Crisis alla Turca II – From Currency Crisis to Debt Crisis? Yilmaz Akyüz

The meltdown of the Turkish currency that began in 2018 has continued unabated with the decline reaching unprecedented proportions in recent days.  The causes of that turmoil including underlying financial fragilities and political shocks were discussed in a previous piece by this author.  Since then the economy has become even more vulnerable in these respects.

Efforts to stabilize the currency resulted in large reserve losses and the lira has lost half of its value against the dollar in the past two years.  A matter of concern now is if this currency turmoil would eventually culminate in an external debt crisis and default.

In previous crises in emerging economies currency and debt crises often came back to back.  Typically, an economy facing sudden stops in capital inflows and steep declines in its currency raised interest rates and deployed reserves in order to stabilize the currency, stay current on its external debt obligations and maintain an open capital account.

When reserves were exhausted, it ended up on the doorsteps of the IMF which provided some funding to enable the country to pay its debt to private creditors and avoid restrictions on capital outflows, and imposed austerity measures deemed to reduce external imbalances and generate confidence in international financial markets.  In most cases private external debt was socialised and the country’s external debt was rolled over at some penalty rates with the help of the IMF.

So far, the Turkish case appears to depart significantly from this pattern.  Despite a steep and sustained drop in its currency and significant loss of reserves which are now well below the level of short-term debt, the country has avoided arrears on its debt payments and has in fact been able to continue borrowing in international markets, albeit at a relatively high cost.   What is going on?

There appear to be four factors that account for the sustained decline of the lira and loss of reserves.

First, like most emerging economies that opened up its local markets to international investors in order to shift from debt to equity and from forex debt to local-currency debt in external financing, Turkey experienced a significant increase in foreign presence in its equity, debt and deposit markets, particularly during the rapid expansion of global liquidity and sharp drops in international interest rates brought about by quantitative easing and zero-bound policy rates in advanced economies in response to the global financial crisis in 2008.

However, since 2018 there has been a rapid exit of foreign capital from local markets, notably from the debt market and this explains an important part of the decline in reserves and downward pressure on the currency.  Malaysia had experienced a similar exodus in 2015 which pushed the ringgit below the levels seen during the 1997 crisis.

Second, the economy is highly dollarized both in credits and deposits.  A constant flight of the residents from the lira has been a major factor in its decline.  This seems to have taken place not so much as capital flight from the country as currency substitution within the Turkish banking system.   Forex deposits of residents as a proportion of total deposits have been on an upward trend since summer 2018, exceeding 50 per cent in recent months.

A third factor is offshore speculation against the lira, notably in London, through derivative contracts very much like that against the Malaysian Ringgit in Singapore during the Asian crisis.  In Malaysia, the Mahathir government effectively shut down the offshore trading in Singapore.

In Turkey in 2018 the authorities limited Turkish banks’ swap, spot and forward transactions with foreign investors to 50 percent of a bank’s equity, reducing it in several steps to 1 per cent in April 2020 before raising it to 10 per cent in September 2020.

A fourth factor is payment of external debt by private corporations.  Alarmed by the sharp decline of the lira in 2018, many debtors in forex, notably financial institutions, started to deleverage, reducing their debt in an effort to avert losses due to sizeable exchange rate risks they were exposed to.  Between March 2018 and March 2020, private external debt fell by some $73 billion while the public sector continued to borrow, seeing its total external debt rise by $36 billion.

Thus, the international financial markets have so far been willing to lend to Turkey in dollars but not in the lira even though the yields on lira bonds exceed those on sovereign (forex) bonds by a large margin.   There are two possible explanations for this.

First, there is too much uncertainty about the future path of the lira, and the interest rate differentials between dollar and lira debt assets fail to cover the mounting exchange rate risk.

Second, given the volatility of the present regime in Turkey, sovereign risk is much higher for lira bonds issued in domestic markets because they come under local jurisdiction.

The lira can fall much further in the period ahead if flight from it continues unabated, its decline fails to bring a sizeable improvement in the current account deficit, the private sector continues to deleverage and pay forex debt, the debt of insolvent companies hit by economic slowdown and the rise of the dollar is pushed onto the government and, finally, if the public sector cannot borrow abroad sufficiently to meet the foreign exchange needs created by all these factors.

There is little scope for interest rate hikes to stabilize the lira not only because the government believes that high interest rates are the main cause of inflation and needs growth to restore credibility among its constituency, but also because under conditions of currency turmoil interest rate hikes may simply point to declining creditworthiness and greater default as shown by events in East Asia during the 1997 crisis.

One counteracting factor could be a rush back of international capital, fire-sale FDI, to capture cheap Turkish assets resulting from hikes in the dollar and deflation in asset prices, as seen in several emerging market crises in the past.

If this currency turmoil will culminate in a debt crisis is difficult to tell.  Countries often default not because they are in debt but because they cannot borrow any more.  Whether or not Turkey will face a sovereign debt crisis will depend on the willingness of international financial markets to keep lending and this depends on their assessment of default risk.

A high stock of debt and a continuous increase in foreign exchange needs make external borrowing more difficult and expensive, and this is also the case in Turkey.   However, it is quite difficult to predict at what point the country will be cut off from international financial markets.  These markets are often seen to pump in money for extended periods to countries widely seen to be on the verge of default.

There are a number of factors in Turkey’s favour in sustaining access to international finance.   First, it has a clean record in debt repayments ‒ the Republic never defaulted on its external obligations and even paid up the debt inherited from the Ottoman Empire.  Second, its debt is not seen as unsustainable, in need of reduction and relief, as in the case of Argentina.   Third, as noted by the World Bank in its Turkey Economic Monitor Report, its external debt profile remains favourable ‒ the average cost of the current debt stock is relatively low and the average maturity is long ‒ and its debt rollover rate is quite high.  Finally, although the risk margin and cost of new debt is very high, there is no obvious upward trend – today Turkey’s 5-year CDS rate is broadly the same as in September 2018.

However, if the need for external financing does not diminish, this Ponzi-like process may well end up in a debt crisis.  On recent trends the external debt to GDP ratio can come to reach the 70-75 per cent range by 2023, well above that of Argentina on the eve of its recent restructuring initiative.

Since the IMF option has been ruled out and the current government does not have many friends left among the major OECD countries that could come to help as in the past, in the event of a sudden stop in lending, debt moratorium and default cannot be avoided.

This could come sooner as a result of political and geopolitical shocks triggering a reassessment of risks, especially since the economy is quite prone to such shocks under the current administration.  Of course, it is possible for the government to seek bilateral bailouts in return for economic and political concessions.  There is also the possibility of a change of government which would in all likelihood open the doors to the IMF and the West.

There is no easy way out for Turkey after so many years of economic mismanagement and waste.  Until recently the economy enjoyed a debt-driven boom sucking in large amounts of imports financed by capital inflows.

Investment has concentrated in areas with little foreign exchange earning prospects such as real estate and physical infrastructure ‒ roads, bridges, airports and hospitals.  Much of the latter capacity remains underutilised, entailing significant contingent liabilities for the government as a result of guarantees given to private constructers in dollars.

The economy has been showing signs of premature de-industrialization that has pervaded many semi-industrialized economies in the past two decades.  Regrettably, while a genuine reform agenda should focus on how to reduce dependence on imports and foreign capital, the current debate in the country is largely concentrated on how to attract more capital.

Yilmaz Akyüz is former Director, UNCTAD, and former Chief Economist, South Centre, Geneva

(This article was originally published in Inter Press service (IPS) news on October 29, 2020.)