On Friday the 15th July, parts of the Turkish military started a coup against the democratically elected government of President Recep Tayyip Erdogan and Prime Minister Binali Yildirim. They raided TV stations, blocked bridges over the Bosporus and declared martial law. However, without wider backing from the army and the public, the attempted coup soon faltered as troops abandoned their positions and weapons. Subsequently, security forces loyal to President Erdogan retook key installations and public buildings, including the military headquarters. By Monday the 18th July the government had re-established control and public order, and after some initial financial market weakness, mainly in the FX and stock market, it looked that it was more or less over.
However, the events since Monday suggest that the failed coup has triggered potentially far-reaching economic and political consequences for Turkey. There has been much focus on the number of state employees dismissed, especially in the education sector, the judiciary and the security services. According to a BBC report, some 50,000 people had been either dismissed, suspended or asked to resign, in addition to those arrested. This is undoubtedly a massive number and any observer would question the impact on the functioning of the civil service, schools and universities, and the police and judiciary. However, according to media reports the total number of public sector employees amounted to 3.44 million in 2014, which would imply that reports about the imminent collapse of the civil service might appear premature.
To be absolutely clear, we are not trying to be facetious in the face of the dramatic events in Turkey. However, the important point is not the numbers, but the stability of Turkey’s institutional framework. Rating agency Standard & Poor’s downgraded the sovereign credit rating on Wednesday to BB from BB+, stating that “…the polarization of Turkey’s political landscape has further eroded its institutional checks and balances”. In addition to the downgrade, the outlook was lowered to “negative”, and on Tuesday Moody’s put the sovereign credit rating under review for downgrade.
This implies that Turkey is very likely to be rated high yield, even if Fitch does not change their ratings. The bond market has already priced this in as the JPM EMBI Global Diversified spread widened from 270bp to 330bp, trading even moderately wider than the average of 303bp for BB-rated sovereign credits. We cannot rule out more spread widening, especially as the removal of Turkey from investment grade indices could trigger forced selling of around USD 7.2 billion according to J.P. Morgan research.
Traditionally markets tend to overshoot in such scenarios. Brazil’s sovereign spread, for example, widened to 590bp from 250bp, albeit over a period of 15 months as the country descended into political turmoil and economic misery. The lesson from Brazil for Turkey is therefore to focus on the economy. Deputy Prime Minister Mehmet Simsek reiterated that the government would maintain sound macroeconomic policies and ruled out capital controls. Economy Minister Nihat Zeybekci added that the economy was solid and Central Bank (CBRT) Governor Murat Cetinkaya assured markets that the central bank would provide liquidity and support to the banking system if required.
These are the right messages, especially as the financing of the current account deficit, which amounted to 4.1% of GDP in 1Q 2016, already heavily depends on portfolio flows. Faced with the risk of portfolio outflows by non-resident investors and lower foreign direct investment inflows, the health of the banking sector will be critical for the economic outlook. One of the most important indicators to look at is the ratio of foreign currency to Turkish lira (TRY) deposits. Turkish lira deposits have been traditionally very sensitive to economic and political risks. As the chart below shows, when lira deposits increased relative to foreign currency deposits, the TRY remained stable or even appreciated against the US dollar, such in 2012/2013 or in recent months
The graph below contains deposit data up to 17th June; hence the impact of the failed coup is not yet visible. And whilst the exchange rate has weakened from 2.90 to 3.09, there is not yet any sign of a domestic panic conversion of Turkish lira into foreign currency. However, it also highlights that the government is now facing the difficult balancing act of keeping the confidence of both foreign and domestic investors, and especially the latter, as 92% of lira deposits have a maturity of less than 3 months, which means increased TRY conversion could quickly turn into a panic rush for the emergency exit.