Friday 17 August 2018

Erdogan must step back from brink to avert a credit event

Turkey’s President Recep Tayyip Erdogan saluting supporters after Friday prayers, in Bayburt, Turkey, yesterday. Photo: AFP/Getty Images
Turkey’s President Recep Tayyip Erdogan saluting supporters after Friday prayers, in Bayburt, Turkey, yesterday. Photo: AFP/Getty Images

Eoghan Sheehan

The currency crisis that has been brewing in Turkey for several months intensified this week culminating yesterday morning when the Lira lost over 14pc of its value, as measured against the US Dollar, in the space of 12 hours.

The Lira is now down over 26pc in the past month and 40pc since the start of the year, raising investor fears that the situation could quickly spiral from a currency crisis into a full-blown credit event.

Despite mounting pressure to reassure investors, president Erdogan yesterday remained defiant, stating that Turkey would prevail in an "economic war" while calling on Turks not to panic or "bow in front of economic threats".

This suggests he is sticking to his nationalist message, for now at least, and may still resist delivering the hard measures Turkey desperately needs.

Investors quickly made up their minds, with the Lira sliding 5pc during his 15-minute speech, and then slumping even further in the afternoon, again signalling the deep concern about the stewardship of the economy under Mr Erdogan and Mr Albayrak, his son-in-law and newly appointed Finance Minister.

The situation facing the Turkish government is complicated further by the fact it is now fighting capital flight on three different fronts.

Firstly, and the most pressing issue for investors, is the health of Turkish corporate balance sheets. Since the last financial crisis, Turkey has posted impressive growth figures but over recent years this growth has been accompanied by increasing debt.

These Turkish borrowing have been heavily reliant on international funds which is now exposing Turkish corporates to rollover risk if short term lending extensions can no longer be agreed.

Adding to Turkey's fiscal woes, new pension and spending increases announced by president Erdogan in the lead-up to his recent election win have further weakened the outlook for Turkey's public finances.

Secondly, Turkey has a huge problem with spiralling inflation, which now stands at 16pc year-on-year by official estimates even before the latest episode of Lira weakness.

In the past, the Turkish authorities have always managed to contain problems by being willing to take aggressive action such as in January 2014, when the central bank hiked its overnight lending rate by 4pc at a midnight meeting.

However with president Erdogan currently pursuing the growth policy which got him re-elected, he favours keeping rates low to stoke domestic growth. Meanwhile, recent changes at the Turkish Central Bank (CBRT) have raised new questions of whether the CBRT still has the independence and autonomy to fight higher inflation like they have on the past.

Finally, Turkey is also embroiled in a political stalemate with the US that has signs of spiralling into sanctions and fines between the two Nato allies.

First, US authorities are looking into impropriety at Turkish Bank Halkbank who are accused of breaking the US financial embargo on Iran. Then there is the fact that Turkey has detained a US pastor on terrorism charges which has further angered the US administration and led to sanctions on two Turkish government officials.

By yesterday afternoon, the five-year credit-default swap, the cost of insurance against default on Turkey's government debt, had climbed to 500bps, up 40pc in the last two weeks and at levels not seen since the 2009 financial crisis.

The CDS surge shows investors are betting Turkey will now have more trouble paying its debt and is a good barometer for investor fears who now rank Turkey more risky than Greece.

Looking ahead, it is really the actions of the CBRT that are most important over the coming days. So far they have remained conspicuously quiet, deciding not to step in and fight against the recent currency weakness.

However, markets are now close to breaking point and the onus is again on the CBRT to act to re-anchor inflation expectations and re-establish their credibility.

The current market expectation is that a rate increase of at least 5pc, from the current 17.75pc interest rate, will be required to stem the tide of Lira losses and traders are nervously awaiting any announcement of an emergency central bank meeting which may happen next week.

Investors will also be hoping for a more conciliatory tone from president Erdogan over the coming days.

In the past he has shown himself to be pragmatic when faced with a crisis and has often stepped back from the brink and allowed officials take necessary measures while he instead focuses on managing the narrative. Whether this is how it plays out this time only time will tell.

If not, rumours about possibly imposing capital controls on international transfers and even a potential IMF assistance program will continue to grow and likely lead to further pain for the Turkish Lira.

Eoghan Sheehan is an FX and Emerging Markets Trader, Bank of Ireland Global Markets

Irish Independent

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