Recent events have brought to a head a long-brewing crisis for Turkey. The Turkish lira already had a difficult year, reaching new record lows against the US dollar. But the lira went into freefall on Aug. 10 after US President Donald Trump tweeted a proposal to double his country’s tariffs on imports of Turkish steel and aluminum. Turkey retaliated by raising tariffs on US cars, alcohol and cigarettes.
This row seems to have tipped the scales for Turkey. Following years of strong growth, the country was already battling an array of escalating structural challenges. Its high dependency on foreign financing – with approximately US$180 billion in external debt coming due – leaves it vulnerable to Fed tightening. A question mark therefore hangs over the ability of Turkey’s banks and corporates to refinance their debt pile. The initial freefall of the lira also exacerbated concerns about the foreign exchange short position of the corporate sector, exposing it to currency fluctuations.
The country is also a net importer of oil. Higher oil prices meant that inflation started to grind upwards and its current account deficit began to widen, leaving it vulnerable to outflows of capital. Turkey does, however, boast a strong sovereign balance sheet, which may need to be deployed to support and recapitalize banks and corporates.
Looking back: the downside of stimulus
Turkey’s impressive growth has been fueled by considerable policy stimulus. Although initially warranted, it became inappropriate once the Turkish economy started to overheat. This caused further macro imbalances such as a rising fiscal deficit, widening of the current-account deficit (5.5 percent of GDP in 2017) and accelerating inflation (15 percent).
Another major issue for Turkey has been the lack of independence demonstrated by the Central Bank of Turkey (CBT), which many believe has led to the country’s too-loose monetary policy. Things took a turn for the worse in July, when the newly re-elected President Recep Tayyip Erdoğan replaced his country’s finance minister with his son-in-law.
To counter concerns about the CBT’s independence, the markets expected a strong macroeconomic response from the government, including higher interest rates and tighter monetary policy. However, the response announced on Aug. 10, as Turkey’s currency plunged, was in the form of a “new economic model” focused on a “strong fight with inflation” and reducing the budget deficit to 1.5 percent of GDP.
We think this new economic model is well-intentioned but essentially inadequate. It fails to provide clarity surrounding a strong economic framework, which means it doesn’t alleviate investors’ concerns about tighter controls on monetary and fiscal policy. As a result, restrictions on the purchase of foreign exchange might be imposed, at least as a temporary measure.
What should investors expect?
How the situation evolves will depend on whether Turkish policymakers introduce the “right” measures to rebalance growth, tackle the macroeconomic imbalances and regain investors’ confidence. We see three possible scenarios:
1. Turkey’s government and central bank could pursue tighter monetary and fiscal policy, along with a less confrontational foreign policy, to support the lira, restore the credibility of monetary and fiscal decision makers, and manage a rebalancing of the economy. If this happens, Turkey may see lower growth in the short to medium term (soft landing) – but it could avoid a recession (hard landing).
2. If monetary and fiscal policies remain too loose, the lira is likely to depreciate further to adjust the current-account deficit. This would further stress the balance sheets of the corporate and banking sectors. Under this scenario, Turkey’s economy would be more likely to face a hard landing, which would hurt earnings expectations and the performance of Turkish asset prices.
3. The worst outcome would be if Turkey faced a sudden stop of capital flows. This would result in more pressure on the lira and a shrinking current-account deficit on the back of contracting imports, which could lead to an economic depression.
Concrete actions needed
Turkey has a large number of challenges to overcome in the short to medium term, and much is riding on policymakers’ response. While the situation remains fragile, the announcement of the “new economic model” is heading in the right direction. However, to restore the credibility of the Turkish authorities, those announcements have to be accompanied by concrete actions. Barring that, investors may see steep earnings downgrades and a higher risk-free rate. Together with Turkey’s ongoing confrontation with Western countries, this could dry up Turkey’s capital flows.
The situation facing Turkey recalls the taper tantrum of 2013. The Fed’s announcement that it would scale back its bond-buying program triggered widespread market volatility, particularly in emerging markets. To the “fragile five” markets impacted at the time, we can now add the likes of Argentina, Chile, Colombia and Russia, whose higher levels of US dollar debt make them vulnerable to Fed quantitative tightening and rising US interest rates. Combined with a more vigorous agenda from President Trump, tensions and volatility could stay high for some time.
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