Turkey’s banks “key source of vulnerability” amid lira strife

Turkey’s banks “key source of vulnerability” amid lira strife
Turkish banks' short-term external debt and FX held at Turkey's central bank ($bn). Data sources: Sources: CBRT, BDDK, Refinitiv, Capital Economics. / Capital Economics.
By bne IntelIiNews March 22, 2021

Turkey’s banking sector is a key source of vulnerability and arguably looks more exposed amid the country’s latest economic turmoil than it was in the run-up to the 2018 lira crisis, Capital Economics said on March 22 in the wake of the abrupt sacking of the Turkish central bank governor.

Naci Agbal was by presidential decree relieved of his duties as Central Bank of Republic of Turkey (CBRT) governor late on March 19, less than 48 hours after delivering a larger-than-expected rate hike in an effort to tame inflation. His successor, Sahap Kavcioglu—seen as an AKP ruling party loyalist who, like President Recep Tayyip Erdogan, is opposed to the use of high interest rates to curb soaring inflation, unconventionally arguing that it indirectly pushes up prices—subsequently released a statement to try to reassure investors that the institution will “continue to use the monetary policy tools effectively in line with its main objective of achieving a permanent fall in inflation”.

Senior emerging markets economist at Capital, Jason Tuvey, said in a note to investors: “As we’ve argued before, the country’s banking sector is a key area of vulnerability. [See here.]. Local banks have made significant loans in foreign currency (or FX-indexed), which could start to go bad on the back of the sharp fall in the lira [triggered by the firing of the CBRT governor]. And tighter financial conditions could weigh on banks’ lira-denominated loans.

“That said, we don’t think that a potential souring of banks’ loan books is the main reason for worry. FX loans are strictly regulated and, despite sharp falls in the lira in recent years, the share of non-performing FX loans is low at just 1.1%. More generally, we estimate that bad loans would have to rise sharply before banks’ capital ratios fell below regulatory minimums.

“Instead, the problem lies with banks’ large burden of maturing (foreign currency denominated) external debts. Banks’ short-term external debts (i.e. those maturing within the next year) amount to $88.7bn, or 12.5% of GDP. Worryingly, there is a potential crunch point in April and May when an estimated $7.3bn in debt repayments are due.”

It’s worth noting, added Tuvey, that Turkish banks managed to secure syndicated loans at the height of the global financial market turmoil around this time last year. “But,” he added, “if borrowing costs rise to prohibitively expensive levels over the coming days and weeks, banks are in a weak position to service their debts. In order to meet external debt repayments during the 2018 currency crisis, banks drew down their FX assets at the central bank held under the so-called ‘reserve option mechanism’. These have not been fully rebuilt over the past couple of years and stand at just over a half of short-term term external debt.”

Illiquid loans

Banks’ other FX assets mostly consist of illiquid loans that cannot be used to service debts and the CBRT’s low foreign exchange reserves mean that it is not in a strong position to step in, noted the economist, concluding: “Indeed, the latest figures show that the central bank’s net reserves amount to less than $11bn. To repay maturing external debts, banks would need to access foreign currency from the spot market, which would put the lira under further downward pressure and cause banks’ balance sheets to shrink and credit conditions to tighten.”

Though Erdogan has a record of dropping grenades under the feet of the markets, his latest intervention in the country’s monetary policy, with the firing of the governor, has left investors puzzled and aghast.

The Economist wrote on March 22: “Unable to keep up with Mr Erdogan’s antics, analysts seem to have given up trying to predict what might happen next.”

It added that the “brutal market reaction may give Mr Erdogan some pause for thought and quoted Paul McNamara, investment director at asset management firm GAM, as saying: “My guess is that it’s going to get through to Erdogan that a country with so much foreign debt does not have the freedom to set interest rates as low as it likes.”

Turkey’s president and the central bank may grudgingly surrender to the markets, McNamara was cited as saying, adding: “There needs to be a realisation they’ve bitten off more than they can chew.”

Turkey's overall short-term foreign debt, falling due in the next 12 months, reached $140bn, about one-fifth of GDP, in January.

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