Turkey’s Lira Sell-off: What Next?

Reasons for the structural weaknesses

Market concerns over the Turkish economy are not new. Investors have been flagging the macroeconomic weaknesses for several quarters and the Turkish lira was already one of the worst performers this year even before tensions started to escalate between the US and Turkey. Indeed, Turkey’s impressive growth in recent years has been boosted by easy credit, low interest rates and large public spending plans. This reliance on credit to drive economic growth higher has led to greater macroeconomic weakness, in particular wider twin deficits. Large spending plans have increased the country’s public deficit, while easy access to credit has led to higher demand for foreign goods and services, thus deepening the current account deficit. This puts Turkey in a situation in which it relies heavily on foreign investors to provide capital. What’s more, fluctuations in market sentiment are having a negative impact on Turkish assets. However, these growing vulnerabilities are only part of the story that has led to the TRY depreciation. The political environment is largely behind the recent market moves. While the financial markets, supranational entities and rating agencies were flagging rising vulnerabilities in Turkey, President Erdogan took few measures to reassure the markets. The government indeed continued to announce new spending plans and praise low interest rates but at the same time it was extremely critical of the financial markets. On top of this, investor fears were compounded by President Erdogan’s increasingly strong influence over Turkey’s financial institutions and central bank decisions. 

Why did the situation worsen in the last few days?

In addition to the structural weakness detailed above, political tensions between the US and Turkey have been rising in recent weeks. In addition to previous sources of political discontent, the detention of the US pastor Brunson has also played a role. It would be a major success for President Trump to bring him home before the mid-term elections but President Erdogan does not agree. These tensions led the US to impose economic sanctions and double tariffs on steel and aluminium last week. The President's speech last Friday devoid of any concrete plans to tackle the problem also accelerated the sell-off movement Investors are worried about contagion risks as some European banks are exposed to Turkish foreign currency debt. Added to that, the Financial Times has published an article about the vulnerability of EU banks to Turkey, fuelling further concern. The contagion effect is limited mainly to South Africa and Argentina. 

What next?

A sizeable emergency interest rate hike, a strategic partnership with the US, an IMF bailout, and capital controls are the most logical options for Turkish policymakers to avoid a major crisis in the country. At this stage, the President has shown little willingness to use such options. Fiscal reforms and budgetary austerity (without recourse from the IMF) could be another way to tackle the severe weakness linked to the “twin deficit”, but it would be a political challenge to implement. Another option is a “wait and see approach” – i.e. let the currency make all the adjustments. This would be quite risky as it would lead to higher inflation, possible corporate bond defaults and no doubt a recession.

Summary of the strategy view

As the situation in Turkey is still quite uncertain, the markets will remain volatile in the near term. The probability of seeing a step in the right direction soon is increasing. At this stage, we estimate the risk of contagion as low. The main sources of contagion would probably be via emerging market bond markets and banks. Indeed, Turkish bonds represent roughly 12% of emerging market hard currency bonds and around 7% of emerging market local currency bonds (based on JP Morgan indices). As a growing share of corporate bonds has been issued in dollars and euros, the risk of defaults is rising, suggesting a higher share of non-performing loans. Even if we start from a low base, a rise could weigh on Turkish banks and potentially also on some European banks that have stakes in local financial institutions. We keep a positive view on equity markets globally. Developed markets are supported by a favourable macroeconomic environment, and strong company results. Valuations remain attractive especially in the eurozone and Japan which are our preferred main markets. Within emerging markets, we remain positive on Asia and Eastern Europe (ex Russia). Seasonality, however, points to lacklustre returns over the summer. Global trade tensions will probably also fuel this rise in volatility. The euro has fallen against the dollar and broken a key support level at around 1.155. A rebound can be expected after this drastic movement. Our forecasts are under review even though we still expect the dollar to weaken over the next 12 months.