Indebted Turkey may face second currency shock with defences weaker

Turkey risks a second wave of lira instability as a global sell-off sparked by the coronavirus leaves emerging markets most vulnerable.

A slump in asset prices across the globe is prompting investors to probe the defences of countries deemed as lacking the firepower to deal with financial turmoil. Turkey, with its huge stock of private sector debt and depleted central bank reserves, may be in the eye of the storm.

Two years ago, Turkey’s lira slumped to a record low against the dollar, sending economic growth into a tailspin. Since then, the government has spent tens of billions of liras to put the economy back on its feet. The central bank, helped by state-run banks, has spent tens of billions more defending the lira and has slashed interest rates to below the rate of inflation.

In this highly volatile global environment, Turkey is now one of the most exposed emerging market countries due to its slack monetary policy and external financing requirement over the next 12 months, largely made up of private sector debt.

Among non-oil producing countries, Argentina, which secured $57 billion of IMF help in September 2018, and Turkey are first in the firing line, William Jackson, chief emerging markets economist at Capital Economics in London, said in a report to clients this week.

A country’s external financing requirement is made up of its current account deficit and its external debt obligations over the next 12 months. Turkey’s current account gap widened on an annual basis in January to $1.8 billion. Economic stimulus has led to a sharp revival in imports in recent months, hence a deterioration in that balance of payments after several monthly surpluses. Export growth has remained relatively suppressed. Tourism revenue, critical to financing the deficit, is now under threat as cases of the coronavirus elsewhere surge.

Turkey needs more than $100 billion to fund its external debt and domestic demand over the next 12 months, Jackson said. With the country running a projected current account deficit, those funds must come from abroad.

erdoğan albayrak
Erdoğan and his son-in-law, Treasury and Finance Minister Berat Albayrak

Spreads on emerging market debt have widened this week to levels unseen since the global financial crisis in 2008. That raises the cost of borrowing for governments and firms, leaving them exposed to further currency weakness. In turn, some foreign investors may be more averse to investing in those economies as concerns for their financial stability increase.

Turkey’s lira, which briefly touched a record low of 7.2 per dollar in August 2018, has slumped this month along with other emerging market currencies as investors sold the assets of developing countries. On Friday, the lira was trading at around 6.27 per dollar, down 3 percent on the week. It reached its lowest levels since September 2016 in volatile trading on Thursday.

Although Turkey's current account deficit problem of 2018 - it had stood at 6.5 percent of GDP as the currency crisis struck - has diminished for now, an increasingly weak lira could spell trouble for Turkey’s indebted companies. That is especially so for businesses with large foreign debts to service and whose cash reserves have been depleted by the post-crisis economic downturn. Turkey’s economy endured a severe recession in the six months to March last year and has only just begun to grow strongly again on an annual basis, squeezing company finances.

Should Turkish firms run into trouble and pressure the balance sheets of banks, any bailout would be contingent on the cash available. President Recep Tayyip Erdoğan has rejected any suggestions of an IMF loan programme. The government ran a large budget deficit last year and the tax incentives and spending it introduced to stimulate economic growth mean it has less cash available.

Turkey’s central bank is also in a weaker position. While its gross foreign currency reserves stand at more than $100 billion, net reserves, excluding those deposited by banks, are about one-third of that amount. The monetary authority has also engaged in currency swaps with state-run banks to help defend the lira over the past year, meaning its immediately available cash in foreign currency to defend the lira could be less than $15 billion.

Further cuts to the central bank’s benchmark interest rate - the Fed and European Central Bank have eased monetary policy due to the coronavirus outbreak - would also render the lira less attractive and intensify investor concern about currency instability. The central bank has slashed borrowing costs for the country’s lenders to 10.75 percent from 24 percent in July to help the government achieve its ambitious goals for economic growth – for this year it targets expansion of 5 percent.

As interest rates fall, Turks are bumping up their foreign currency deposits, which now stand at more than 25 percent of total deposits. Inflation of 12.4 percent means the lira provides paltry returns for deposit holders.

While Turkey ideally needs to raise interest rates to defend the lira, polls of economists held earlier this week forecast that the central bank would cut them for a seventh-consecutive meeting to 10.25 percent when its managers convene next Thursday.

But with government concerns about the trajectory of economic growth deepening due to the coronavirus – the authorities reported a second case of the illness on Friday - the bank, whose political independence has been severely compromised since its boss was sacked by Erdoğan in July, may surprise investors again and implement a bigger cut than forecast.

Some economists are talking about a rate cut to 9.75 percent, which would meet Erdoğan’s demands for single-digit interest rates in the country. But with Turkey’s vulnerabilities now a renewed concern for investors in emerging markets, such a move might be very ill-advised.

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