Talking Turkey

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Turkey's currency saga continued this week as the lira tumbled, resulting in a year-to-date decline of over 40% relative to the US dollar (Exhibit 1). Turkish corporates, with over $330 billion (37% GDP)of outstanding foreign currency denominated debt, have become a key focus for the market. The depreciating currency has spurred concerns about corporate borrowers and if any contingent liabilities will challenge the sovereign's ability to repay its debt.

Exhibit 1: Turkish lira has tumbled by over 40% this year
Turkish lira / US dollar daily FX rate
January 1, 2018 – August 14, 2018

Source: Bloomberg

Amid the currency volatility, Turkish sovereign USD denominated bond spreads widened by as much as 150bps this week, as measured by the JP Morgan EMBI Global Diversified Turkey sub-index. Declining Turkish assets weighed on other EM countries such as Argentina, South Africa, Mexico and Indonesia, causing broader concerns about emerging markets in general.


Exhibit 2: Turkish sovereign USD denominated bond spreads widened this week
Credit spreads of JPM EMBI Global Diversified index vs. Turkey sub-index
December 31, 2009 – August 14, 2018


Source: Bloomberg

On Monday, August 13, the Turkish central bank and the banking regulator announced a series of macro prudential measures to help support financial stability and effective functioning of domestic financial markets through the volatility.

According to the Central Bank of the Republic of Turkey (CBRT) press release, the central bank will provide unlimited liquidity to banks with the framework of intraday and overnight lending facilities, as well as lowering the reserve requirement rates for the lira and FX liabilities.

The regulator also limited Turkish banks' ability to transform lira in to foreign exchange with a 50% capital limit on swap positions with non-resident banks, as reported by Turkey's Banking Regulation and Supervision Agency (BRSA).

On Tuesday August 14, the central bank and regulator deployed additional measures to raise the cost of selling lira in the FX forward markets – an effort to stem/reverse the lira's slide. This had the effect of driving the tomorrow/next FX forward rates2 to short lira from 18% on August 9 to near 40% on August 15 (Exhibit 3).

The regulator continued to limit swap positions with non-resident banks by lowering capital limit from 50% to 25%, as reported by the BRSA. The central bank is only offering liquidity in the overnight market at 19.25% vs the traditional weekly repo auctions at 17.75%.

Exhibit 3: USD/TRY tomorrow/next forward implied yield
January 1, 2018 – August 14, 2018


Source: Bloomberg


To assess Turkey's credit profile and evaluate potential outcomes that could restore investor confidence, we consulted Aegon's Phil Torres, global co-head of emerging markets.

 

Q: What are your fundamental views on Turkey?
Turkey is well characterized as a high growth low debt issuer. Since 2003 the country has averaged 5.5% annual growth interrupted once by the 2008 global financial crisis, and second by the 2016 presidential coup attempt. As of April 2018, Turkey's general government gross debt to GDP was a low 28%, as reported by the International Monetary Fund (IMF). Historically, the country had displayed credible economic policymaking decisions. According to our analysts' estimates, coupled with the Turkish Minister of Finance's comments, a further source of strength and resiliency for the economy are the high capital levels, low non-performing loan ratios and very low unhedged FX exposure in the banking system. On average, system-wide Tier 1 capital adequacy ratios are estimated to have been 15% and non-performing loans at 2.8% as of Q2 2018 per our analysts' estimates and corporate earnings releases. However, including watch-list loans, emerging problem loans could have been as high as 8% according to the IMF, perhaps signaling emerging loan quality weaknesses.

The current pro-cyclical policy setting has led to rising risks from economic overheating as the current president's increasingly autocratic leadership style has eroded some of the aforementioned strengths. An important policy departure, relative to the prior era, and potential cause of the pro-cyclical policy stance, has been the central bank's reluctance to raise interest rates during this period of rapid GDP growth and elevated inflation. Notably, the IMF estimates Turkey's output gap has widened to 2% above potential GDP growth in Q1 2018. The recent high rate of domestic growth has led to a widening of the current account deficit, high and advancing core inflation, and a worsening net international investment position.

The current account deficit, which tends to swell with a strong domestic consumer economy and higher energy prices, was estimated to have been $50 billion USD, or approximately 5% of GDP1. Short-term external government and corporate debt stood at 12% of GDP as reported by the CBRT and IMF. Notably, government debt remains robust with an average maturity of 16 years, while corporate external debt remains primarily short term. Interestingly, Turkey has held a similar external liability profile for over a decade with no extreme events, suggesting a robust relationship with direct and portfolio lenders developed over time. Turkey's external debt appears sustainable but sensitive to FX and rollover risks considering the low level of central bank FX reserves and diminished role of FDI in filling the annual funding needs.

