“Respect the law”
The story goes that back in 2001 (on February 19th, to be precise), President Ahmet Necdet Sezer waved a copy of the Turkish Constitution in a National Security Council meeting and then threw it at Prime Minister Bülent Ecevit, demanding that he “respect the law”. Deputy PM Hüsamettin Özkan subsequently hurled the book back, simultaneously accusing the president of being “ungrateful”. When PM Ecevit left the meeting and called a press conference to announce that “there was a serious crisis at the top of the state”, markets tumbled. Interest rates shot up to +1000%, equities lost 15% on the day, and the Central Bank of Turkey (CBT) was no longer able to maintain the fixed exchange rate regime. Within days a severe economic crises had unfolded, as a banking and balance of payment crisis followed the devaluation of the Turkish lira (TRY). By May 2001, the International Monetary Fund (IMF) stepped in with a USD 19bn bailout, at that time the largest amount with respect to a country’s quota at the Fund.
While “the constitution throwing” incident is sometimes seen as the catalyst for the subsequent crises, the main underlying reasons instead lay in the country’s large macro imbalances that were not consistent with the fixed exchange regime. That the domestic crisis overlapped with the start of US recession in 2001 and broader outflows from Emerging Markets did not help. Against a less than forgiving backdrop, the market showed little tolerance for domestic political tension, and the subsequent crises. As the old adage goes, it is not the speed that kills but the sudden stop.
As then, Turkey’s current woes have little to do with the political crisis around the imprisonment of Pastor Brunson and the subsequent US retaliation. It is true that the pressure on Turkish external and local bonds and the TRY have escalated dramatically over the last couple of days due to increasing tensions with the US administration, but the real problem lies deeper.
Weak macro has been flagged for some time
Turkey has been flagged as one of the weakest EM credits facing tighter funding conditions for much of the year given its wide current account deficit (c.6% of GDP), large private sector USD liabilities (USD 325bn), and low international reserves position ( USD 80bn gross FX reserves and net USD 26bn). In addition, the economy has been overheating with GDP growth way above its potential (6% real growth on average over the last 3 years vs. long-term average of 4.5%) due to government’s domestic credit expansion via Treasury guaranteed loan facilities. Annual inflation has been one of the highest in the EM (15.9% as of July) and looks to continue increasing.
Although these fundamental challenges have been widely known by investors for a long time, Turkey has successfully muddled through the external shocks since the taper tantrum in 2013. Three recent developments changed the stasis and contributed to a rapid repricing of Turkish risk:
Few external backstops
A scarcity of backstops in this sell off further complicates the situation, thus prompting investors to price in fatter tail risks and worst-case scenarios. President Erdogan is strongly opposed to IMF-sponsored macro stabilisation programs and will therefore explore other routes before asking for the Fund’s help. Given the Turkish government’s deteriorated relations with both Saudi and the UAE over Qatar and Jerusalem, the probability of GCC support (minus Qatar) remains limited. China is unlikely to offer a blanket bailout, although might step in at a later stage in an exchange of assets at distressed valuations. Turkey is still important for the EU, at least for its role on controlling refugee flows and close economic links, but outright support without IMF-World Bank involvement seems unlikely.
This leaves us with the possible scenario of burden sharing with the local and external stakeholders before government steps in. After all, Turkey’s vulnerability is private sector leverage, rather than the sovereign balance sheet.
While the situation is still quite fluid, the government’s first response has been maintaining confidence in the banking system via Lira and FX liquidity injections and easing collateral constraints. This, however, may add more fuel to Lira weakness in the absence of marked tightening by the CBT, and/or a comprehensive economic plan to keep the sovereign and the banks’ access to the international capital market open. After all, the high refinancing need over the next 12 months is much higher than the CBT and authorities can plug exclusively with domestic funds.
There is a risk that the next reaction is of a less constructive nature. The authorities could choose to try tackling symptoms instead of causes, using regulatory and administrative means in order to mitigate the impacts of the ongoing economic and financial market pressures. Such a strategy could include inconsistent policies, such as fiscal stimuli or targeted loans for example, which would work against the adjustment required to reduce Turkey’s large and growing imbalances. In such a scenario, Turkish financial assets would remain under heightened pressure. Whilst contagion has been limited so far, Turkey is too large an emerging market to ignore, meaning spillover risks will have to be monitored.