With Turkish capital markets closed for a week-long holiday, traders expected last week's Turkish Lira fireworks to remain subdued. And yet, after closing for trading at around 6.00 last Friday, the Lira has resumed its drop, and was trading as low as 6.20 against the dollar after an unknown driver fired shots at the US embassy in Ankara (nobody was hurt), and a report from the WSJ that the US has rebuffed all possibility of negotiations over the release of pastor Brunson.
And according to a new report from SocGen analyst Phoenix Kalen, today's drop may be just the start of the latest sharp slide in the Turkish currency, one which will eventually see the lira drop to 7.0 by the end of the third quarter, then tumbled as low as 8 by the end of the year, before regaining some ground back to 7.0 by the end of the first half of 2019.
Kalen first lays the underlying drivers for Turkish asset deterioration as follows: overly-loose monetary policy, market participants perceiving a lack of central banking independence/credibility, a deteriorating fiscal stance, a large current account deficit that is financed by short-term flows, and an ongoing eastward political shift.
Seeing little hope that any of these adverse catalysts will change in the near future, SocGen sees Turkey engaged in a protracted trudge "toward the brink of a financial crisis." Furthermore, the French bank no longer expects an imminent substantial interest rate hike by the CBRT before its 13 September MPC meeting. Meanwhile, as Turkey-US diplomatic relations have deteriorated, focusing the public's attention on Erdogan's nationalistic agenda, Turkish policy makers are taking short-term measures to address financial stability by attacking short sellers and market liquidity without tackling macroeconomic and monetary policy imbalances.
The punchline: SocGen sees USDTRY trading up to 8.0 before reaching the "pain threshold that compels Turkey to compromise on some of its strategic objectives." In other words for Erdogan to fold in the diplomatic war with trump, the lira will have to plunge to a new record low.
Digging into the report, in its assessment of the likely scenarios for how Turkish authorities will respond to the country's challenges in the coming months, Kalen lays out three possible scenarios, of which the most likely one (55%) is that the nation continues on its protracted trudge toward a financial crisis, with the resulting financial stress eventually prompting capitulation. And while there is a modest probability for the worst-case scenario, SocGen also sees an outcome in which Turkey "descends into economic and financial crisis" with the USDTRY climing to 9.0.
Here are the details via SocGen:
55% probability (base case): Protracted trudge toward the brink of financial crisis.
- Turkey-US tensions escalate. We believe the Turkish authorities will take the lead from the country’s president, who may be unwilling to relent in the very near term on the diplomatic / foreign policy front. The rift between Turkey and the US may continue to widen, amidst escalating rounds of sanctions, threats, and retaliatory responses. (In this context, a Turkish appeals court rejected the application to release Pastor Brunson on Friday, 17 August, which could prompt another round of US sanctions against Turkey.)
- Stumbling toward financial crisis, before turning back from the brink. Although Turkey may be able to piece together sufficient financial assistance from its closest allies to meet financing needs over the short term, under this scenario, depreciation pressure on Turkish assets would return forcefully. In particular, the CBRT’s unwillingness to shift the interest rate policy corridor higher could exacerbate weakness in TRY. Under this updated base case scenario, we no longer expect an imminent substantial interest rate hike by the CBRT before its 13 September MPC meeting. Indeed, the central bank has displayed an increased willingness to wait out higher CPI readings while observing the impact of ongoing economic rebalancing, (or alternatively, is politically constrained from tightening policy). GDP growth would slow significantly, but the country would not enter a recession.
- Financial stress eventually compels capitulation. We anticipate that over a period of several months, renewed banking sector stress, the growing need to recapitalize troubled banks, mounting NPLs arising from higher corporate FX debt burden, difficulties for corporates to access external markets, and a decrease of the Turkish population’s confidence in the lira may put so much internal pressure on President Erdoğan that he is compelled to go back to the negotiating table. This could in turn lead to diplomatic concessions with the US and efforts to repair the relationship. Post that turning point, a gradual recovery in TRY-denominated assets could follow
40% probability: Diplomatic compromises are reached
- Diplomacy prevails. This could happen in the near term if economic pragmatism resurfaces as a high priority for Turkey’s leadership, if European leaders attempt to mediate between Turkey and the US, or if the US administration fully realizes the dangers of pushing Turkey further into the Eastern orbit and chooses to adopt a softer negotiating stance.
5% probability: Turkey descends into economic and financial crisis
- A financial crisis and deep recession. Under this scenario, President Erdoğan refuses to compromise on his stated priorities, while skirmishes with the US intensify, leading to restrictions on the ability of foreign nations to engage with Turkish entities. Amidst severe currency depreciation (in which we could envision USD-TRY climbing to 9.0), Turkey experiences mounting financing pressures across public and private sectors, while access to Western funding sources becomes strained. A financial crisis culminates in a sharp economic recession, with Turkey forced to seek substantial financial assistance.
SocGen also lays out all the recent measures that have been implemented by Turkish regulators designed to facilitate smooth functioning of the financial system, ease pressure on the banking sector, and discourage speculation in the currency markets.
