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 forward-looking data-based quarterly reports to assess key investment issues in this region. In late 2020 we said that Turkey had an “end game in sight”. This tipping point was reached, and Turkey now has a new central bank governor and finance minister along with rising interest rates. However, in this piece, we argue that a return to Turkish interest rate cuts is only a matter of time.
In November 2020, President Erdogan replaced Murat Uysal with Naci Agbal as Governor of the CBRT. Some change was inevitable, given a 30% decline in the lira. Finance minister Berat Albayrak, who is also the President’s son-in-law, resigned a day later.
Governor Agbal’s policies appear at odds with President Erdogan’s views on interest rates. Despite this, Mr. Agbal has pledged to keep monetary policy tight until later this year and has not ruled out further rate hikes. The central bank has increased the policy rate by 875bps since November, highlighting the new hawkish strategy. Investor sentiment has improved considerably, foreign capital flows have increased, and the lira is among the best performing emerging economy currencies over the past three months. Central bank reserves have increased but are still well below an adequate level.
This tight policy phase may be short-lived, as President Erdogan continues to criticise high-interest rates, blaming higher borrowing costs for persistently high inflation. The lack of central bank independence remains a significant determinant of currency and price movements.
The economy has shown signs of improvement in 2021, but we note:
1. FX Reserves are wholly inadequate. The central bank remains vulnerable to external shocks and still retains limited power to defend the lira.
Reserves: These rose in the most recent period, given the c. USD 20bn of flows into local bond and equity markets. However, this positive was partially offset by the c. USD 10bn current account deficit. Total reserve growth in the period was c. USD 11bn.
Swaps: The CBRT continues to use USD swaps with local banks to flatter its stated position. These totalled USD 56bn at end December, down modestly from Q3 (USD 58bn). If these and less liquid gold are excluded, the available ‘fungible’ reserve position is negative.
FX deposit preference and the shortening of the banks’ liability structure: Despite the movement towards positive real deposit rates, the preference for FX deposits has continued. These now account for 52% of M2. Within this, demand deposits are 43% of total. This remains a worry, as our prior work shows that a rising share of M1 in the monetary base is a precursor and characteristic of countries that subsequently experience rapid inflation and monetary debasement.
Indeed, under relative PPP, the “true” inflation rate in Turkey is probably around 25% instead of the current stated 15.6%. Therefore, despite the recent rise in the CBRT rate, real TRY deposit rates are still very negative. The locals continued preference for USD is clear.
2. The external liability structure also continues to shorten.
Governor Agbal, therefore, needs to not only fund this CA deficit (2% p.a) but also stem a shortening total economy liability structure (see chart below). Short-term debt now accounts for 31% of total external debt. It represents 160% of reserves, which rises to 218% on a remaining maturity basis. Further rate hikes are inevitable in the near term (evidenced this week with the ‘market surprise’ of +200bps).
3. Attracting foreign capital will get more problematic if rates do not rise.
The inflow of foreign capital since the change in regime at the CBRT and the Finance Ministry has resulted in over USD 20bn of capital inflow. This may continue to rise in the coming weeks and months, but retaining this flow to support the deficit will become more difficult as:
a. The cost of Turkish USD financing is already approaching the 2019 lows;
b. The domestic equity market valuation is no longer “cheap”; and
c. FDI has remained weak for years and is unlikely to reverse short term (it is now primarily sourced from Qatar).
4. Navigating continued higher rates will be difficult without a significant NPL cycle in the banks and/or political interference.
With banking system loans still expanding at 35% YoY, led by the state banks, we believe any popping of the Turkish credit bubble will result in a rapid rise in the bank NPL ratio. If interest rates continue to rise, this seems inevitable.
So what now for Turkey?
The recent rate hike was needed, but dollarisation trends continue, and reserve growth is weak. The major risk is that this capital inflow reverses. There are two potential catalysts:
President Erdogan: Monetary policy in Turkey remains a political decision that needs to balance:
a. The weak economy;
b. Political popularity (the President’s support has fallen due to both a weak economy and rapid food price inflation); and
c. Minimize the risk of a large NPL cycle in the banks (currently reported at c. 4%).
President Erdogan’s view on interest rates is unchanged. He most recently said:
“I know our friends are getting angry but, with all due respect, if I am the President of this country, I will continue to talk about this because I don’t believe my country can develop with high interest rates,” – President Erdogan, January 22nd, 2021.
A rate cutting cycle may be devastating for the TRY exchange rate (and the domestic corporates who retain large FX loan exposures).
5. External Political risk
Relations between Turkey and the US are likely to remain difficult under President Biden. Further sanctions risk remains, supplementing those introduced by President Trump in December following the purchase of Russian surface to air missiles. The EU also initially agreed to impose sanctions in December 2020 over disputed drilling operations in the East Mediterranean. However, these were delayed in January due to positive talks between Turkey and Greece.
Turkish interest rate cuts anyone? Is it just a matter of time? The potential consequences are clear….
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