In a scathing report published earlier today, rating agency Fitch which last month downgraded Turkey to BB, “outlook negative”, warned that the moves taken by the Turkish government remain insufficient to restore credibility, and said that the incomplete political response cannot fully address underlying causes of lira’s fall, namely large current account deficit & external financing requirements, the country’s burgeoning USD-denominated debt load and added that even should the country raise rates – which Erdogan has vowed he won’t do – the abrupt tightening in financial conditions will sharpen the slowdown in GDP growth already under way.
In short, “the absence of an orthodox monetary policy response to the lira’s fall, and the rhetoric of the Turkish authorities have increased the difficulty of restoring economic stability and sustainability.”
Yet while traders have speculated that a rate hike, while insufficient, would be a welcome first step toward stabilizing the Turkish economy (along with an IMF bailout and/or capital controls) and is far more needed than tinkering with the Lira’s liquidity conditions to “burn the shorts” (to borrow a phrase from Elon Musk), some have suggested that even a rate hike would no longer be sufficient to prevent the death spiral that Turkey finds itself in.
As Bloomberg’s Marcus Ashworth wrote recently, “officials need to demonstrate a total change of attitude, and clearly signal that this won’t be a case of “one and done.” Investors need to see that a series of increases are on their way, and that they will continue until inflation is controlled. This is the only way the doom loop can be broken.”
Alas, even that would not be sufficient to break Turkey’s so-called doom loop.
For starters, Turkish inflation has been out of control for a while, and the current account has been in deficit for years.
While investors have in the past ignored Erdogan’s obstinate refusal to accept basic economic fundamentals, things have taken on a distinct urgency as a result of the diplomatic spat with Trump which has exposed Erdogan’s stubborn intransigence to resolve Turkey’s lingering problems (which in turn will only make them worse).
For one, absent capital controls which he vowed he won’t do to avoid an investor panic, Erdogan can’t close down Turkey’s financial borders. The president is in charge of what for now at least is an open economy that is extremely reliant on external dollar funding…
… which means that not only are the tools of economic warfare out of his hands, one potential weapon — capital controls — has the potential to seriously worsen the situation, and the self-fulfilling contagion that would ensue has been dubbed the “worst case scenario.”
There is also the direct link to the Turkish banking sector, which has become especially vulnerable as a result of the lira’s freefall, resulting in a surge of nonperforming loans as borrowers are suddenly unable to repay their debt, especially if it is dollar-denominated. And much of it is: some 40% percent of the nation’s corporate lending is in foreign currencies, a proportion that only grows as the currency declines.
Then there is the debt sold by the banks themselves:
Lenders have traditionally borrowed dollars and euros by tapping foreign bank syndicates, which have been keen to lend foreign currency out to one year in order to access the juicy yields on offer in the domestic corporate debt market. For many years, western banks have subsidized that market by lending at below-market rates — financing has typically been around 120-130 basis points more than Libor.
Turkish banks so far havent’ had to pay a bigger margin to access foreign-currency loans as the big debt maturities only kick in next month, although with banks facing $16 billion in foreign FX denominated bond maturities until 2019, that hasn’t kept bank bonds from tumbling in recent days, as we discussed earlier this week.
A catastrophic sign would be if foreign banks started to pull back substantially from lending syndicates as banks seek to tap foreign markets, and as unable to rollover maturing debt. Clear evidence of a withdrawal here would the beginning of the end for lenders and companies.
Putting these various factors together, JPMorgan has created the following circular schematic, showing Turkey’s so-called “doom loop”, or the negative feedback loop that demonstrates why Erdogan may have no actionable choices to break the country’s toxic spiral:
- Turkish Lira plunges, central bank hikes rates, raising funding costs for everyone in the economy
- Domestic borrowers, unable to fund the surging interest expense, scramble to deleverage
- A sharp growth slowdown emerges, even as inflation remains persistently high
- Non-performing loans soar as borrowers are unable to repay their lenders
- Bank assets liquidation accelerates, raising concerns over the health of the local banking sector
- Foreign lenders pull back until there is stability in the economy, meanwhile making FX-debt rollover impossible
- The lira plunges more, forcing even higher rates and the cycle repeats anew.
This is shown visually in the JJPM chart beow.
And finally, since it is all about the debt in the Turkish economy, here is another infographic from JPM which maps all the debt in the Turkish economy.
So is there really no exit for Erdogan?
Not at all: both Erdogan and the rest of the emerging markets would be saved overnight if two necessary and sufficient things happened (as Macquarie explained earlier): i) the Fed stops hiking rates, and restoring global liquidity by sending the dollar sharply lower, and ii) China and the US reach a compromise on trade, allowing China to stop worrying about its domestic troubles and resumes reflating the global economy, which for most of 2016 and 2017 allowed emerging markets to be one of the best performing assets in the world. Or as Viktor Shvets put it, the “US determines global liquidity and cost of capital while also providing end-user demand, while China is able to reflate global economy through its intensive commodity & investment business model, sheltered behind capital controls.“
How likely those two things are to happen? We leave it up to readers.
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