By Richard Jenkins, CFA, Emerging Market Debt Portfolio Manager, EMEA Fixed Income Beta and Zhen Li, CFA, Senior Portfolio Manager, Emerging Market Debt
Simmering economic and financial problems in Turkey reached a boiling point on Friday as markets were unconvinced that Turkish President Recep Erdogan could contain the country’s economic problems and the US president threatened a doubling of some metal tariffs on Turkey. The lira fell to an all-time low, driving steep losses in emerging market equities and currencies.
The latest turbulence underscores investors’ diminishing confidence in Turkey’s ability to resolve its significant fiscal challenges. Turkey has been stuck in a vicious circle for years: high, uncontrolled inflation resulting from the pursuit of credit-fueled economic growth without an effective policy response from a central bank lacking real autonomy from the government. This has led to an increasingly weaker lira, sending the inflation rate higher. While this is not a new phenomenon for Turkey, its domestic problems are now exacerbated by a number of external challenges.
The “lower for longer” interest rate mantra from major central banks during the long recovery from the financial crisis pushed investors into higher-yielding assets, like Turkish debt. More recently, with those same central banks beginning to tighten, whether through explicit rate hikes or slowing or unwinding QE asset purchases, those same yield-hungry inflows are reversing, particularly from countries like Turkey that lack strong fundamentals and attractive valuations. Turkey runs a sizable current account deficit that is financed primarily by portfolio flows that are very sensitive to investor sentiment.
As US growth pulls ahead while other countries’ growth is slowing, this divergence is driving the US dollar higher, exacerbating Turkey’s current account deficit. Turkey has twin deficits, and its corporate and banking sectors have high levels of cross-border debt. Turkey’s short term external debt is greater than its foreign currency reserves. In principle if all of Turkey’s short-term debt matured today, the country would not have enough reserves to cover it. Investors know that US dollar appreciation reduces Turkey’s ability to finance its balance of payments, and that this will have a considerable impact on corporate balance sheets, which causes non-performing loan levels to rise across the banking system and increasing corporate default rates.
Meanwhile, political risk is rising. Part of Erdogan’s moves to consolidate power has involved re-shuffling his economic team and removing more market-friendly officials. Turkey’s central bank appears to have become more politicized; for example, the central bank took no action at its most recent monetary policy meeting despite, the consumer price index reaching 15% alongside signs of further rises.
While recent selloffs in countries like Argentina were driven by high foreign currency government debt and the high foreign ownership of debt, Turkey stands at the opposite end of the spectrum. Foreign currency government debt to GDP stands at 11% of GDP for government and foreign ownership of government debt at 20%. The problem lies in the corporate sector where debt now stands at the equivalent of 37% of GDP (21.6% in case of banks). It is no wonder that the European Central Bank (ECB) is particularly focused on Turkey, as what appears to be a domestic problem may soon become a European banking sector problem. The recent emergency monetary measures by the Turkish central bank is expected to have an impact on growth, with real GDP growth expected to fall from 7.4% in 2017 to 4.1% in 2018 and further down to 3.4% in 2019.
What is needed to restore investor confidence? Markets will be closely watching Turkey’s macro targets for the next few years. To stabilize the lira, this would need to include signs that the leadership is prepared to target slower growth, credible efforts to reduce inflation to single digits and explicit guidance on how the country plans to manage the current account and budget shortfalls. These are the key elements to break the vicious circle. If the government is unable to deliver on the reforms market is looking for, we expect any interest rate hikes can only offer short-term relief and in our view, further sell-offs would be inevitable, as would reaction from the credit rating agencies, with the next rating review by S&P scheduled on the 17th of August. Global investors will be focused on Turkey until then.
Consumer Price Index (CPI): A measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is calculated by taking price changes for each item in the pre-determined basket of goods and averaging them. Changes in the CPI are used to assess price changes associated with the cost of living; the CPI is one of the most frequently used statistics for identifying periods of inflation or deflation.
Gross Domestic Product (GDP): The monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
The views expressed in this material are the views of Richard Jenkins through the period ended August 10, 2018 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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