UBS: Turkey could be heading into a balance-of-payments crisis

Turkish
President Tayyip Erdogan makes a speech during a ceremony marking
the second anniversary of the attempted coup at the Presidential
Palace in Ankara, Turkey, July 15, 2018.
REUTERS/Umit Bektas/File
Photo

• The Turkish
  lira crisis is far from over.
• The country is potentially heading into a
  balance-of-payments crisis, according to UBS.
• President Tayyip Erdogan has made multiple speeches
  showing that he does not understand basic economics.
• Without a sharp rise in interest rates, which Erdogan
  opposes, Turkey may have to restrict cash withdrawals from
  banks or get a bailout from the IMF.
  
• Watch
  the Turkish lira trade in real time here.

The Turkish
lira ticked up 6% Tuesday morning after
the country’s central bank increased the liquidity of Turkish
banks by loosening their reserve requirements.

But the crisis is far from over.

The lira is down 43% against the US dollar this year. Unless
President Tayyip Erdogan makes a major U-turn by ordering an
increase in central bank interest rates, the lira — and
Turkey’s economy — is going nowhere fast.

That U-turn seems unlikely, analysts say, because of
Erdogan’s apparently irrational belief that high interest rates
are “evil.”

‘The economy stands on the brink of a debt and currency crisis’

“A number of policy errors have led to Turkey’s current
predicament,” Credit Suisse analysts Alexander Redman and Arun
Sai told clients recently.

“The economy stands on the brink of a debt and currency crisis
with only political will standing between resolution and a
precipice, in our view. Turkish policy makers are left with
unpalatable options including a sizeable emergency rate hike, the
introduction of capital controls, a heavily conditional IMF
bailout, or attempting to muddle through the uncertainty.”

They continued: “As preventable crises go, Turkey’s current
episode is tough to eclipse.” 

‘Worse than Argentina’

It’s “Worse than Argentina,” according to Exotix Capital analysts
Stuart Culverhouse and Hasnain Malik, referring to
the hyperinflation that crippled that country earlier this
year. Argentina is suffering from high inflation and a big
budget deficit, brought on in part by the US dollar’s relative
strength against the weak peso. The Argentinian central bank has
hiked rates to fight its crisis, all the way up to 45%.

But “Turkey’s currency crisis seems to be more pronounced than
Argentina’s was in April 2018 and has produced the sharpest fall
in EM currencies since Donald Trump was elected US President in
November 2016,” Culverhouse and Malik say.

It’s also worse than the recession in Turkey started by the
2001 deficit payments crisis, according to Bank of America
Merril Lynch’s Ferhan Salman. “Gross external debt has reached
US$466bn (Mar-2018, about 60% of GDP), surpassing the levels of
the 2001 financial crisis. External debt rollover needs in the
next 12 months are also high (US$180bn – about 22% of GDP),” he
told clients. 

‘We have been here before’

“We have been here before,” says Russ Mould of AJ Bell, in terms
of the 2001 crisis.

The immediate trigger for the collapse of the lira was US
economic sanctions, mainly on steel and aluminum, imposed by
President Donald Trump. But Turkey’s currency — and thus its
economy — was especially vulnerable because
Erdogan has strongly held beliefs about the function of his
central bank that most economists regard as irrational.

In basic terms, if you have high inflation then the central bank
should increase interest rates to drive prices down again.

Turkey’s inflation problem

In Turkey, inflation is currently running at 16%. (By
contrast, it’s about 2% in the UK and the US.) The Turkish
central bank held its interest rates at 17.75% in July.

That spread between the two rates — about 2% — will not
be enough to tempt Turks into depositing their cash in Turkish
banks, analysts believe. Rather, Turkey needs to hike rates by 5
or 10 percentage points, to something like 25%, in order to
create a “real” interest rate on cash above the rate of
inflation.

Increased cash deposits would shore up the Turkish financial
system, reduce the amount of cash in circulation, and bring
inflation down. It would also increase the value of the lira, and
stabilize Turkey’s economy. The downside, of course, is that a
reduction of cash in circulation would also trigger an increase
in unemployment, something that Erdogan is no doubt keen to
avoid.

The
lira has lost more than 70% of its value against the US dollar
this year.
Yahoo
Finance

Erdogan says some irrational things

So analysts are peering back through the archives to gauge the
likelihood of Erdogan being persuaded to change his mind. Credit
Suisse’s Redmun and Sai found two quotes from Erdogan published
in mid-May, in which the president expressed unorthodox views
about economics.

At a meeting in Chatham House, London, Erdogan told attendees to
“please learn” that low interest rates deliver low inflation,

according to the Financial Times.

Also in May,
Erdogan spoke to reporters at Bloomberg. He said:

“When the people fall into difficulties because of monetary
policies, who are they going to hold accountable? 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.”

He also confirmed that he was going to have a role setting
interest rates himself, confirming his central bank’s monetary
independence was over.

‘How can you invest in a country when the guy doesn’t believe in
basic interest rate theory?’

And he told Bloomberg staff at a lunch that he was resolutely
opposed to raising rates.

“How can you invest in a country when the guy doesn’t believe in
basic interest rate theory?” The FT reported one attendee as
saying. “Turkey almost looks uninvestible.”

Then in June,
Erdogan made an infamous election speech to business leaders in
Ankara, in which he said interest rates were “evil” (emphasis
ours):

“If my people say continue on this path in the elections, I say I
will emerge with victory in the fight against this curse of
interest rates … Because my belief is: interest
rates are the mother and father of all evil.”

Turkey could be heading into technical bankruptcy

Tilmann Kolb of UBS wrote in a note four days ago that Turkey
could be headed into “a full-fledged balance-of-payments crisis.”
In plain English, that would mean Turkey’s currency becomes so
devalued it becomes unable to pay its debts or buy services from
abroad — technical bankruptcy for the entire country.

“At this point, we are not sure if the policymakers have a
detailed plan for coordination or disagree on the measures, or if
communication and implementation are being blocked at the highest
level,” Kolb wrote. “Any of these is worrying given the urgent
need to act, in our view.”

He added: “The crisis looks likely to deepen at this point, and
so does a further depreciation of the lira. We think the risks
are skewed toward a further dollarization of the Turkish economy,
and possibly a full-fledged balance-of-payments crisis, the
introduction of capital controls, or an involvement of the IMF.
While the window for a rebound of the lira has not fully closed,
we continue to advise investors to reduce exposure to the
currency.”