Monday, May 21, 2018

God Help Turkey: Lira Crashes As US Yields Explode

 (Staff articles from The BLOOMBERG & DAILY RECKONING on May & February 2018.)

With Turkey’s central bank sitting on the sidelines observing a currency meltdown and double-digit inflation, one brokerage is looking for help from a higher power.

“God help Turkey,” Istanbul-based broker Alnus Yatirim said in the sign-off to its morning note to clients on Monday. “We’re faced with a central bank that is watching the market when it needs to lead and direct it.”

The brokerage predicted that the TRY could fall to 4.58 per dollar by the end of this week - or rather the start as it is already there now, give or take - and 4.75 next week.

The market is testing whether the central bank’s verbal interventions are a bluff or not, Alnus said. Without policy action, the damage is likely to spiral, it said, citing the $222 billion of net debt held by Turkish non-financial companies in overseas currencies. Each 1 cent depreciation in the currency adds about 5 billion liras to the cost of Turkey’s foreign borrowings, it said.

Adding to an already dire picture, overnight rumors emerged that the government will seize foreign currency deposits although Turkey’s banking regulator chief Mehmet Ali Akben said such speculation is "absurd," Sabah newspaper reported. "Such a decision is neither discussed or a work has been done on it" he said noting that banks’ rollover ratio is around 110%, and adding that they have no problem in foreign borrowing.

Although just as one Turkish official was about to sound somewhat credible, he added that similar speculations are being made before every election and accused credit rating agencies of trying to spread negative mood. He also said that the Turkish banking system is strong, although one look at today's 10Y Turkish yield which just hit an all time high of 15%, may suggest otherwise.

The comments come as Turkey competes with Argentina, Angola and Venezuela for the world’s worst-performing currency this year. The Turkish lira has declined more than 16 percent against the dollar in 2018, the most outside those three nations. Such losses will continue if there’s no intervention, Alnus said.

Based on the pace of the lira’s weakening in recent weeks, the currency could fall to 4.58 per dollar by the end of this week and 4.75 per greenback next week, the brokerage said. The lira dropped 1.4 percent to touch a record low of 4.5621 per dollar on Monday.

Lira Extends Slide to Record as Rising Treasury Yield Fuels Rout

Turkey’s lira tumbled, hitting new all-time lows against both the U.S. dollar and the euro, as increasing U.S. Treasury yields deepened a rout in the currency.

The lira led losses in emerging markets to extend last week’s slide of around 4 percent. The higher U.S. yields are exacerbating the pressure by reducing the allure of riskier assets, while a lack of action by the Turkish central bank this month is disappointing investors hoping for rate hikes.

The lira was 1.8 percent lower at 4.5736 per dollar by 2:33 p.m. in Istanbul, after falling to a record low 4.5751. One-month implied volatility on the dollar-lira pair, an indicator of expected swings, surged to 22 percent, extending its climb to the highest level since January 2017. The yield on 10-year government bonds rose 16 basis points to 15.22 percent, a new record.

“We do not want to sound like a broken record, but after the lira plunged to yet another record low it is evident that unless the central bank acts decisively and raises interest rates substantially at an emergency meeting, the sell-off is likely to continue,” said Piotr Matys, an emerging-market currency strategist at Rabobank in London.

Erdogan Plans to Tighten His Grip on Turkey’s Economy

Turkish President Recep Tayyip Erdogan said he intends to tighten his grip on the economy and take more responsibility for monetary policy if he wins an election next month.

With the Turkish lira at a record low against the dollar and down this year against all 17 major currencies tracked by Bloomberg, Erdogan told Bloomberg TV in London on Monday that after the vote transforms Turkey into a full presidential system, he expects the central bank will have to heed his calls for lower interest rates. The central bank’s key rate is now 13.5 percent, compared with 10.9 percent consumer-price inflation.

“When the people fall into difficulties because of monetary policies, who are they going to hold accountable?” the 64-year-old president said in the interview. “They’ll hold the president accountable. Since they’ll ask the president about it, we have to give off the image of a president who’s influential on monetary policies.”

That “may make some uncomfortable,” he said. “But we have to do it. Because it’s those who rule the state who are accountable to the citizens.” The lira slid to its weakest level ever against the dollar after his remarks were published, losing as much as 0.9 percent to 4.4045, down 14 percent this year.

Even the threat of political interference in setting interest rates will harm the economy, said Durmus Yilmaz, Turkey’s central bank governor from 2006 to 2011 and now an adviser to a newly formed opposition party.

