Earlier this week, we dubbed Turkey's unprecedented, bizarre intervention in the FX market Erdogan's "Whatever it takes" moment in homage to Mario Draghi's similar deus ex machina, and according to a Reuters report, this is more or less exactly what happened.
As a reminder, almost a decade ago when the euro was collapsing and was widely viewed as reaching parity with the dollar in the near future, then-ECB president Mario Draghi unveiled his “whatever it takes” pledge to keep the Eurozone from falling apart due to the extreme widening of sovereign spread during the debt crisis. Indeed, even though Draghi’s words birthed the OMT facility, the ECB has never had to invoke it.
Now, according to Reuters, something similar took place late last week when the Turkish lira was cratering every single day in response to Erdogan's crazy economic theories (where lowering rates is somehow expected to reduce inflation). It was then that Turkey's Treasury was working on "an ambitious but risky plan" to reverse a crash in the currency that would only be launched if it crossed the "absurd" threshold of 18 to the dollar, according to four people with knowledge of discussions, a threshold which was reached just days later.
The team of Treasury bureaucrats decided that lira depreciation beyond that level - which would damage the economy in ways that are "hard to repair", one senior Turkish official told Reuters, so they needed a scheme to avoid that if needed.
According to sources, the idea - to provide a government guarantee against FX losses on lira deposits, which is as ridiculous as it sounds as it merely shifts the risk to the government balance sheet - was also floated in the midst of the last currency crisis in 2018, but it was shelved at the time due to risks. This time the risks - which have already sent Turkey's CDS blowing out - were seen as acceptable.
Among the measures Erdogan announced in response to the recent Lira volatility, are:
- A new Lira deposit instrument that will compensate depositors for losses from Lira depreciation. If the loss from Lira depreciation is higher than the interest gain on the deposit, the difference will be transferred to the depositor and will not be subject to withholding tax.
- The TCMB will offer Lira forward rates to exporters having pricing difficulties due to the exchange rate volatility.
- The withholding tax on returns from domestic government bonds will be removed. The withholding tax on corporate dividends will be reduced to 10%.
- Exporters and industrialists will be given a corporate tax discount of 1pp.
- The state contribution to the personal retirement system will be increased to 30%.
As Reuters reports, the Turkish Treasury team evaluated several other options but settled on the deposit scheme that was studied in 2018. At the time, then-Treasury Minister Berat Albayrak - Erdogan's son-in-law - decided against it, the source said.
So on Monday, President Erdogan's government pulled the trigger on the latest plan - just hours after the lira spiralled beyond 18 for the first time to a record low of 18.4 versus the USD. Another source with knowledge of the government's plan said the exchange rate - whose redline was 18 lira against the dollar and 20 to buy a euro - had reached "bubble" proportions necessitating an intervention.
"This situation was not sustainable - these were problematic and really absurd levels," the person said. After the relief rally, the person added, "if the dollar can fall to around 9, that will be a good level."
Which brings us to Erdogan's late Monday announcement - which was strategically timed to coincide with a period of low liquidity so that stops could be taken out quickly with another billion in FX intervention by the central bank - and which sparked the currency's biggest daily rally on record, to as far as 12 to the dollar, arresting a historic selloff that the president himself set off by engineering a series of aggressive interest rate cuts.
So far, the plan has worked as even the most experienced currency traders sift through the wreckage to figure out just what Turkey is doing. For its part, Turkey will do everything it can do push the lira higher even as Erdogan keeps cutting rates amid soaring, 20%+ inflation. A source told Reuters that the government hopes the lira will strengthen to the 9 range but expects it to remain between 12 to 14 to the dollar for a couple months.
That may well work but then the lira will only collapse that much faster and reach much lower levels (more on which shortly).
Central to Erdogan's promise was an effective tax-free guarantee, backed by the Treasury, that Turks would be made good on the difference between what they earn on their deposits through interest rates and any adverse exchange rate move, encouraging savers to sell dollars and buy lira. What is really happening is that Erdogan is transfering FX risk to the country's balance sheet, effectively a stealth rate hike, only one which could have catastrophic consequences for Turkey's balance sheet. Indeed, as Turkey's CDS shows, while the lira may have surged - however briefly - this has come at the expense of the country's surging default risk.
