 percent lira devaluation since the start of the year on non-financial Turkish companies totals some $13.3 billion, which is enough to wipe out a percentage points from Turkey’s GDP; ceteris paribus.

Yet, what brought the Asian giants to their knees during the Asian crisis were troubles in the banking sector.

And that is exactly what makes Turkey’s currency crisis of today different from that of the Asian case two decades ago.

During the liquidity boom following the 2008 global financial crisis, Turkish banks were heavily engaged in “swap funding” activities. That is, borrowing with several year maturities through syndicated loans from foreign banks. These loans were exchanged for lira and given to households and businesses as lira loans, mortgages or for instalment loans to buy consumer goods. This capital overheated the Turkish economy. Yet, the cross-currency swaps rather had shorter maturities - less than one year - as they were exchanged into liras for funding; creating fragilities in today’s weak lira environment.

Disregarding the growing troubles in the current account, the government permitted such transactions for the sake of boosting domestic demand-based growth through bank lending, mostly for political reasons. Leaving aside the above-mentioned real sector companies that have fallen into trouble after accumulating cheap external debt over the past decade, the swap funding activities of banks landed into the economy in the form of lira loans to Turkish households, who were restricted from getting hard currency loans by the banking watchdog. Thus, the absence of extensive hard currency loans among households is what makes Turkey's problems different from those of the Asian Crisis.

But the troubles for Turkey’s banking sector, which has quite high levels of regulatory capital, have started due to the lira’s slump because most of their funding came in hard currency form over a period of several years.

Very high inflation in Turkey, which is set to break through 20 percent by the end of this year and could head towards 40 percent next year, is of course accompanied by similarly high interest rates. That is where the Turkish banks’ funding scheme gets into trouble. Now with a sizable maturity mismatch on their lira accounts - longer-dated lira loans and shorter-dated lira funding - the banks risk eroding their capital if inflation spirals further out of control and leads to a bigger spike in Turkish interest rates.

There may be a further hard currency squeeze on Turkish banks due to a slowdown in the renewal of foreign loans by investors or should foreign exchange deposit holders, who own some $150 billion, suffer a crisis in confidence over how the government is dealing with the country’s economic problems.

Instead of trying to cool down an overheating economy, President Recep Tayyip Erdoğan’s insistence on pursuing very strong growth for 2017 and this year - the economy grew an average of more than 8 percent annually in the nine months to March - has brought economic and financial risks to a seriously high level.

Given economic imbalances and stalling growth coupled with a very high inflation rate, Turkey’s fast-growing economy is set to plummet into a very sharp recession, come what may. It is now time for proper leadership to steer Turkey and its banks through stormy waters by improving the public budget and getting serious about inflation.

The future of the Turkish economy, which is going through an “a la Turca” type of currency crisis that could swiftly spiral out of control, largely depends on stabilising the lira.

For the moment, with local elections around the corner in March and the newly introduced presidential system, prudent collective thinking is lacking. The situation in Turkey looks destined to get worse before it improves.

The risks are of course serious: the lira meltdown, combined with spirals of rising inflation and interest rates can morph into a systematic private sector debt crisis that would also be detrimental to the country’s banks. And that would mean a real economic crisis, not just a grand currency devaluation.  


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