Turkey’s currency has been in freefall, hitting new record lows almost every single day. The lira’s depreciations against the US dollar has already reached 9% since the start of the year, making it the worst performing emerging market currency to date in 2017. The lira was trading at TRY3.94 per dollar, and at TRY4.10 against the euro on January 11.
There is no single reason behind the lira’s troubles. The list is long: the slowing economy, sticky and rising inflation, geopolitical risks and domestic political jitters; together with uncertainty about the central bank’s policy action in the face of political pressure not to raise interest rates.
Besides, it looks like investors are pricing in a possible rating downgrade by Fitch Ratings, which is expected to announce its rating review of Turkey on January 27, three days after the central bank’s next scheduled monetary policy committee meeting. Two other major rating companies Standard & Poor’s and Moody’s Investors Service already downgraded Turkey to junk in 2016.
As the currency sank to a fresh low of 3.78 per dollar on January 10, the country’s central bank intervened by cutting the foreign exchange reserve requirement ratios by 50 basis points across the board. It also lowered the interbank borrowing limit to TRY22bn. The bank also provided an additional liquidity of $1.5bn to the financial system. But, after a short-lived break, the lira’s slide continued.
“None of the measures will likely have any meaningful market impact,” said JP Morgan. “At this moment, we believe only monetary policy tightening can break the depreciation trend. Yet, we remain wary that the central bank has the willingness and capacity to tighten aggressively, with any small hike (e.g. 50bp) likely to prove too little too late.”
JP Morgan analysts think rate hikes of the order of 150-200bp are required to stabilize the currency.
Indebted private sector
A weaker lira is fuelling inflation, eroding households’ purchasing power at a time when domestic demand remains anaemic and the economy is already slowing. President Recep Tayyip Erdogan has therefore been calling for cheaper credit, asking state banks and central bank to cut interest rates to boost economic activity.
The World Bank this week slashed its 2017 and 2018 GDP growth projections for the Turkish economy, citing political uncertainties and financial market volatility. The bank now expects the Turkish economy to grow by 3% this year and at 3.5% 2018.
The currency’s weakness and high inflation are causing other problems too. Investors are demanding higher returns in Treasury auctions, and if the value of the lira continues to fall, the burden of debt service on Turkey’s indebted corporations will only rise.
Local companies have accumulated a large amount of foreign debt over the past decade. The net FX short position of Turkey’s non-financial companies stood at $212.6bn (some 29% of estimated GDP) at the end of October versus $28.5bn (5.3% of GDP) in 2006.
Foreign assets of non-financial firms increased to $99.8bn at end-October 2016 from $62.7bn at end-2006, while their foreign liabilities rose by $220bn to $312.4bn over the past 10 years.
“Turkey’s corporate FX debt mismatch is an issue that receives considerable attention at times of lira weakness,” Renaissance Capital said in an emailed report, published in mid-December.
Analysts at Renaissance Capital think these primarily dollar liabilities are largely unhedged. “But if these are hedged, why is there so much historical and current effort to defend a weak lira?...This [FX debt of corporations] means currency weakness creates a negative feedback loop for the Turkish economy. Before these loans risk becoming NPLs, corporates can respond to higher dollar liabilities via price hikes (tough), belt tightening (easier), export growth (possible if not cash-flow constrained or capex dependent) and equity injections.”
But the country’s central bank challenges such negative assessments. “The continuation of the upward trend in the FX short positions of companies is regarded as a fragility factor in terms of FX risk but the factors that reduce these risks should not be ignored,” the bank argued in the latest issue of its Financial Stability Report, published in November last year.
FX loans are mostly concentrated in manufacturing industry, and the electricity, gas and water, transport and construction sectors, and these have a significant share in total exports and government service/product purchasing guarantees within public-private partnership (PPP) projects (power plants, airports, city hospitals), according to the bank.
Most of the FX financial liabilities of these companies are composed of loans with maturities over five years, it added.
The bank also argued that while the share of large firms in FX and TL loans increased compared to the previous report period (May 2016), the share of micro and SMEs decreased significantly.