“This rhetoric is extremely dangerous and will put Turkey in a dead end street,” Yilmaz said in an interview responding to Erdogan’s remarks. “Turkey did try the exact same thing in 1994 and that's how we ended up with a crisis where interest rates, which politicians at the time thought were too high,” rocketed to more than 400 percent.

Erdogan last month called snap elections for June 24, when a victory would consolidate his one-man rule of a country he’s governed since 2003. Since putting down a coup attempt in 2016, Erdogan has used emergency rule to increase his control over the region’s largest economy. A referendum last year weakened the role of parliament and gave the president sweeping authority in the most radical constitutional overhaul since the republic was founded 95 years ago.

“From the moment we move to a presidential governing system, our effectiveness there will be very different,” he said. “We’re going to do this so we can be held accountable for the responsibility we’ve taken.”

The one-time Islamist firebrand, who was jailed on charges of inciting hatred in 1999, was in London meeting with executives, bankers and investors amid a sense of mounting crisis in Turkey’s economy. He’ll meet U.K. Prime Minister Theresa May and Queen Elizabeth II later on Tuesday.

The outreach comes as Turkey’s relations with its NATO allies fray and its diplomatic focus shifts toward Russia and Iran. The country faces the unprecedented risk of sanctions from the U.S., a risk that Erdogan downplayed.

“We can’t cut off our ties with Russia,” he said in response to whether he was prepared for U.S. sanctions should he consummate the purchase of a missile defense system from Vladimir Putin’s government. “If we’re allies with the U.S., we need solidarity, not sanctions.”

The rapidity of the changes to Turkey’s economic and foreign policies has shaken investor confidence, which is critical because Turkey’s current-account deficit demands steady inflows from abroad. The shortfall in the first quarter of this year was more than $16 billion, almost double the same period last year.

Turkey Will Be Ground Zero in the Next Global Debt Crisis

Turkey is a beautiful country with a rich history, including Greek, Roman and Muslim influences, making it one of the most fascinating places on Earth. It is literally a bridge between East and West: The mile-long Bosphorus Bridge, just north of Istanbul, connects Europe and Asia across the Bosphorus Strait.

Turkey has been a magnet for direct foreign investment from abroad and dollar-denominated loans by international banks to local enterprises. This investment enthusiasm is understandable given Turkey’s well-educated population of 83 million, and its rank as the 17th-largest economy in the world, with a GDP of just under US$1 trillion.

The flood of bank lending and direct foreign investment has given rise to another flood of hot-money portfolio investors in Turkish stocks, chasing high returns with cheap dollar funding in a variation of the global carry trade. So-called emerging-market (EM) funds, offered by Morgan Stanley, Goldman Sachs and others, are stuffed full of Turkish stocks and bonds.

In my many visits there since 1996, I have observed Turkey’s shift from a firmly secular society to one dominated by religious and authoritarian rule. As Turkey turns its back on Western society, it still relies on Western institutions to deal with potential debt, currency and reserve crises. Turkey’s new alienation from the West may mean that Western help will not be available in a future financial crisis.

But there’s a dark side to this seeming success story. Turkey’s external US dollar-denominated debt is so large that a combination of rising US dollar interest rates and a slowing global economy could quickly turn Turkey from model EM to the canary in the coal mine of the next great global debt crisis.

The risk of a major debt crisis beginning in Turkey is heightened by the rise of Turkey’s President Recep Tayyip Erdoğan as an autocratic strongman in the mould of Argentina’s Juan Perón and other populist nationalists who have ruined strong economies.

Begin with a look at the Turkish debt situation. Turkey’s debt is huge; one of the highest debt burdens of any EM. Turkey owes US$450 billion to foreign creditors, of which US$276 billion is denominated in hard currency, mostly dollars and euros. The remainder of US$174 billion is denominated in Turkey’s local currency, the lira.

Both kinds of debt are problematic. The lira debt is a growing burden because lira interest rates have skyrocketed from 6% to 12% in the past five years. The foreign currency debt is problematic for two reasons.

The first is that, since 2013, the lira has devalued from 1.75 to 3.89 to the US dollar, which increases the amount of lira needed by local companies to repay their external debt. The second reason is that US and euro interest rates are starting to rise, which also makes the external debt burden more difficult to service.

Turkey’s hard currency reserve position is adequate for the moment, with about 100% coverage of foreign debt. The problem is not an immediate debt crisis but the likelihood that foreign credit could dry up or reserves could drain quickly, leading to a tipping point and a rapid loss of confidence.

Unfortunately, there are numerous economic and geopolitical catalysts for such a loss of confidence. The principal catalyst is a sharp deterioration in Turkey’s relations with the West, and increasing links between Turkey and Russia that could lead to a crisis.