Erdogan has been pushing ahead with a "new economic model" he says will boost growth, exports and credit - despite the currency crash, soaring inflation of more than 21% and an erosion of Turks' savings and earnings. Turkish officials were clearly delighted with the outcome as a few more days of currency collapse and even Erdogan's regime was in danger of a revolt.
"The steps will raise the risk of inflation, but this can be compensated in the coming period," said an anonymous Turkish official scared to ggive his name over fears he would be disappeared by Erdogan. "For the state, this was preferred ... because not acting could have posed much more serious and irreparable risks."
So where does this leave us, and will Turkey's whatever it takes moment be as successful as Draghi's?
The answer is no. As Goldman wrote overnight, the recent move is clearly very significant but it is also worth noting that the Lira only recovered the losses it made in the last two weeks and the depreciation year-to-date is still very sizeable.
Meanwhile, the details on how Turkey's new Lira deposit instrument will be implemented are still missing and questions on what type of deposits it will cover (retail vs corporate) and who will compensate the depositors for FX losses (the Treasury, the TCMB or the banks) remain. So far, market participants tend to think this instrument will be provided to retail depositors and the Treasury will cover the potential losses from exchange rate depreciation.
At this stage, Goldman emphasizes the following points:
- Although the announcement had a notable impact on the Lira and may contribute to easing the concerns of depositors, the measures do not address the fundamental reason for the depreciation of the currency and rising inflation, in our view. Any institution or household with access to loans at rates close to the repo rate has the incentive to borrow to buy real assets or FX, given the current and expected inflation rates.
- The measure appears to be mainly targeted at reducing the rate of dollarisation in the deposit market. However, we neither think that the pressure on the TRY originates from there, nor that the dollarisation of the deposit market is the main source of potential financial instability per se. It is not clear to us how the measure incentivizes savers who currently hold their savings outside the banks in FX or other assets to put more of their savings into the banks.
- In the event of a Lira depreciation, compensating the depositors for their losses through Lira payments could lead to sizable losses for the institution compensating. Without knowing who will be compensated and by whom, it is hard to estimate the size of the risk.
Most importantly, assuming that the Treasury or the TCMB will compensate for the potential losses, this is a credit negative development as it puts additional FX risk on the public sector balance sheet.
Goldman's bottom line: "we think that this measure is unlikely to structurally stabilise inflation or the exchange rate."
We agree, and so does Bloomberg's Onur Ant agrees, who writes that Turkey’s emergency measures to bolster the volatile lira are in effect an interest rate hike in disguise, steps that leave the government budget more vulnerable to future currency shocks.
Should the lira’s decline against hard currencies exceed banks’ interest rates, the government will pay holders of lira deposits the differential. But by putting a floor under the lira in that way, the government has raised rates without saying so while depriving lira-holders of the benefits, critics said.
“There has been an epic interest rate hike without calling it one,” according to Refet Gurkaynak, a professor of economics at Bilkent University in Ankara. “There will be a big burden on the budget when there is a sharp increase in the foreign-exchange rate. This kind of burden usually gets monetized, which means even higher foreign-exchange and inflation rates.”
As noted above, the plan is intended to suppress retail investors’ demand for dollars, but skirting a formal rate hike comes at a cost: The Treasury will now underwrite losses in new lira deposits in the case of another run on the currency. That puts a strain on one of the few remaining bright spots in Turkey’s economy -- its fiscal position -- and highlights a growing trend among policy makers to lean on the public budget to pay for the cost of misguided policies.
“We can say that the budget -- the last remaining anchor -- has been sacrificed to claim that a rate hike has been avoided,” according to Ibrahim Turhan, a former deputy governor of the Turkish central bank who is now an opposition politician. “In this way, the cost of the lira’s depreciation has been put on the society as a whole.”
Bingo, however while Erdogan knows well that this plan has only made the inevitable collapse even more painful, he has bought himself a few weeks and/or months of time. Which is why we expect that Erdogan will now rush to pull forward the 2023 elections and be "re-elected" because he is fully aware that his scheme will crash and burn, leading to hyperinflation and currency collapse, long before then.
Meanwhile, keep an eye not only on the Turkish currency - which within a few months will be trading at new all time lows - but also the country's CDS because now that it has transferred over FX risk to its balance sheet, expect a full-blown economic collapse in Turkey within the year.