- What factors are driving down the economy?
- Can the crisis spread financial contagion to other nations?
- What is expected?
The Republic of Turkey, a transcontinental country in Eurasia, was the world’s 14th largest economy in terms of GDP (purchasing power parity) in 2017 (Source: Central Intelligence Agency [CIA]) and is among the founding members of OECD (Organisation for Economic Co-operation and Development) and the G-20. The nation seems to be on the brink of economic crisis after years of strong and continued growth. The rising inflation, high foreign borrowings, widening balance of payments deficit and free fall in the domestic currency are certain areas that are raising alarm bells on its financial and fiscal health.
The Turkish currency; lira has plunged more than 65% of its value against the US dollar YTD, while it also hit a record low of 7.24 USD/TRY in the mid of August 2018. The lira, which has been persistently under pressure for the past few quarters, nosedived after the US President Donald Trump announced the doubling of tariffs for steel and aluminium exports from Turkey. The falling currency has prompted concerns on Turkey’s economy, which is heavily reliant on foreign currency loans, which could further move in trouble, while also instigate a financial contagion, initially to its lenders (mainly the banks in EU). However, this may lead to way down for other emerging markets with some of these also facing similar issues lately.
Notably, Turkey was among the fastest growing emerging economies in 2017, with more than 7% GDP expansion and continued its growth, with a YoY growth of 7.4% (Q1 2018) prior to contracting 5.2% (Q2 2018) YoY growth. But this progression was at the cost of the economy. Turkey’s economic growth has been largely backed by real estate and construction boom, which was indirectly fuelled by the availability of easy credit and ever-expanding government spending. In the absence of enough savings and high domestic consumption, the value and volume of imports grew, while the same was financed with huge foreign investments either directly or indirectly for the public, corporates and government alike. The headline macroeconomic data continued to be strong until 2017 and investors from the different parts of the world persistently invested capital in terms of equity, bond market or FDI terms. Though, the pace of export could not match up the inflows and resulted in persistent and widening current and fiscal account deficit. This resulted in a $31.25 bn current account deficit up to June 2018, which was one of the largest deficits as compared to other emerging economies in the world. It is expected to hit around 6% of the GDP in 2018.
The foreign financers can be easily blamed for the Turkish bonanza in the past few years as they saw Turkey and other developing economies as attractive investment destinations compared to the ultra-low-interest-rate environments being maintained by central banks in the US and Europe. Currently, as the interest rates are beginning to rise in these more stable economies, investors are turning away from the emerging markets. Nevertheless, it is more of a lost opportunity for the incumbent Turkish government which has failed to utilise those funds in building a stable and linear economy. The government should have infused a system which had better control over the country’s and corporate finances, identified and filled the gaps in terms of local production and developed the services sector, managed a futuristic and sustainable monetary policy, while plugged the export-import gap among others.
Nevertheless, the present state of the economy is facing heat on nearly all the fronts mentioned above. Over a third of the country’s debt is in the foreign denomination and the weakening of the lira is making the repayment costlier, while also appending the inflationary pressure. Turkey’s external debt reached 52.9% of the GDP in Q1 2018, which is one of the highest debt burdens among the emerging markets. Furthermore, over half of the external debt is in the US dollar and this makes repayment tougher due to the depreciating scenario against the USD.
Turkey’s short-term external debt stood at more than $122 bn (Q1 2018), maturing within a year. In order to service its short-term debt and to finance its current account deficit, the nation needs to secure almost one-fifth of its GDP, a tough task following the recent turn of events while hinting for a risk of systemic default. Further, up to an extent the situation could have been handled by raising the domestic interest rates, which could have increased domestic savings, provided an incentive for foreign investors, while also aided support for lowering the imports and improved current account deficit. Though the steps might have resulted in a bit of slowdown of economic growth, this would still have been much stable to handle.
However, the government under President Erdogan sent the economy to soar to new heights by doing the contrary of what was required as stated above. Erdogan was re-elected as the president this year (2018) and he has never been in favour of raising interest rates, wherein the absence of an orthodox monetary policy intensified the fall of the currency. Financial market investors are also uneasy on President Erdogan's ‘executive presidency’, controlling the economy with an influence on the central bank, which caused a further damage. The double-digit and rising inflation were exacerbated by the run-up in the fuel prices in an energy importing country like Turkey and is creating a case for stagflation. The Central Bank of the Republic of Turkey (TCMB) hiked its annual inflation forecast to 14.5% in September 2018, this was way higher than the targeted 5% inflation in the earlier monetary policy for the same year. Turkey's strained relations with the United States added fuel to fire and further subverted investor’s confidence. Turkish detention of the US pastor on terror charges, refusal to cooperate with Trump’s sanctions on Iran and increasing links with Russia resulted in the imposition of 2x tariffs on Turkish steel and aluminium export to the US acted as a catalyst, which is driving the lira down.
The effects can be seen on the broader markets, wherein Turkey’s stock market has fallen more than 19% YTD and 10-year Government Bond Yield skyrocketed and is currently around 20% after hitting more than 22% last month. The credit rating agency Moody’s has downgraded Turkey’s sovereign debt, meanwhile Standard & Poor’s (S&P) has cut Turkey’s debt rating into junk territory. S&P also predicted an inflation rate of 22% by the end of 2018 and forecasted a recession in 2019.
Additionally, the currency crisis in Turkey has led to investors’ concern over the sign of contagion risk too. The currencies in the emerging markets like South Africa, Colombia, Mexico, Brazil and Argentina are also hit, as they are likely to see a rise in borrowing costs due to exposure to the US dollar borrowings meanwhile running large current account deficit with weak governance and high inflation, making them vulnerable. The lira crisis has sent ripple effects throughout global markets, increasing investors' risk aversion to emerging-market currencies and has put more pressure on the Euro. The European banks, particularly of Spain, France and Italy carry a large exposure to the Turkish borrowers and saw their share prices sliding. According to BIS (Bank for International Settlements), European banks have a ~75% share in the total foreign banks’ exposure of Turkey and this makes them more vulnerable than other countries due to a risk of losing substantial paybacks.
Turkey’s economy is stuck in a vicious cycle of mounting debt, rising inflation and currency depreciation. Although there is some form of support which is coming from Qatar through $15 bn planned FDI investment, while there is a discussion between Russia, Turkey and Iran to eliminate dollar-denominated transactions for mutual trade might help short-term financing problems. Broadly, Turkey need both immediate and long-term measures to stabilise its financial market. The International Monetary Fund (IMF) may rescue Turkey by temporary financial assistance as was the case with Argentina and Pakistan, but the US may veto to put conditions on the same. Nevertheless, the support from the IMF comes with tough conditions regarding austerity which the government might find difficult to implement. Further, harsh measures usually lead to a backlash from society and corporates, while also weaken the political support and populace of the pro-public government, which is definitely not on cards of Erdogan. The Central Bank of the Republic of Turkey has taken some recent steps to plunk liquidity from the system. The bank increased its one-week repo rate to 24% from 17.25% on the 13th of September, which cooled down the fire in both lira prices and stock and bond temporarily. But investors are looking for more concrete and credible steps towards a fiscal discipline, restructuring debt and delicately contracting inflation without hitting the growth aggressively. Turkey’s closeness to the US’ strategic rivals; Iran and Russia has strained the relationship with the US and estrangement from the NATO and this has undermined investors’ confidence with negative implications. Therefore, as an immediate step, Turkey need to raise its interest rates, notwithstanding Erdogan’s aversion, otherwise pressure on currency and other assets classes will force Turkey for a hard landing of its economy or even recession in the coming quarters.