Recent polls show that 68% of Turkish citizens believe that Turkey’s alliance with Europe and the US is breaking down. The same poll shows 71.5% of Turkish citizens believe that Turkey should enter into an economic, political and security alliance with Russia.

Another irritant is the widespread belief in Turkey that the US played a role in the attempted military coup d’état against President Erdoğan in July 2016. This suspicion is heightened by the fact that the US refuses to extradite Erdoğan’s political enemy, Fethullah Gülen, who lives in exile in Pennsylvania.

Erdoğan alleges that Gülen tried to force him from office in 2013 based on false charges — what Erdoğan called a ‘judicial coup’. The combined impact of a so-called judicial coup and an actual military coup attempt have led to profound distrust between the US and Turkey.

The US court system is also currently hearing a trial in which a Turkish-Iranian gold dealer, Reza Zarrab, has turned state’s witness, and is providing testimony involving bribes and kickbacks by the Erdoğan government.

The US government’s main charge is that Turkey helped both Russia and Iran avoid US government economic sanctions. A newly passed Russian sanctions bill would impose severe penalties on Turkey if it goes ahead, with a proposed purchase of Russian anti-aircraft systems.

A more serious point of contention between the US and Turkey involves the role of the Kurds in Syria. From Turkey’s perspective, the Kurds are a separatist movement that threatens the territorial integrity of Turkey. The most extreme Kurds are pushing for an independent Kurdistan that would include parts of present-day Turkey, Syria, Iraq and Iran.

From the US’s perspective, the Kurds are a potent fighting force who have been instrumental in the decimation of ISIS, and are now playing a key role in support of Syrian freedom fighters opposing the regime of Syrian President Bashar al-Assad. The Kurds are bitter enemies of Turkey and good friends with the US.

Another confrontation between the US and Turkey is emerging over the status of Qatar. Saudi Arabia economically isolated and physically blockaded Qatar because of its support for terrorists and Islamic radicals. The US has tried to mitigate this conflict, but on balance supports the Saudi position.

Turkey has come to the aid of Qatar with both financial support and a military presence. A war between Saudi Arabia and Qatar would, in effect, be a proxy war between the US and Turkey — two erstwhile NATO allies.

Right now, this is eerily similar to Thailand in 1997. US-Turkish relations are at their lowest point since the breakup of the Ottoman Empire in 1922. This deterioration in relations has important economic implications. If Turkey were to find itself in financial distress — a highly likely outcome in the near future — the usual place to turn for a financial lifeline is the IMF. However, the US and its Western allies, especially Germany, have effective veto power over IMF bailouts.

The US might demand conditions on any IMF assistance to Turkey in the form of compliance with Russia sanctions. Turkey would likely reject such conditions, leading to an impasse on the subject of IMF aid.

The Turkish stock market has been on a tear for the past two years, since the failure of a coup attempt in July 2016. However, recent experience shows that emerging-markets (EM) stocks are highly susceptible to US rate hikes and hot-money outflows. The Fed’s experimental ‘double tightening’, consisting of rate hikes and balance sheet normalisation, could send EMs — and Turkey in particular — into a tailspin.

With geopolitical tensions rising, and the US aggressively tightening monetary policy, what are the prospects for the Turkish lira and Turkish markets in the months ahead?

The single most important trend is Turkey’s growing isolation from the West at the same time that Turkey’s external debt burden spirals out of control. The geopolitical issues noted above — involving Syria, Qatar, the Kurds, Russia and Iran — could lead to a sharp break in US-Turkey relations and Turkey’s departure from NATO.

President Erdoğan is strong-willed but also defiant and stubborn in the face of what he regards as the infringement on Turkey’s sovereignty by the US and Europe. Far from negotiating with the IMF in the event of distress, Erdoğan could easily impose capital controls, which would effectively be a default on all external debt and lock all equity investments in place, with no ability to cash out for dollars. Turkish stock and bond markets would plunge at best or cease to function at worst.

The situation in Turkey is uncomfortably close to the situations that arose in Thailand in 1997 and Russia in 1998. In both instances, both countries closed their capital accounts after attracting billions of dollars in foreign loans and investment. Those Thai and Russian defaults precipitated one of the most acute and dangerous liquidity crises in world history.

Just the existence of these geopolitical fault lines and potential financial defaults is enough to slow down new investment and loan rollovers in ways that make a credit crisis in Turkey even more likely.

Erdogan's Islamic Turkey is heading horribly towards a currency crisis.