Turkey: Lira's collapse intensifies pressure on country's corporates and summons ghost of financial crisis
August 29, 2018
The Turkish lira has tumbled against the dollar in recent weeks, from around TRY 5.00 per USD at the beginning of August to around TRY 6.50 per USD at the close of the month. The huge currency depreciation will further strain the corporate sector and the country’s banks; fan inflationary pressures; and increase the likelihood of a hard economic landing. A raft of recent regulatory and macroprudential measures by the authorities have failed to stabilize the lira, which is likely to remain highly volatile unless more decisive steps are taken to tighten monetary and fiscal policy, and soothe geopolitical tensions with the U.S.
The U.S. announcement that it would double tariffs on Turkey’s steel and aluminum exports amid an ongoing diplomatic row between the two countries triggered the currency collapse. However, more fundamental factors such as soaring inflation, a lack of investor confidence in the Central Bank’s independence and loose fiscal policy are ultimately to blame for the lira’s weakness.
With the currency now down around 70% against the dollar so far in 2018, this is making the private sector’s external debt burden ever more difficult to manage. According to Treasury statistics, from May 2018 to December 2019, the private sector needs to make over USD 100 billion in external debt repayments. It is now increasingly likely that firms will default on their loans or attempt a restructuring, as several high-profile companies reportedly did even before the recent currency crash.
In addition, the weaker lira is likely to cause inflation—which is already at an over one-decade high—to rise even further, increasing input costs for local firms. Moreover, the resulting uncertainty is likely to dampen private investment and economic growth.
The combination of a higher external debt burden and weaker growth at home threatens the country’s financial sector and has recently led credit rating agencies Moody’s and Fitch to downgrade dozens of local financial institutions. A wave of debt restructuring and a higher non-performing loan ratio—from the admittedly current low level of around 3%—would hurt banks’ profitability, as would a sharp economic slowdown. In addition, the possibility of U.S. sanctions on Turkish banks, although unlikely, is a major downside risk. While Turkish institutions still have access to international funding, this is likely to become more expensive and harder to obtain as foreign banks look to limit their exposure to the country.
Michael Langham, economist at Fitch Solutions, highlights another risk banks could have to contend with: “If depositors begin to withdraw their holdings en masse and foreign investors envisage capital controls as increasingly possible the currency crisis could morph into a banking crisis. This would likely require state support for the banking sector and could aggravate the slowdown in credit supply, effectively shutting off borrowing streams for Turkey’s highly leveraged private sector.”
To prop up the lira and safeguard financial stability, the authorities have announced a string of measures in recent weeks, which have failed to convince markets. Most significantly, the Central Bank has increased borrowing costs by forcing banks to borrow from the overnight rate—currently at 19.25%—rather than the lower one-week repo rate. However, this monetary tightening is far too slight, particularly given that the recent price surge has caused the differential between nominal interest rates and inflation to narrow sharply. In addition, opting to raise rates subtly rather than hiking the main policy rate does little to dispel fears about a lack of Central Bank independence, and undermines the Bank’s recent simplification of the monetary policy framework. The Bank has also lowered reserve requirements and boosted liquidity provision to shore up financial stability, while the authorities have restricted short-selling of the lira and secured a USD 3 billion currency swap deal with Qatar.
For his part Berat Albayrak, Turkey’s treasury and finance minister, has struck a market-friendly tone, reiterating the importance of budget discipline and constraining inflation, and ruling out capital controls. However, specific policy measures are thin on the ground. The medium-term program, set to be presented in September, will be a key gauge of the government’s commitment to reducing fiscal imbalances. The fiscal situation has deteriorated notably since the start of the year; according to government data, the budget deficit in TRY terms soared over 80% in the first seven months and will likely worsen further in the short term, as the impact of election-campaign promises continues to be felt.
Looking ahead, in the absence of significantly tighter monetary and fiscal policy and lower geopolitical tensions with the U.S, the lira is likely to remain under pressure and highly volatile.
Author: Oliver Reynolds, Economist