Wednesday, August 15, 2018

Lessons from the Turkish Lira Crisis

By Roy C. Smith

Turkey is the world’s 17th largest economy by GDP ($850 billion in 2017), bigger than all but six of the 28 EU countries, and just a bit smaller than Spain. It is the largest and most modern economy of the Middle East, and last year it grew at 7% (more than China). It is also a NATO member.

Last week, however, the Turkish lira dropped 20% against the US dollar, bringing its year to date decline to 46% and igniting fears of a financial crisis in the country. This is because Turkey has $460 billion (53% of GDP) in “external debt” (i.e., denominated in currencies other than the lira, mostly US dollars), about half of which is private sector debt. Approximately $30 billion of this debt is estimated to come due this year when it must be repaid or refinanced in global capital markets.

The plunge in the value of the lira has made meeting maturing dollar payments much more expensive for borrowers, and foreign banks more reluctant to roll the loans over. The cost of credit insurance on Turkish debt increased by 20% just in the last week (higher than Greece or Pakistan) as the probability of wider debt default increased.  Bloomberg reports that Turkish banks are in the process of restructuring more than $20 billion of distressed corporate debt.  

Investors have shown concern about investment conditions in Turkey even before the powers of strongman President Recep Tayyip Erdogan were further increased after his recent reelection. To retain his political support, Erdogan has been an aggressive driver of the economy, promoting large debt-financed construction projects and forcing interest rates down to encourage growth, despite rising inflation that reached 15.9% in July. Erdogan’s increasingly populist and nationalist policies have eroded relations with the EU (which Turkey has sought to join for many years) and the US. Indeed, the sharp drop in the lira in the past week was attributed to Donald Trump’s doubling tariffs on Turkish steel and aluminum exports to the US because of Erdogan’s refusal to release an American pastor charged with participating in the 2016 unsuccessful coup attempt against Erdogan.

Mr. Trump’s action may have sparked a market reaction to a changed political-economic outlook for Turkey, but sooner or later the underlying facts would have brought about a similar response. Markets react, however, not just to changed information but also to changed psychological factors – anticipating what other investors will do to get out ahead of a panic.

Turkish stocks have dropped 20% since the beginning of the year, not a panic yet. But markets are now worried that one could happen if the economy drops into recession, bankruptcies increase and strain the banking system already weakened by the falling lira (and banks having to refinance their own maturing dollar debts). Under these conditions the banks will have nowhere to turn but to the government.

But the government has foreign debt coming due also, which it will only be able to rollover at much higher interest rates. Yields on 10-year lira bonds are already at 21%.

This is what happened in the Greek crisis in 2010 that took years and more than $320 billion in three bailouts by the Eurozone countries to bring to a minimal level of resolution. But the Turkish economy is about four times larger than Greece’s and there is no Eurozone community to cushion Turkey’s problems.

To try to avoid a financial crisis the Turkish central bank pushed up local interest rates to a growth-killing 18% in June. The drop in the lira has caused many Turkish investors and bank depositors to try to get their money out of the country into something safe. Repaying foreign currency debt that banks won’t rollover has strained Turkey’s foreign exchange reserves, but these reserves are quite small and may soon be exhausted. When they are, the country will have little choice but to either default on all its foreign debt (which takes several years of recession and austerity to remedy) or to call on the International Monetary Fund for assistance, which only comes with harsh economic remediation measures, to restore normal conditions.

There are a few lessons to be found in these events.

One.  Whether they prefer it or not, all countries are bound together by their use and dependence on global capital markets. These now represent about $300 trillion of market value that is subject to changing investor concerns. Emerging market countries like Turkey have benefited enormously from access to this source of funding for its economic development. Denied foreign credit, most countries are subject to reductions of growth rates, market values and general prosperity. But to retain access to foreign credit, countries must conform to acceptable economic and political norms. Turkey’s relatively high growth rate in recent years was financed by foreign capital, but access to this capital involves accepting the norms and disciplines associated with it.

Two. Too much foreign currency borrowing is dangerous for emerging market countries. Access to it can be denied suddenly if global financial markets lose confidence in the country, for whatever reason. When it does, big trouble inevitably follows. And, contagion to other countries can occur when a major country is under pressure. The Turkish situation has not led to wide contagion yet; the JP Morgan Emerging Market Bond Index is down 9% from the beginning of the year, and down 5% since July, but not in contagion range. However, signs are already visible that foreign investors are extracting money from Argentina, Indonesia and some other countries with problems like Turkey’s.

Three.  US tariffs and sanctions can make things substantially worse. They can be powerful particularly because they can halt dollar funds flows of various types that connect countries to the global economy.  Because of the size of the US market for goods and services, and because the US dollar is used to enable more than 70% of foreign trade, US sanctions are by far the most potent of all as Iran, Russia, North Korea, and Cuba have experienced. 

Four. But, especially because they are potent, sanctions (or tariffs imposed in lieu of sanctions) can be dangerous too for those that impose them. Sanctions aim to weaken countries and induce them to behave differently, but the behavior change cannot happen quickly. Sanctioned countries first respond politically by threatening retaliation (ineffective) and to replace imports with locally manufactured goods (impossible in the short to mid-term).  Mr. Erdogan has said Turkey will not yield to US pressure, though it has little capacity to resist. But reversing sanctions can take years to play out (Cuban sanctions have been in place for more than 50 years), during which time the targeted countries suffer economic hardship, and relations deteriorate significantly. These results interfere with other political goals and intentions of the sanction imposers. It can hardly be in the US interest to cripple the Turkish economy to such an extent that is driven into the arms of the Russians or Chinese, NATO is weakened, and/or tumultuous “Arab Spring” regime-change conditions emerge with uncertain consequences.

Five. No matter how authoritarian a government may be, it can be brought to its knees by the consequences of the withdrawal of foreign credit. After the run on the lira, President Erdogan blamed it on the actions by Mr. Trump and threatened retaliation and other measures. He has also disclaimed the idea of requesting assistance from the IMF. But he is in the grip of a major crisis that will only get worse if he avoids coming to terms with it. Market forces are more powerful than he is, though apparently, he doesn’t know that yet.

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