At the peak of the Turkish currency crisis in mid-August, in addition to general concerns about the state of the local economy, one sector got hit especially hard: Turkish banks, which saw their bonds plunge amid growing concerns that the currency slump would makes it impossible for lenders to repay dollar-denominated debts or rollover maturities.
The prompt liquidation was driven by were fears that Turkish lenders would struggle to find the capital to repay the $34.4 billion of bonds sold during a decade of rapid economic growth and historically low global borrowing costs. The near-term along is daunting as Turkish banks have to service $7.6 billion in USD-denominated debt by the end of 2019.
So in a panic scramble to shore up liquidity and reassure investors of their viability, Turkish banks pulled as much as $4.5 billion worth of gold reserves, which they then sold in exchange for "more liquid" assets.
Zooming on just the recent action shows that weekly holdings reported by the Central Bank of Turkey fell by a whopping 20% since June 15 to 15.5 million ounces according to Bloomberg, with the bulk of the exodus, or $3.3 billion, sparked by the central bank's decision last month to lower reserve requirements.
As a reminder, in order to stem the plunge in the lira, on August 13 the Turkish central bank cut reserve requirements for banks by 4% points for foreign exchange liabilities over one, two and three years, and by 2.5% points over other maturities. This, the central bank said, equated to $3 billion worth of dollar-equivalent gold liquidity.
But why would banks proceed to liquidate their gold holdings as reserves were released?
For one reason: unlike most countries, in Turkey commercial banks are allowed to meet reserve requirements with gold bullion deposits, which also explains why Turkey was the hub smuggling some 200 tons of gold to Iran (a money-laundering scheme that also included the scandal-plagued Halkbank) in exchange for various products during the 2013 Iran sanctions.
Furthermore, Turkish banks mostly borrow on international markets in dollars and other hard currencies, while hedging dollar liabilities using gold deposits instead of the volatile lira, even as their loans are denominated in lira, making gold the fulcrum security in bank balance sheets.
Like in India, gold is especially revered in Turkey which is one of the 20 largest sovereign owners of the precious metal and boasts the fifth-biggest consumer demand in the world, according to 2017 data from the World Gold Council. It refines scrap gold into jewelry sold all over the Middle East, and - when the Iran sanctions hit in earnest in November - Turkish gold will once again serve as a monetary lifeline to Tehran, as the untracable gold-petro-yuandollar loop is restored.
Commenting on the sharp plunge in gold reserves, Capital Economics' Jason Tuvey said that "the commercial banks were probably switching to more liquid assets, given what has happened to the lira." Confirming what we said above, Tuvey also noted that "there’s been concern at the commercial banks over their external debt burden, which has been reflected in the rising bank bond yields."
To be sure, the plunge in Turkish bank bonds has paused as most rushed to shore up their liquidity by dumping gold, and boosting optimistic expectations they will survive the crisis.
But they may not be out of the woods just yet.
Last week, in what some dubbed an act of defiance against Erdogan, the Turkish central bank raised the one-week repo rate by 625 basis points to 24%, more than economists expected. While the anticipated hike helped stop the record 40% plunge in the lira this year, the currency resumed its slide on Friday amid fears that the economy is now set for a hard landing and economic depression along with a surge in corporate defaults: the traditional aftermath of any emerging markets currency crisis.
Ultimately, the question is whether the central bank can restore investor confidence - and just how long the emerging market crisis, and capital outflows, will continue.
"The most drastic drop appeared in August when the lira gold crisis was at its peak,” Cagdas Kuckemiroglu, Turkey-based consultant for Metals Focus told Bloomberg. "Whether the sell-off continues will depend on how the market reacts to yesterday’s interest rate change."
If the reaction is adverse, expect much more gold selling, which incidentally may also explain the ongoing gold weakness in recent weeks, driven by the concerted gold selling out of Turkey.
Meanwhile, the "doomsday" debt clock is ticking: according to Nora Neuteboom from ABN Amro, of the $118 billion in short-term debts due by September 2019, 15% is owed by publicly owned banks, and 44% by private financial institutions.
"But, of course, you can’t repay your debt in gold, so they’re probably selling to shore up finances for when their debt becomes due," Neuteboom said.