- Stealth tightening by using the interest rates corridor to push up the average cost of funding. Currently, the interest rate framework in Turkey consists of the benchmark one-week repo rate (at 17.75%), the overnight borrowing rate (at 16.25%), the overnight lending rate (at 19.25%), and the emergency late liquidity window facility (at 20.75%). The CBRT has not offered any funding to banks via the one-week benchmark repo rate since 13 August. Nearly all of the banks’ funding requirements during the week of 13 August have gone through the overnight lending rate, whose usage effectively means implementing a rate hike of 150bp. If necessary, the CBRT could channel funding requirements to the late liquidity window, whose sole reliance would effectively bring average funding costs to 20.75% (300bp above the benchmark oneweek repo rate).
- Measures to improve TRY liquidity management. CBRT has promised to meet all the liquidity needs of the banks. There were revisions to discount rates for collaterals against TRY-denominated transactions, and tweaks to increase flexibility in banks’ collateral management. TRY reserve requirement ratios were reduced by 250bp across all maturities.
- Measures to facilitate FX liquidity management. Banks can now borrow FX deposits in multiple maturities, with the central bank presenting the possibility of increases in FX deposit limits. Reserve requirements for non-core FX liabilities were reduced by 400bp for maturities up to 3 years. Reserve option mechanism (ROM) limits were lowered to increase the USD liquidity provided to banks.
- Limits on FX swap transactions. Tighter limits were placed on the amount of currency swap transactions in which banks can engage, capping total transactions at 50% of shareholder equity, and then subsequently at 25%. In effect, this measure restricts access to TRY liquidity in the offshore swap market, pushing up short-term borrowing costs, thereby increasing costs for market participants to borrow TRY from local lenders to short the currency.
- Suspension of marking-to-market of securities held by banks. Turkish regulators this week temporarily suspended the mark-to-market requirement for banks when valuing assets held on banks’ balance sheets and in calculating measures of financial strength (e.g. capital adequacy ratios, or CAR). This suspension helps alleviate the reported deterioration in CAR, enabling banks to postpone measures to protect capital, such as restricting lending.
- Possible acceleration of corporate restructurings. Turkish regulators are considering a proposal to accelerate the restructuring of corporate debt, which would allow banks to avoid recording those loans as impaired. Turkish corporates are currently renegotiating more than USD 20bn in loans, according to news sources. Adoption of this proposal may marginally alleviate upward pressure on banking sector NPL ratios and provisioning requirements.
However, and echoing what we have said previously, what is most notable is what the Central Bank of the Republic of Turkey has NOT done through the recent turmoil. Namely, it has refrained from an explicit interest rate hike (upward shift of the entire policy corridor), "despite this being the clearest possible indication of a commitment to tame inflation pressure, improve financial stability, and demonstrate monetary policy-making independence." The CBRT’s deployment of a range of other tools and reliance on the interest rate corridor for stealth / temporary tightening suggest that it is disinclined to sustainably tighten the policy framework to protect its primary mandate (i.e. to achieve price stability). This means that the CBRT will remain far behind the curve in tackling Turkey’s inflationary pressures, and for the overly-loose policy stance to regularly translate into a driver of currency weakness.
What about the recent spike in the lira?
Well, although the lira appreciated significantly during 14-16 August, this development was not a reflection of improved market sentiment toward Turkey. Rather, the TRY rebound reflected the higher funding rates facing lenders, and the substantially higher costs of holding short-TRY positions. Importantly, with the one-shot nature of some of policy instruments employed, it may be difficult for the CBRT to re-deploy the same measures with similar effectiveness in the future.
At the same time, while yields on short-dated TURKGBs have declined, reflecting the decreased probability of aggressive near-term interest rate hikes, yields on mid- and long-dated TRY-denominated government bonds remain near the decade-high levels reached between 10-13 August.
Additionally, although bank stock and bonds have recovered slightly from their nadir, valuations remain depressed, suggesting market scepticism toward a durable improvement in the domestic macroeconomic and external backdrops.
As a result of the country's overly loose monetary policy, headline CPI will likely climb over 20% YoY. According to SocGen, some local economists have estimated that headline CPI (15.9% YoY in July 2018) could climb above 20% over the next several months, while core CPI (15.1% YoY in July) could exceed 18%.
And while SocGen touches on various other key points, including the geopolitical significance of Turkey in NATO (and what the process for withdrawing from NATO would look like), what economic measures Erdogan's administration has announced, whether capital controls are likely, what Turkey's short term financing needs are, and its source of financing, what is perhaps most curious is how the local population has reacted to the collapse in the country's currency.
Here SocGen notes that Turkish banks reported retail FX deposit withdrawals of several billion USD from branches during 9-10 August, according to local news sources. However, the currency panic appeared to have largely abated early last week – partly due to stabilizing measures from the central bank and the banking regulator, partly due to nationalistic sentiment, partly due to assurances from the government against capital controls, and possibly partly due to the fear of government reprisal for deposit withdrawal activity.
With these considerations in mind, here are the bank's end-of-quarter USDTRY exchange rate forecasts:
- 3Q18: 7.0
- 4Q18: 8.0
- 1Q19: 7.5
- 2Q19: 7.0
We now expect that any local SocGen offices in Turkey will be promptly shuttered following this "treasonous" analysis which was surely funded by the exiled cleric Gulen, the Turkish "shadow state", and/or the Trump administration.