“Of the approximately 27,000 firms with FX loan balances, 1,100 firms with FX liabilities worth of over TRY100mn (€25mn) hold 75% of total FX debt. The weighted average maturity of all FX loans used by these companies is over seven years.”
Moreover, credit standards are tightened more for micro and SMEs. “In other words, this decline in the share of SME loans stemmed from the cautious attitude of banks alongside demand.”
Troubles for banks
While the central bank does not seem to be too much worried about companies’ FX liabilities and their impact on the lenders, Moody’s this week warned that Turkish banks’ asset quality may worsen this year, driven by the combination of high inflation, lira depreciation and the general worsening of the investment climate because of security issues and geopolitical tensions.
The Turkish banking industry’s non-performing loans/total loans ratio stood at 3.4% at the end of November, up from 3.2% a year ago, according to data from banking watchdog BDDK.
Bank lending rose by 16% y/y to TRY1.7tn in January-November, while banks registered a 47% y/y increase in their combined net income to TRY35.05bn in the period.
“We expect gross NPLs to be above 4% by year end, which will require increased provisioning expenses and will reduce banks’ profitability”, the rating company said in a report.
The rise in inflation for household and other imported items is likely to adversely affect households’ ability to repay their debt obligations and be credit negative for banks’ consumer loan portfolios’ asset quality, according to Moody’s. Consumer credits, which accounted for 19.5% of all bank lending, increased by 9.4% y/y to TRY331bn in January-November.
Senior government officials rebuffed Moody’s assessments as baseless and irrational.
“Banks’ asset quality will not deteriorate, NPLs will not increase to 4%. We have established a TRY250bn new credit facility to SMEs under the Credit Guarantee Fund, which will help companies manage their cash flows,” Deputy PM Nurettin Canikli said. “Moody’s’ views are irrational”, he added.
“Moody’s negative predictions do not fit with reality,” Bulent Gedikli, one of President Recep Tayyip Erdogan’s advisors, tweeted. “Does Moody’s want Turkish banks to recall loans? This won’t happen”, he said.
Better market outlook after referendum?
Turkish bulls prefer to look at the way depreciation helps the economy. The depreciation helps to buoy Turkish export competitiveness, according to analysts at IHS. “Stronger export competitiveness will contribute positively to industrial gains, particularly of export-oriented manufacturing sectors such as vehicles and textiles,” they said in an emailed note.
They also pointed to the fact that the slide of lira makes imports more costly, thus undermining retail activity that may involve imported goods and/or services. “Industrial production growth will continue to mount both in the first quarter and throughout the year. The positive impact on headline economic activity will be offset by what is expected to be a year of weak retail trade and household consumption gains”.
Analysts at IHS expect boosting demand to remain a top priority of Turkish economic policymaking. “Which is why interest rates are expected to remain low even as inflation accelerates.”
While most analysts seem quite pessimistic about the prospects, some therefore see opportunities ahead.
“But with positioning so bearish, pricing cheap and Turkey’s historical ability to bounce, we think Turkey is a market that can foreseeably deliver a Brazil-style positioning shift, possibly by March 2017,” Renaissance Capital said in a separate report, published on January 5.
“What can reverse the deteriorating economy and sentiment hits to the currency?” they ask. The question is “Surprising as it may seem, but President Erdogan formally getting the executive presidency he craves could be a catalyst.”
While fundamentally the consolidation of power could cut Turkey’s structural growth potential, cyclically the destructive focus on short-term votes to win the referendum should give way to a more pragmatic focus on returning to growth, according to Renaissance Capital.
“Assuming investors are indifferent to democratic shades of grey but just want stability and grounds for optimism, Erdogan achieving his executive presidency after over three-and-a-half years of post-Gezi political volatility should be welcomed. Just as the market response to Trump surprised many, do not be surprised if the markets take a positive view of Erdogan achieving his objective.”
For the time being, the risk-reward is poor, but at least now we see how it can possibly improve, they said.