By Seamus Murphy, Managing Director, Carraighill

August 6th, 2020

Carraighill first published on Turkey in November 2019. This was our first report on an emerging market country, building on our successful research of European countries over several years. We followed by releasing ‘Dissecting Turkey’ in May 2020, the first in a series of quarterly reports to assess key investment issues. We have just published the second release of ‘Dissecting Turkey’ and we felt it necessary to share our conclusions publicly. The situation in Turkey is at a critical juncture and we now see an “end game in sight”.

1. State influence and money supply growth is accelerating: The state’s influence in the economy and the banking system continues to increase. The stock of private sector credit outstanding has now risen by 23% year to date, with the state banks’ share of total loans now at 38% (up from 35% at end 2019). M1 and M3 are coincidentally growing at an astonishing YoY pace of 81% and 39% respectively. This lending boom is occurring at a time when activity in Turkish industry has collapsed (tourism numbers have fallen 99%, with all major industries contracting year-to-date). 

2. The reserve position is precarious: The CBRT has accelerated FX borrowing from domestic banks to bolster gross reserves (USD 54bn of forwards and futures at the end of June 2020). It has also introduced measures to coerce banks to further increase TRY credit growth and limit USD deposit growth (the new asset ratio is an example). However, the real return on TRY deposits is now -5% (compared to -3% in May). This compares to +1% on the USD equivalent. Indeed, if we exclude gold and the domestic bank currency swaps from gross reserves and place this value over the TRY deposit base, it suggests zero room to accommodate a switch in depositor preference (-1% is most recent ratio, compared to 17% in May and 29% at end 2019). This high domestic flight risk away from TRY deposits (already 50% of total) lingers at a time when the current account deficit is running at -2% of GDP and portfolio flows remain negative (the stock is now USD 115bn, down from USD 179bn at the end of 2019).

3. The end game of this experimental policy appears to be in play: Turkey is quickly reaching the end of this experimental credit driven adjustment process. Higher domestic interest rates will be required to reverse dollarisation and fund the current account deficit, at a time when the economy is already contracting. The TRY/USD 3-month swap curve is currently priced at 22% (compared to the 8.25% reference rate).

4. Policy change is required: Turkey requires economic and monetary policy changes. Only then can there be a positive reassessment of future returns from Turkish assets. The country remains well placed geographically, with low relative wages, and a young well-educated population. However, the political and economic adjustment process of moving from 39% M3 growth to a much lower level is likely to be significant and will involve a broader recovery programme that is likely to be led by external creditors (IMF or equivalent). Bank equity is likely to be significantly impaired as the ‘true level’ of potential losses unfold in a country where bank corporate FX debt as a share of GDP is currently 21% (we estimate a minimum capital impairment of 64% of the current banking system’s CET1 capital base). 

5: Investment implications are available to Carraighill subscribers: If you would like to access the reports mentioned in this article, Carraighill Research Access enables you to access these and other thematic and sectoral research reports through our secure online portal. If you would like to speak to a partner or analyst on the topics raised in this piece, you can contact us here.