Crisis alla Turca

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Yilmaz Akyüz is former Director, UNCTAD, and former Chief Economist, South Centre, Geneva

GENEVA, Aug 28 2018 (IPS) - The meltdown of the Turkish currency over a matter of a few days in August 2018 has elicited various reactions and interpretations both at home and abroad, and created widespread concern that it could mark the beginning of a series of crisis in emerging economies exposed to a reassessment of risks by international investors and lenders as well as a rapid normalization of monetary policy in the United States.

Some commentators have attributed the crisis to the sanctions imposed by the Trump administration discontent with the foreign policies pursued by Turkey on many fronts. The Erdogan government has been too happy to put the blame on “the economic warfare launched by the United States”, rather than years of misguided policies that rendered the economy highly susceptible to political and economic shocks. It has even enjoyed support from some western governments weary of Trump’s errant foreign policy. Others drew parallels with previous crises in emerging economies, notably the East Asian crisis, placing particular emphasis on the role of external debt in dollars, notably excessive short-term borrowing.

Yilmaz Akyüz

In reality Trump sanctions only acted as a trigger as the economy was sitting on a time bomb. The currency was already under pressure before the sanctions came into force because of growing awareness of the fragility of the economy. The lira had lost a quarter of its value against the dollar between January and July 2018.

On the other hand, there are some crucial differences between the underlying vulnerabilities culminating in Turkish and East Asian crises, particularly with respect to the size of current account deficits, the foreign presence in domestic securities, credit and deposit markets, the extent of dollarization and the scope for capital flight by residents. In all these respects Turkey has been much more vulnerable to currency turmoil than were the East Asian economies in the 1990s.

In a book published by OUP last year, I identified Turkey as the most fragile emerging economy highly vulnerable to external financial crisis after examining, as of end 2013, various sources of potential pressure on its currency and drain on its international reserves in the event of a sharp turnaround in market sentiments and a sudden stop of capital inflows. It was clear that in such an event, Turkey could not at the same time finance its current account deficit, remain current on its external debt payments in dollars and allow a rapid exit of non-resident portfolio investors from domestic financial markets even in the absence of capital flight by residents. It was also remarked that capital flight for residents often constituted greater pressure on the currency and international reserves. This was a serious potential threat in Turkey as residents could freely buy and sell dollars, hold forex deposits in local banks and transfer their assets abroad.

The economy has become even more fragile since then. The current account deficit has remained unchecked as the government sought consumption/construction-led, debt-driven economic expansion which has added very little to productive capacity and export potential. Persistent deficits have been financed by massive sale of national assets and external borrowing, leading to a rapid deterioration of the net international investment position, from around ‒42 per cent of GDP in 2013 to over ‒54 per cent by 2018.

External debt as a proportion of GDP rose from 41 per cent in 2013 to 63 per cent on the eve of the crisis. A large proportion of this debt, over 25 per cent of GDP, had a remaining maturity of up to one year. The sum total of short-term debt and current account deficits was more than twice as much as international reserves. Furthermore, the presence of non-resident portfolio investors in domestic markets became more visible and capital flight by residents remained an even more serious source of pressure on the currency and reserves for political as well as economic reasons.

Sovereign external debt now accounts for some 20 per cent of the total while the rest is equally divided between banks and non-financial corporations. The latter have been allowed to borrow in dollars both at home and abroad irrespective of their potential to earn foreign currency to service it. Such debt poses greater threat to stability than sovereign debt since, at times of currency turmoil, private debtors attempt to close their open positions by purchasing foreign currency in order to avoid further losses and this in turn accelerates the decline of the currency.

Turkey has thus practised an extreme form of laissez faire in financial affairs and, in effect, become a highly dollarized, dual-currency economy. Not only liabilities and assets are increasingly denominated in the dollar, but also an important part of property prices, incomes and rents, as well as government contracts in public private partnership projects are fixed in dollars.

In such an economy, a significant loss of confidence can exert intense pressure on the currency irrespective of volume and terms of external debt. With Trump sanctions the lira started a free fall primarily because of flight of residents, both asset holders and dollar debtors, from the currency, sudden stop of capital inflows and the exit of non-residents from local markets. Besides, the decline was accentuated by speculators, shorting liras in swap operations in anticipation of a significant drop in the currency. The short-term dollar debt to international creditors has not yet come into play. Still, the outcome has been steep falls in the lira and stocks and a hike in yields on local-currency sovereign debt. The cost of insuring Turkish debt (Credit Default Swaps – CDS) has shot up, reaching 500 basis points compared to 240bp for Brazil and 315bp for Greece.

In view of stern opposition of the President, the Central Bank avoided a hike in lending rates, but closed its low-cost repo funding, forcing banks to borrow at its more expensive overnight rate ‒ something aptly described as “stealth” tactic to hike borrowing costs. Further, it has limited currency swap transactions to curb speculation against the lira.

Turkey, as most other major emerging economies, is highly averse to recourse to the IMF for international liquidity because of its appalling record in interventions in past crises in emerging economies. As anticipated in an earlier IPSarticle, it thus sought help from its close allies, securing a pledge of $15 billion from Qatar.

These measures, together with 9-days respite from Muslim Eid Al-Adha brought some calm to currency and financial markets. But all is not over yet. The underlying structural fragilities remain unabated and cannot be remedied overnight because they involve severe balance sheet distortions and imbalances.

Even if the lira remains relatively stable from now on, the sharp decline it has so far undergone ‒ by some 40 per cent since the beginning of the year ‒ could impinge heavily on unhedged debtors, resulting in serious debt servicing difficulties and even defaults. As Bloomberg reports the CDS curve is inverted ‒ as it was in Greece in the worst days of its debt crisis ‒ not only for sovereign debt but also for the debt of some of the biggest commercial banks; that is, it costs more to insure one-year default than to buy five-year protection. This suggests that markets are expecting imminent debt-servicing difficulties.

As loans and bonds mature in coming months, the country may find it very difficult to persuade creditors to roll over debt or to replace maturing bonds with new ones even at significantly higher rates. An important part of syndicated bank loans is due for renewal in September 2018. The dispute with the US involving the state-owned Halkbank over Iranian sanctions can make the renewal process complicated (I thank Hakan Ozyildiz for this point). Thus, with short-term debt coming into play, the crisis could cease to be a currency crisis but a full-blown debt and banking crisis, leading to a deep and protracted economic contraction.

The crisis could also generate severe contagion to the rest of the world. Defaults by Turkish debtors could squeeze some European creditors, mainly a number of banks in Spain, Italy and France who have relatively high exposure directly or through subsidiaries in Turkey. This would also have a serious impact on global risk appetite. A sharp reassessment of risks, together with monetary tightening in the US and Trump follies in trade, could wreak havoc in several emerging economies who have gone out of bounds in the years of easy money since 2008.

When so many policy mistakes are committed and so much debt is accumulated and assets are lost, there is no easy way out. But, it is always possible to ease the pain. It is not clear if the Turkish government will be able to move from populist rhetoric to effective economic measures to address the root causes of the crisis. On the other hand, should the crisis spread globally, the international community is unlikely to be able to manage it in an orderly and equitable way, rather than muddling through it as in the past, because it is no more prepared to respond to such crises than it had been in previous episodes.