NEWS ECONOMY NEWS        28/05/2020

Fitch answers questions on Turkey’ potential balance of payments crisis

On May 6th, 2020,  Fitch Solutions hosted a webinar titled, ‘Turkey’s Macroeconomic Outlook: Covid-19 To Exacerbate Key Structural Challenges’ covering some key emerging market themes, and it has now provided answers to some of the questions it received during the webinar as follows:


“How will external headwinds develop over the coming months?


Turkey faces a very challenging external environment due to deep recessions in its key European export markets. To take one example, we now expect that economic activity in Germany will contract by 5% this year. The economic recovery in Europe, and elsewhere, will be slow and patchy. Our working assumption is that activity in most major economies will begin to rise in year-on-year terms in Q3 or Q4, but that global output will fall by 3.0% over the entire year. As such, we forecast Turkey to also contract 3.4% in 2020, with risks tilted to the downside. Downward risks also stem from the possibility of a second Covid-19 wave and it is worth remembering that, even if the global economy picks up faster than we expect, Turkey may struggle to capitalize on stronger demand. Tourism, which contributes about 12% of GDP in Turkey, is likely to be one of the sectors that experiences the longest disruptions. Unlike during previous periods of economic weakness in Turkey, the country is unlikely to be able to reply on external demand as a support. Our Global team see continued challenges for emerging market (EM) currencies and expect EM rates to go even lower over the coming months to support growth. However, Turkey has less room to manoeuvre in regards to enacting stimulus measures to support growth than many of its EM peers, given its low reserves and high exposure to FX-external debt. If fiscal stimulus is ramped up too quickly or monetary easing continues on its aggressive path, foreign interest in Turkish assets would likely fall further, aggravating the precarious external funding position.


How stable is Turkey’s current account balance?


We forecast that Turkey will post a current account surplus of 0.2% of GDP in 2020, as was the case in 2019, but this will reflect tighter external financing conditions and a need for reserves. Turkey’s current account balance is relatively unstable, given its high reliance on ‘hot money’ inflows to fund the deficit. For example, portfolio investment inflows fell from USD 23.7bn in 2017 to USD 32mn in 2018, as investors pulled out of Turkish assets during the lira sell-off. The more stable form of funding – foreign direct investment – inflows account for 27.5% of liabilities, reflecting how exposed Turkey is to ‘hot money’ liabilities that could flee the country quickly and leave the economy with a sharp funding gap. Indeed, reserves dropped by USD 16.6bn in March, as the current account posted a USD 4.9bn deficit, up from USD 0.1bn a year earlier. When taking into account Turkey’s low reserve base (about USD 25.2bn less than its short-term external liabilities) the economy will need to run a smaller current account surplus to avoid further eroding reserves.


Unlike in 2019, when the economy benefited from external demand to post a current account surplus, 2020 will be significantly more challenging. We estimate that goods & services exports will decline by 16.7% in 2020, as key income streams falter. Tourism and passenger travel provided USD 42.4bn of income for the Turkish economy in 2019, 65.3% of total service sector exports. As tourism and travel activity collapsed in Q2 and the potential for a very slow recovery in the sector due to continued restrictions on travel, we expect a significant share of this income could be lost. As such, import demand will need to contract sharply to offset the external demand losses. Some of this will be driven by weaker energy imports, which we except to result in around USD 8-10bn in savings relative to 2019. In addition, on May 20 the government announced additional tariffs on 800 imported goods of up to 30%, including some construction and autos related goods, as well as some consumer luxury goods (the tariffs did not cover Turkey’s free trade agreements). Total goods imports amounted to USD 198.9bn in 2019, so we expect that a slump in domestic consumption and investment will cause this to fall significantly in 2020.


And what is the risk of a balance of payments crisis?


While a balance of payments crisis is not our core view, the risks are rising. As we highlighted in the webinar, much will depend on the ability of Turkey to roll-over external liabilities, rebuild its reserve buffer and stem capital outflows. Supporting our core view, the Central Bank of the Republic of Turkey (CBRT) secured an amendment to its swap deal with the Qatar Central Bank, raising the overall limit to an equivalent USD15bn in their respective currencies, from USD 5bn before. This will provide some FX-liquidity and ease investor nerves about Turkey’s funding lines. We note that if external debt roll-over rates fall to their 2009 lows, Turkey’s private sector could see below 70% roll-over rates, equating to about USD 50.5bn in external debts not being rolled over in 2020 and resulting in limited reserves being depleted even further. Evidence of companies struggling to access foreign funding and reserves being reduced could spark fears among depositors and banks about their FX reserves and put pressure on the lira.


How would policymakers respond to a potential balance of payments crisis? And what could capital controls look like?


The most likely outcome would be a combination of interest rate hikes and capital controls, resulting in a sudden tightening of credit supply and domestic demand. We would not anticipate the same degree of hikes as in 2018, when rates were hiked by 1200 basis points to 24.00% and we would not expect full capital controls. Partial controls to restrict capital outflows may be introduced. For example, a law forcing exporters to repatriate revenues within 180 days was imposed in September 2018, shortly after the lira sold off aggressively. Lira shorts have already been squeezed in offshore markets, such as in March 2019, to deter speculative bets by foreign investors. Both rate cuts and capital controls would create political challenges and would entail a much deeper recession than we are currently forecasting, putting pressure on President Recep Tayyip Erdoğan. A combined USD 7.5bn left the country due to direct and portfolio investments abroad in 2019. However, capital controls risk deterring capital inflows and worsening the external financing crunch. A Fed swap line looks particularly unlikely to materialize and it would in any case likely not be large enough to fully offset Turkey’s financing issues. The CBRT’s lack of reserves, the pace at which its reserves have fallen and the uncertainty surrounding the Bank’s use of swap positions with Turkish banks to bolster its reserve figures would all make the Fed wary of entering a sizeable swap agreement. On March 19, the Fed expanded its existing swap lines to a number of central banks, including Ems such as Mexico and Brazil, though Turkey was not included despite its clear need. Another option could be the Fed’s repo facility, as agreed with Bank Indonesia, but this again requires reserves that the CBRT is already short of. Turkey has reportedly turned to the UK and Japan for potential swaps, which in our opinion highlights the diminishing potential for a Fed swap line or even from the European Central Bank (ECB).


