Foreign investors are fleeing, worried about surging inflation, deeply negative real interest rates, and a central bank unwilling to crack down on inflation.
By Nick Corbishley, for WOLF STREET:
The Central Bank of the Republic of Turkey (CBRT) has burned through tens of billions of dollars of increasingly scarce foreign-exchange reserves trying to prop up the lira. It has also borrowed vast sums of foreign currencies from domestic banks and then sold those currencies to buy lira. But to no avail. The Turkish lira is plumbing depths it’s never seen before. This week, it sank to a record low of 8.30 lira to the euro and closed on Friday at 8.25. This three year chart also shows the currency crisis in August-September 2018:
In terms of the dollar, the lira had hit a record low on May 8, at 7.2 lira to the dollar. Then the dollar spiraled into a sharp decline against a basket of other currencies. And the TRY found some relief against the dollar. But that ended early this week, when the lira started falling against the dollar as well, even as the dollar was falling against other currencies — to close on Friday at 7.0 TRY to the USD — stirring fears that Turkey could be on the cusp of yet another debt crisis, just two years after the last one.
A Bleaker Panorama.
Today, Turkey faces a bleaker panorama than it did two years ago. The economy is weaker today than it was then, having already been through one crisis in 2018. Now, the virus crisis has wiped out a big chunk of the nation’s revenue from tourism and exports while the plunging lira is making it hard, once again, for companies and the government to service their foreign-denominated debts, which in April still accounted for 37% of the total debt owed by Turkish borrowers.
This preponderance of foreign-denominated debt in Turkey is a huge risk for banks based in the country, warns S&P. Some of these banks are owned by European banks.
The CBRT, after burning through scarce foreign-exchange reserves to prop up the lira, has another option to try to prop up the lira: raising the benchmark interest rate.
But that is anathema to Turkey’s president Recep Tayyip Erdogan, whose post-2018-crisis plan all along was to reanimate the economy by recreating the exact same debt-fueled consumer and construction booms that paved the way to the last crisis. The CBRT’s former governor, Murat Cetinkaya, tried to hike rates anyway and was sacked for it by Erdogan in July 2019 and replaced with his deputy, who spent the next nine months slashing Turkey’s benchmark rate — to 8.25%.
Back in 2018, Turkey’s consumer price inflation had surpassed 25%, which in part triggered the currency crisis. And to combat it, the CBRT had raised interest rates, which brought inflation back down, and in mid-2019 inflation was back to about 8%. But since then, inflation started storming higher and hit 12.6% in June!
Now, the benchmark rate is substantially below the official inflation rate, and has been for the past six months. In other words, real interest rates have become extremely negative. Given Erdogan’s intolerance for rate hikes, they’re likely to stay that way for some time.
This has raised concerns among foreign investors that if inflation continues to rise, the central bank will be neither willing nor able to raise borrowing costs quickly enough to bring it under control. With real interest rates already deeply negative, many investors feel that they are not being adequately compensated for the risk of holding Turkish assets. The result has been a flight out of Turkey’s bond and stock markets.
Foreign investors pulled more than $7 billion out of Turkey’s local currency bond market in the first six months of the year — the largest drawdown in the first half on record — and $4.3 billion from Turkish equities, according to data from the CBRT.
Blowing New Bubbles.
To make sure the lower interest rates it had set translated into lots of new bank lending, the CBRT, at Erdogan’s behest, devised incentives to encourage banks to lend out money and penalties for those that refused. It had the desired effect: by May 2020, the country’s total supply of domestic credit had reached $551 billion — an increase of 30% year-over-year.
Fueled by dirt-cheap mortgages (in real terms) provided by state-owned lenders, house sales have skyrocketed, helping to fill the pockets of Erdogan’s friends in the construction industry. In June alone, home sales surged by 209% year on year, helped along by the fact that state-owned lenders were offering mortgages at rates well below the rate of inflation.
Credit for consumer goods is also flowing freely, just like the good old days. But just as before, most of the goods Turkish consumers are buying are imported from oversees, which means the balance of payments deficit is once again widening. Between January and May this year, imports exceeded exports by $16 billion, putting the current-account deficit on track to reach $40 billion by the end of the year — its widest since 2017.
Where’s the money?
Normally, countries that find themselves in such a situation would issue long-term debt to fund the gap. But with foreign investors increasingly abandoning Turkish bonds, Ankara doesn’t have that luxury. The CBRT’s foreign currency reserves are very low: the central bank’s official net international reserves currently stand at $31 billion, according to Reuters. But minus swap lines, gold reserves and lines to domestic banks, the number is believed to be negative.
Some large emerging economies with better credit ratings and better relations to the US government, such as Mexico, Brazil, Singapore and South Korea, have been able to alleviate their short-term dollar funding pressures by drawing on the dollar swap lines hastily rolled out by the Federal Reserve at the beginning of the pandemic. But Turkey does not have that luxury. It has repeatedly asked the Fed for a swap line but has been rebuffed each time, partly due to Washington’s rocky ties with Ankara.
Ankara is not completely out of options. In May, as its funding pressures mounted, it managed to persuade Qatar to triple its swap line, from €5 billion to €15 billion. A month later, the CBRT announced it had used a funding facility for Chinese yuan for the first time under an already established swap agreement with the People’s Bank of China, though it’s not clear how much for. To meet Turkey’s funding needs, it will need to be a lot. By Nick Corbishley, for WOLF STREET.
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