Exhibit 4: External financing requirement as a percentage of GDP
Annual data from 2003 – 2017

Source: Economist Intelligence Unit, Aegon Asset Management US. External Financing Requirement Defined as: External Short Term Debt Maturities, Total foreign debt service due, Current Account, Net Foreign Direct Investment.

Throughout the course of this year, our credit evaluation for Turkey has evolved to highlight the growing risks to the country's outlook. As shown in Exhibit 5, we maintain a positive outlook on Turkey's economic strength, but are growing concerned about weakening institutional credibility and most notably, event risks tied to the external funding exposures noted above. In aggregate, the strong growth, low sovereign debt, near balanced budget, and strong banking system, combined with external funding weaknesses left us modestly sanguine about the sovereign's credit profile. However, as you can tell in the table below, our view deteriorated over a fairly short window of time in 2018.


Exhibit 5: Aegon AM US' credit evaluation progression for Turkey during 2018
As of August 5, 2018

Source: Aegon AM US and Moody's Investor Services. The credit quality of a security or group of securities does not ensure the stability or safety of the overall portfolio.

Q: Do you believe Turkey's currency depreciation could lead to a sovereign default?

According to the IMF, the Turkish lira depreciation, if permanent, may leave Turkey's external debt stock near 80% including 60% of private sector debt. This is high and increases short-term volatility as investor sentiment and credit evaluation evolve. Additionally, by many estimates of currency value, including our own, the lira entered this crisis as one of the most undervalued currencies in the world. If recent events do not change long term competitiveness and inflation or current accounts do not deviate substantially from forecasts then, on a medium-term basis there is scope for the lira to naturally normalize at levels substantially stronger than what underlie these estimates of external stock. All the same, under our present understanding, we do not believe the recent currency movement will lead to a sovereign default. The weakening of lira will likely lead to a slower economic growth path, external rebalancing, and perhaps a government organized restructuring of some corporate lira debt. We believe the strong starting point health of the sovereign balance sheet, tightening of domestic lending policies by regulators, and the natural decline in the current account as the economy contracts can be leveraged to restore investor confidence and avoid a sovereign default on what is a fairly long maturity debt structure.

Q: What are the range of potential outcomes for Turkey's current currency and debt debacle?

Although it's somewhat late in the game, we believe that policies could be implemented to stabilize financial markets and mitigate default risk.

In our view, the most likely scenario is that the Central Bank of the Republic of Turkey (CBRT) uses monetary policy and related tools in an attempt to remedy the situation. It is likely the central bank continues its recent policy actions, as discussed above, to stabilize the currency and supply any excess lira liquidity needs to the banks. The markets remain rightly skeptical that the recently reluctant central bank will more forward rapidly with what orthodox economists would recommend in a significantly higher monetary policy.

Turkey may need to seek new sources of credit from friendly sovereign institutions if the current account and short term funding needs cannot be managed by traditional means. Traditionally Turkey would approach the IMF for support contingent upon a variety of reforms. However, given the political costs involved with an IMF approach, we think Turkey will treat this as a near last option. A more likely scenario would be an attempt to piecemeal support from multiple parties such as the European Central Bank, People's Bank of China or Gulf Cooperation Council.

Less likely, albeit possible, Turkey could attempt to limit outflows with formal capital control. Capital controls may however deter much needed inflows and consequently are unlikely an option.

Finally, with a low but non-zero probability, the least likely result in our opinion is that Turkey does nothing. Ultimately, they could nationalize defaulted corporates and banks and print lira, possibly leading to hyperinflation and a sovereign default. As explained above, this is the least probable scenario for a variety of reasons and considering the starting point strengths of the sovereign balance sheet we are not presently considering this a core scenario. As with all our credit evaluations, we will certainly allow the data and events to shape our opinions in this fluid situation.
  

 

1Central Bank of the Republic of Turkey (CBRT), EVDS statistical database and the World Bank.

2Tomorrow/next is a specialized forward transaction in forward exchanged markets. The one-day swap rate is quoted between tomorrow and the next day. The source is Bloomberg.

3Council on Foreign Relations, IMF and the Central Bank of the Republic of Turkey

 

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Phil Torres

About Phil Torres

Phil Torres is global co-head of emerging markets and director of emerging markets research. As co-head of emerging markets, Phil is a portfolio manager for the firm's international fixed income portfolios investing primarily in emerging market debt and local markets. He is also responsible for overseeing the Emerging Markets Research team. Prior to his current role, Phil was the founding partner and co-portfolio manager of the Harbert Macro Fund, an emerging markets global macro hedge fund. Prior to that, Phil worked as a portfolio manager at UBS Asset Management, JBS USA, Vara Capital Management, and Ritchie Capital Management. He has 23 years of industry experience and has been with the firm since 2016. Phil received his BA from Tufts University and his MBA from the University of Chicago.