Head - EMEA Investment Strategy
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President Erdogan's measures have so far been insufficient
The challenges within the Turkish economy have been apparent for many months, not helped by the unorthodox economy policy of President Erdogan and his son-in-law Finance Minister (Berat Albayrak).
In particular, the inflation rate of 8.5% in December 2017 and the current account deficit of over USD 20 billion required higher interest rates which were not forthcoming, prompting the initial fall in the currency from 4.0 versus the USD four months ago. The inflation rate has now risen to 15.9%, and the current account deficit has risen to USD 27.7 billion (over 7% of GDP).
There have been three important recent catalysts.
Firstly, Turkey has detained US pastor Andrew Brunson for nearly two years, moved him to house arrest on 25th July and resisted calls for his release by the US. The pastor had been arrested following accusations of links to the banned Kurdistan Worsters Party and the Gulenist Movement, who have been blamed for the failed military coup in Turkey in 2016.
Secondly, last week the ECB’s Single Supervisory Mechanism voiced their concern over Turkish borrowers that may not be hedged against Turkish Lira weakness and could potentially default on foreign currency loans.
Thirdly, last Friday the US announced a doubling of its tariffs on Turkish exports of steel and aluminium to 50% and 20% respectively. Turkey exported over $1 billion of steel and $60 million of aluminium to the US last year.
In combination this led to a 20% fall in the currency last week to 7.0 (taking the currency loss for the year to 45%), underperforming broad EM FX. One-month implied volatility in the Turkish Lira has also jumped to its highest level in over 10 years.
As further indicators of the rising pressures, the local 10-year sovereign bonds are now yielding 20.7% and the 5-year credit default swap spread is now up to 541 basis points. The Turkey local currency bond index (approximately 2% weighting of emerging market benchmark indices) is down over 50% this year, in USD unhedged terms. In hedged USD, it is down 22% year-to-date. The Turkey USD sovereign bond index (approximately 7% weighting of benchmark indices) is now down 15.5% in 2018.
The Turkish government responded with two measures. Firstly, a reduction in the bank reserve requirement by 2.5% for all maturity brackets, freeing up TRY 10 billion, and secondly a restriction in swap transactions to limit the currency pressures. They also stated that they would not be implementing capital controls.
These measures are necessary but far from sufficient. In the absence of sharply higher interest rates the currency is likely to remain under pressure. The weaker the currency, and the longer it is weak for, the greater the damage to the banks and the economy. This is an “old-style” emerging crisis, and as such could ultimately result in a balance of payments crisis which requires IMF involvement.
In our view President Erdogan is not likely to approach the IMF for support for some time. So it is too early to buy Turkish assets, and the key issues now are the potential wider ramifications.
While the broad European banks index is down sharply, with the biggest losses coming in those banks with significant Turkish exposures, overall exposure is small, with data from the European Banking Authority showing that overall Turkey credit exposure of European banks is approximately 1% of all European bank assets. Latest BIS data show that Turkish borrowers owe nearly USD 140 billion to Spanish Italian and French banks, with the largest exposure in Spain (which has 36% of total European bank exposure to Turkey), France with 16% and Italy with 8%.
The events in Turkey have led to wider contagion across CEEMEA currencies, with the South African Rand and the Russian Ruble down significantly. While these two currencies have also been under pressure in recent months due to idiosyncratic issues, weakness in the last few days has been driven by Turkey contagion. It is likely that investor sentiment towards these two countries could be weak for several weeks, even if the likelihood of Turkey-style collapses is low.
Broader European equity markets have been under pressure driven by Turkish concerns. However, we don’t expect that the Turkish challenges in themselves are likely to end the European bull market which remains underpinned by firming economic and corporate data, although the fragile and fluid Turkish situation could hold back the market recoveries for a short time.