Turkey pulls back from the brink

On September 13, Turkey came in from the cold when its central bank hiked interest rates by a higher than expected 5%, ending a crisis that had enveloped the country and spread to emerging markets, and putting it on the slow road to recovery.

With a ballooning balance of payments deficit, high levels of foreign currency debt and under the cosh of US economic sanctions, the country may still not avoid a recession, but its central bank managed to claw back some credibility.

The Turkish lira rallied on the back of the hike, a significant recovery after losing 40% of its value since the start of the year. The move was also significant because it showed that the central bank’s claim to be independent from President Erdogan – a vocal opponent of high interest rates – carried some credence after all.

After months of promising reforms but delivering nothing, The central bank had hinted at a softening of its stance on September 7, following the publication of the inflation figures for August.

“Recent developments regarding the inflation outlook indicate significant risks to price stability. The central bank will take the necessary actions to support price stability,” the bank said, adding that “(The) monetary stance will be adjusted at the September monetary policy committee meeting in view of the latest developments.”

Bankers have been waiting for a decisive policy response from the central bank since the June elections, when Erdogan was voted back in for another five-year term and promised to take more direct control over monetary policy. At the same time, he replaced finance minister Mehmet Simsek, a former Merrill Lynch banker and seen as markets-friendly, with Berat Albayrak, his son-in-law and former energy minister, to run a new combined ministry of treasury and finance.

The appointment of Albayrak has only underlined the breakdown in communication between Turkey and the international financial markets.

“There is no trust in the central bank and that is a very dangerous position to be in,” said Tim Ash, head of emerging markets for BlueBay Asset Management. “The Erdogan government blames sanctions, but it’s problems are about overheating and policy error.”

Erdogan has stated publicly his opposition to high interest rates – calling them the “mother of all evil” – taking the unorthodox view that high rates stoke inflation, rather than curbing it.

“Erdogan doesn’t want to raise rates – it’s about usury. There’s an Islamic socialist element to this. But there’s a savings shortage that needs to be filled,” said one banker.

Albayrak took action after his previous response were timid at best. On August 20, the central bank raised the short-term repo rate, a tactic goes back to the policy of the former governor with his interest rate corridor. In Ash’s opinion, that was a fudge designed to send a message to Erdogan that real interests were not rising while increasing borrowing rates. “But it’s not good for transparency and doesn’t represent sustained tightening. It’s like having a daily MPC,” he said.

At the same time as raising the repo rate, Turkey struck a deal with Qatar, which provided US$15bn in liquidity. It has held talks with other countries but it has yet to secure additional funding from elsewhere.

On August 17, Moody’s downgraded the Government of Turkey’s long-term issuer ratings to Ba3 from Ba2 and changed its rating outlook to negative, concluding the review for downgrade that was initiated on June 1.

Hubble bubble

Turkey’s problems have been bubbling for years. The country’s over-reliance on foreign money, and high inflation have attracted yield-hungry investors, although the tightening of rates in the US has reversed these flows. But the final straw for investors is the refusal by Turkey to raise interest rates to curb inflation.

“The government’s delay in introducing and implementing a credible economic plan to address the underlying causes of the crisis adds to these concerns. At the same time, Turkey’s external funding needs remain significant and the risk of a balance of payments crisis continues to rise,” Moody’s analysts said.

The pressure is more intense in the bank and corporate sector as they look to refinance loans. Turkish banks are highly reliant on foreign currency funding and had market funds of around US$186bn denominated in foreign currency as of June, equivalent to 75% of their total wholesale funds, according to Moody’s. Therefore, the Turkish banking system is particularly sensitive to potential shifts in investor sentiment, because these foreign currency liabilities must be refinanced on an ongoing basis.

Furthermore, in the next 12 months, Moody’s says around US$77bn of foreign currency wholesale bonds and syndicated loans, or 41% of the total market funding, needs to be refinanced. Turkish banks hold around US$48bn of liquid assets in foreign currency and have US$57bn of compulsory reserves with the central bank, which would not be entirely available. “Investors would like to see a high proportion of that debt either rolled over or paid down through companies dipping into dollar reserves,” said another banker.

The central bank’s action must now back up its rate hike with a coherent financial plan.

“The probability that the Turkish authorities will manage to engineer a “soft landing” of the economy is declining in the context of its weakened institutions, increasing tensions with the US and deteriorating investor confidence,” said Moody’s.

“Turkey’s credit quality remains, nevertheless, supported by a large and diversified economy and a still relatively strong fiscal position. The country’s debt burden remains moderate by global standards and the government has successfully managed previous serious economic and financial shocks.”

It raised US$9bn last year in the international capital markets, predominantly in US dollars, compared with the US$6.5bn that it usually does. The Turkish reasury usually front-loads, and has already raised US$4.5bn this year.

“With a funding glut from last year, it can afford to wait. Although, given its reliance on external funding, it’s not clear how long for,” said one DCM banker.

Relative isolation

Some observers have played down the impact of Turkey’s travails on the sell-off in emerging markets, even though both are partly driven by a tightening in US interest rates.

Dimitry Griko, chief investment officer, fixed income for EG Capital Advisors, said: “It is short-sighted to apply the problems in Turkey to the rest of EM. The situation in Turkey is local and to a significant extent self-inflicted. Yes, this is the realisation of some of the risks that we all associate with EM and that can apply to some countries, but this would not be a spill-over from the Turkish situation. There is no reason that this situation will lead to economic deterioration across other EM countries.”

Even so, the decision by the central bank will inevitably have a knock-on effect.

With the central bank taking decisive action, President Erdogan must now decide whether to start rebuilding bridges with the US. He is not the first world leader to pick a fight with Donald Trump but the scrap must find a resolution if Turkey is to be fully rehabilitated on the international scene.

In August, the US imposed sanctions on Turkey, including a doubling of tariffs on metal imports, after it refused to release Andrew Brunson, an American pastor who has been held in Turkey for nearly two years over alleged links to outlawed political groups. “We are cutting back on Turkey!” said President Trump in a tweet.

“The most pressing issue for Turkey is to normalise it relationship with the US. It derives two-thirds of its trade financing and investment from the West,” said BlueBay’s Ash.

The row with the US has spooked investors and turned what many viewed as a manageable economic challenge into a full-blown crisis that has reverberated throughout emerging markets. Domestic funding conditions have deteriorated, with benchmark bond yields on the government’s domestic securities topping 20% in mid- August.

“Given Turkey’s reliance on significant foreign capital inflows to fund its large current account deficit and to refinance its external debt, foreign investor confidence matters more than in most other countries,” said a Moody’s report from August 31.

There are suggestions that Turkey’s woes could end in a bailout from the International Monetary Fund, as has happened with Argentina, although that would likely require a resolution with the US, as well as a willingness by Turkey to adopt fiscal austerity.

That may be too much for Erdogan, but his central bank has blinked first, sending a signal that this monetary iconoclast will have to start playing by international rules.