Investors in Turkey are no strangers to volatility, which has plagued one of the Middle East’s largest economies for years. But not everyone can surround this time.
De lira tumbled until Friday a record low, even though the central bank has spent billions in the past year to clean up. Earlier this week, the cost of borrowing money offshore jumped above 1,000%, the latest sign of dysfunction in Turkey’s money markets.
Authorities have resisted rising interest rates despite pressure on the currency to weaken further, causing an outflow of foreign capital and leaving the economy vulnerable when its currency collapses.
The background
A credit binge lies at the heart of the turbulence. Even before the coronavirus pandemic hit Turkey, the central bank was deep in a frontloaded easing cycle, emboldened by President Recep Tayyip Erdogan’s growth-at-all-cost approach to the economy.
To mitigate the battle of the coronavirus pandemic, authorities then doubled down by creating an engineering campaign to gain credit flowing through the economy. According to the central bank’s preference statistics, lending growth over the past 13 weeks was 40% annually, reaching 50% in May, the fastest rate since at least 2008.
De explosion of credit has brought the country’s current balance back into deficit and risks fueling a fresh rate of inflation that has devalued the lira over the years.
Why not increase rates?
First up are Erdogan’s unorthodox consider that higher interest rates win the price prices. Last year, he fired a central bank governor for failing to cut borrowing costs.
There is also the more pragmatic purpose of employment. Erdogan has suffered his most stinking defeated in elections last year, when his party lost control of major municipalities, including the capital Ankara and commercial hub Istanbul.
With official unemployment near the highest level in more than a decade, the economic blow of the coronavirus pandemic could test the popularity of the ruling AK Party. The economy is set to shrink by 4% by 2020, according to the median estimate of analysts surveyed by Bloomberg.
But is not the lira so important to keep in check?
It is. In fact, it is the most viewed economic indicator in a country where more than $ 200 billion in household wealth and business savings are held in foreign currencies.
It is also an existential issue for many of the country’s companies, which are sitting on $ 289 billion in debt for foreign currency, accounting for more than a third of the economy’s output. The economy as a whole has $ 169.5 billion in external debt to roll over the next 12 months.
So what’s the plan?
The authorities seem to have adopted a bilingual approach to get the best of both worlds: low rates to stimulate growth and a stable lira.
They have tried to meet the increased demand for foreign currency by spending the central bank’s reserves. As a result, their gross currency buffers have fallen more than a third this year to $ 49.2 billion as of July 17, including gold, they stand at 89.5 billion.
Meanwhile, they have restricted the flow of capital to wager the possibility of foreign investors against the lira. Local banks were banned from lending more than 0.5% of their capital to offshore counterparties, which limited the market’s ability to free up the exchange rate.
How long can this take?
According to some analysts, there is limited room for maneuver. Goldman Sachs Group Inc. estimates that the central bank has spent $ 65 billion on lifting the lira this year, putting the difference between its assets and liabilities in foreign currency at a negative $ 41.3 billion at the end of June.
This is in part because it also borrows dollars from local lenders to increase their coffers, essentially recycling dollars and euros that savers in Turkey have placed with local lenders.
The stricter liquidity measures have stood in the way of an aggravated write-off. But that has come at a significant cost. While they are in place, foreign investors will be reluctant to return money in the country as the cost of hedging or financing their positions can become incredibly expensive and unpredictable.
On Tuesday, the cost of borrowing overtime was borrowed spiked to more than 1,000% as liquidity evaporates, leaving many investors with no other option but to dump Turkish assets. The squeeze was so serious that several global banks failed to meet their lira obligations.
What happens next?
Some say the central bank will introduce and aggressively increase rates as it declines in 2018. But those hoping for such a move amid Thursday’s slide were disappointed. Instead, the regulator said it would roll back liquidity steps taken to support the economy during the global pandemic. The lira extended its retreat.
Still, there are signs that officials may change their position. State lenders were largely absent from the currency market on Thursday and appeared to let the lira flow freely. Authorities also made some restrictions on foreign exchange currency trading and are reining in policies that cause a credit crunch.
There is also the option of the last ditch effort to use some form of financial assistance from the International Monetary Fund, although Erdogan has strongly condemned that.
Could a crisis affect other emerging markets?
Turkey is no longer an emerging market dear. Trading volumes have dropped considerably and foreign investors are positioned lightly. The share of foreign property in the debt of the local currency has fallen to a record low of 4.2%, while the weight of Turkey in the benchmark MSCI equity index in two years is almost half to just 0.4 %.
Still, in dollars and other hard currency indices in emerging markets, only seven nations have heavier weights than Turkey, and forced sales by passive funds could sell a wider sale. This could annoy traders and restrict investment in other markets.
(Adds details of latest policy response in section entitled What happens next?)
.