Will the Turkish government do a deal with the International Monetary Fund (IMF)?


If all other options are exhausted, we do see this as a possibility. It would be a massive political climb down for President Erdogan, who has long opposed turning to the IMF, denouncing his predecessors who had to turn to the IMF for support in the early 2000s. In an April poll of Turkish citizens run by the Istanbul Economy Research, 69.2% of respondents rejected the notion of Turkey borrowing from the IMF amid the Covid-19 outbreak, suggesting that a deal would be very unpopular. A funding agreement would probably include controversial requirements, forcing the authorities to rollback policies, like low interest rates, that President Erdogan has championed. With parliamentary and presidential elections not scheduled until 2023, however, there would be time for the economy to recover and President Erdogan to prepare for campaigning.


How sustainable is Turkey’s government debt?


At 33.1% of GDP as of end-2019, the government’s debt ratio is probably one of the strongest fundamentals within the Turkish economy, well below the emerging market aggregate of 52.1%. As such, we do not view the government debt position as a significant risk to macro stability. However, the Covid-19 outbreak and loss of revenues will put a huge strain of the budget balance in 2020 and we expect that the government’s debt ratio will climb to 40.8% of GDP by end-2020


The government tapped international markets for funds in February and the CBRT has begun expanding its balance sheet with government bond purchases to meet some of the increased funding requirements. Nevertheless, increased using of the CBRT’s balance sheet to finance the government’s debt may unnerve some investors and the ability to draw upon non-tax revenues has been largely eroded in 2019. We note some off-balance sheet costs could arise from public guarantees and from state owned enterprises, which have around USD 14.3bn (1.9% of GDP) in external debt in 2019. As such, the position could deteriorate over the course of 2020.


How will monetary policy develop over the coming months/what is your short-term outlook for the lira?


We expect that the CBRT will continue on its easing path, but highlight the increasingly difficult balancing act that policymakers have to strike. Disinflationary pressures are growing from weakening demand-side pressures and lower energy prices, with our Oil & Gas team forecasting that oil prices will average just under half of their 2019 level. Yet, the Bank also faces input inflationary pressures from the lira, which has lost 14.0% in the year-to-date. As such, we forecast inflation to average 10.0% in 2020, down from its year-to-date average of 11.8% but above the CBRT’s target band of 5.0% ± 2pp. Lira weakness will elevate the costs of Turkey’s foreign currency debt and could be aggravated by additional cuts, with Turkey’s real rate already one of the most negative among EMs. Turkey needs to attract ‘hot money’ inflows given the pressure on reserves and further cuts would make this even more challenging as Turkey’s carry trade allure fades. However, in its latest inflation report the CBRT indicated its expectation for inflation to fall to 7.4% by end-2020 and as such, we expect it to maintain its dovish stance. We forecast that the key policy rate will fall from 8.25% to 8.00% by the end of the year.


We forecast that the exchange rate will average TRY 7.00/USD in 2020, from an average of TRY 6.41/USD in the year-to-date, but with risks to the downside. The lira has pulled backed from its low of TRY 7.49/USD on May 7 to TRY 6.77/USD. However, we believe that risks remain tilted to the downside given the precariousness of Turkey’s external debt position. We also see risks of Turkey increasing its money supply more aggressively in response to the downturn and this could add to the unit’s weakness over the coming months. Much will depend on Turkey’s ability to rein in its current account deficit and stop the leakage of reserves, and somewhat out of its control, broader market sentiment towards risk assets and the effectiveness of stimulus packages in supporting a growth recovery in H220.


How will the fall in the lira and the recession affect Turkish banks?


The banking sector will face declining asset quality and weaker profitability as a result of the economic downturn and policy measures introduced to reduce pressure on households and non-financial corporates. Efforts to delay soured loan recognition by regulators and extensions on interest and principal repayments will effect banks’ cash flow and likely result in reduced credit supply, as banks seek to maintain capital buffers amid tightened external financing conditions. However, we note the Turkish banking sector has a relatively good track record of accessing foreign financing during periods of risk aversion, such as in 2018. For now, believe the sector can weather any external financing pressure. In addition, loan growth will slow amid a drop in domestic activity – with both consumer spending and business investment scaling back, curbing demand for credit. This will ultimately weigh on banks’ profitability. Another source of vulnerability is banks’ over-leverage in lira, which we have highlighted previously. At loan-to-deposit ratios of 1.3x in lira and 0.8x in FX in March, banks excess FX reserves have been used to bolster the CBRT’s reserves in return for lira, which they have lent to domestic borrowers. This leaves banks exposed to the CBRT and the level of FX reserves on its balance sheet, as these are the banking system’s assets. A sharp decline in CBRT’s FX reserves observed in May (down 34% ytd) will raise concerns about the ability for banks to call on their FX reserves at the CBRT. As such, the banks – which account for 46.8% of short-term external liabilities – are interlinked into Turkey’s overall balance of payments stability. A balance of payments crisis risks destabilizing the banking sector, despite strong capital buffers.”


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