Turkey Lira Vertigo Neglects Gravitational Forces
Turkey’s lira has rallied nearly 7% against the US dollar so far this year and is up more than 20% since mid-November when the central bank governor and finance minister were replaced. The central bank has hiked its main policy rate 6.75%-points to 17% to quell 15% annual inflation. The return to orthodox monetary policy near halved the sovereign’s 5-year credit default swap spreads from over 500 bps in most of 2020 to below 300 bps for the first time since the onset of the global pandemic as the IMF and government estimate the economy was one of the few globally to expand last year after GDP rebounded in the second half.
Foreign stock inflows hit USD 1.4 billion while local bonds attracted USD 2.5 billion in November/December following the rate hikes after outflows of USD 13 billion the first ten months of last year, according to central bank data. Since then, overseas buyers have focused on local bonds despite inflation as CBRT Governor Agbal promises to keep rates elevated “for an extended period.” At the same time, as foreign investors search for yield Turkey attracted record demand at its first Eurobond sale of 2020 in January with USD 15 billion in orders for the USD 3.5 billion two-part offer. However, foreign investors sold USD 795 million in Turkish equities from mid-January through early February, according to official data, even as the bourse has recorded a 3% advance year-to-date and is up 24% the past three months in USD terms on the MSCI Index.
Foreign portfolio investors’ positive sentiment about lira strength and embrace of Central Bank Governor Agbal’s projection that inflation will end the year at 9.4% and meet the official 5% target by 2023 are not yet reflected by local savers. After Turkish residents’ FX deposits increased 20% in 2019 and a further 22% to USD 235.7 billion last year, they continued to rise in January, with non-lira deposits higher than those in local currency. Historical analysis from past emerging markets crises dating back to the 1994 Mexican “tequila crisis” indicates that local investor activity is a better forward-looking indicator than foreign investor flows.
While the TRY and local bonds may appear attractive today, outstanding vulnerabilities are likely to derail current enthusiasm. Rather than use large fiscal stimulus during the pandemic, Turkey relied on massive money and credit growth. The banking sector, with USD 8.25 billion in short-term external loans (excluding trade credits), expects NPLs to reach 7%. In the construction sector alone about 10% of all loans are bad, according to Fitch Ratings, while the debt of private electricity distribution companies tops USD 7 billion and reports indicate their inability to repay loans or access fresh cash resulted in power cuts. Banks face increasing pressure this year from maturing loan deferrals from battered small business, especially in the tourism sector where income fell 70% in 2020 and is unlikely to recovery this year.
More broadly, the perennial current account deficit, which reached 5.3% of GDP in December, is not expected to improve. Last year foreign direct investment covered only 0.8% of the deficit which should have benefitted from low global energy prices. Turkey imports almost all the oil and natural gas it consumes and with rising prices the deficit will be further pressured. At the same time, as economic recovery takes hold – with the IMF predicting GDP will grow 6% — the trade deficit will increase as goods imports are expected to rebound sharply on a stronger lira. In addition, although mainly a private sector headache, external debt payments over the next twelve months total some USD 170 billion.
Finally, politics and geopolitics are also likely to make investors wary. President Erdogan’s increasingly authoritarian rule may expand as he calls for a re-write of the constitution in advance of scheduled 2023 elections. Relations with the US and other NATO allies are already tense due to the government’s external forays in the Mediterranean and Syria and the purchase of Russia’s S-400 missile defense system which resulted in targeted sanctions under the former US administration. After last year’s run down of foreign reserves to support the lira, news that Turkey hired a high-priced Washington law firm for “strategic advice and outreach” over the US’ ban of the delivery of F-35s after it purchased the Russian S-400 is a stark reminder that the country’s founder’s “Peace at Home, Peace in the World” stance no longer applies as the 100th anniversary of the Republic approaches. Despite the economic and currency rebound in recent months, Turkey’s debt, deficits, politics, and geopolitics outside headline monetary position reshuffle will settle investor enthusiasm in the months to come for lukewarm selective ardor across asset classes.