Turkey: Controlling the Conflagration

Published on February 4, 2014

The Turkish Lira and domestic financial markets have been in a nasty tailspin ever since the escalating political and corruption scandals, including attacks on Prime Minister Tayyip Erdogan’s own family, triggered another damaging string of high level cabinet resignations in Erdogan’s near twelve-year-old AKP government in mid-December.

Ankara’s domestic political woes added to the mix of the risk reassessment and global sell-off in the Emerging Markets, forcing the Central Bank of Turkey to dramatically hike the benchmark weekly repo rate by more than 500 basis points to 10% from 4.5%, and the top rate to 12% from 7.75%, despite a slowing economy and highly public political pressure from Erdogan to refrain from doing so.

But no sooner had the Lira stabilized that Erdogan himself undermined the central bank, trying to distance himself from the consequences of the rate hike and alluding to a mysterious “Plan B” in case the central bank actions fail to calm the markets. The statement only added to the uncertainty, keeping the market on edge even as volatility eased back a bit.

*** Economic officials in Ankara have gone to lengths to downplay these “Plan B” comments to us, interpreted by markets as a potential threat of capital controls, with Finance Minister Mehmet Simsek publicly “clarifying” Plan B as some sort of vague, innocuous, and we suspect hastily spun and politically expedient, promise to ease the pain of the higher rates on domestic small businesses, banks, and individuals. ***

*** The Central Bank, despite all the political pressure it is under, has in the meantime also confirmed that it will not hesitate to hike rates even further, including tightening shorter term money market liquidity conditions if needed. In other words, further rate hikes will be the more likely first response to another flare up in markets than capital controls, which have been rejected in no uncertain terms to us by Turkish officials. And with the threat to act again if need be, and expectations that the crisis may stabilize, even if it realistically takes some time, there is no talk or consideration whatsoever (at least now), of seeking external assistance. ***

*** Importantly, Deputy Prime Minister Ali Babacan, the powerful de facto co-charge of the Finance Minister on economic policy, a few days ago further laid out the details of Erdogan’s Plan Bas well as a purported “Plan C.” While Erdogan’s harsh, anti-rate hike political stance and threats are dismissed to some extent as understandable populism and “retail” politics, Babacan is seen as more credible on economic policy, and his silence to date had been been interpreted by some as signs that he may in fact be distancing himself from his long-time ally and harboring sympathy with the Gulenist “defectors” – just in case. ***

Somewhat alarmingly however, while continuing to deny any plans for capital controls, these Plans B and C do include references to increased punishments for parties guilty of breaking yet to be specified financial laws. A critical element to any stabilization of Turkey’s markets will be whether these “alternative plans” are left to wither on the vine of political  rhetoric or whether Erdogan in fact is tempted or embattled enough to use them to expand his already extensive vendettas into the nervous financial sector. While we remain cautious, we expect, with the crisis as deep as it has already gone, that he will choose the former, more pragmatic course.

Central bank officials are also fiercely defending the bank’s independence, adamantly dismissing rumors Erdogan will seek to change the Bank’s mandate, which already factors in growth, even if it focuses first and foremost on maintaining its inflation target. While official forecasts are for a 6.6% inflation rate, above the bank’s 5% upper target, they concede that the real inflation rate will certainly exceed 7.5% for some time, and that it may take up to 18 months or more to get back to the 5% target. They reinforce the point by stressing that at 10%, market rates and financial conditions have already been aggressively tightened in real terms.

Backdrop to the Crisis

The scandals and ensuing market collapse of the last few months brought to head an internecine power struggle between Erdogan and his former religious, wealthy, and populist ally, Fethullah Gulen, threatening the already fraying grasp of the AKP’s leadership on power just as it faces critical elections ahead.

That culminated with a series of highly political rants and attacks by Erdogan against “the interest rate lobby” and references to an “outside interference” conspiracy against him that were devastating to market confidence in its assessment of the government’s ability to successfully take the raging  financial crisis head on.

Needless to say, Erdogan’s political travails only added to the mix of crises simultaneously flaring in Argentina, Venezuela, Ukraine, and Thailand to fuel the fire of a broader Emerging Market reassessment of risk as the Federal Reserve began its long awaited “tapering” of its bond purchases; with perhaps most quietly threatening of all, a highly visible collapse of a wealth management product marketed by the state-owned Industrial and Commercial Bank of China’s only serving to highlight fears of a credit bubble and a more sustained slowdown in the world’s second largest economy.

Finally, on January 28,the Central Bank of Turkey, accused to then of being unduly influenced by Erdogan, decisively hiked domestic interest rates, led by the key weekly repo policy rate being pushed up by more than double to a whopping 10%.

The central bank insists the rate hikes will be temporary, and eased as soon as (and assuming) currency pressures abate. But investors are rightly concerned that if prolonged, the crisis will not only weaken growth in Turkey, but that a persistently weakened Lira could threaten the roll-over of a significant stock of foreign currency debt owed by the non-financial corporate sector of Turkey – in effect, a “classic” balance of payments crisis.

The Economic Challenge Ahead

Turkish economic officials fully acknowledge potential funding fears, and estimate 2014 debt funding needs in the range of $165 billion. Added to running a $55-$60 billion current account deficit, Turkey’s total funding needs this year are estimated at some $210 to $220 billion.

We are told that the total external debt/GDP ratio is currently at approximately 43% of GDP, with only 15% comprising government borrowings, and the other 28% owed by the domestic banks and non-financial institutions. But officials are quick to point out that in a worst case scenario the country’s FX reserves still stand at around  $120 billion (approximately $20 billion of that in gold), which would put their rollover coverage ratio significantly above, for example, what it was even during the darkest days of the 2008 Lehman collapse global financial crisis, which they survived.

Market commentators and analysts, however, point to a much smaller, $40 billion, estimate for reserves, but the discrepancy has been pointed out to us – rightly or not – as due to an inconsistent emphasis on a net, and not gross, number based on calculations that treat assets and liabilities “in an inconsistent manner.” Whatever the case, officials do not feel, and certainly at least hope, that its reserve levels will all be a moot issue.

Turkish officials are also adamant in asserting Ankara will neither need nor seek any new external balance of payment assistance from the International Monetary Fund or swap lines with other central banks. Before getting to the point of external assistance, which is as can be imagined far from any public consideration, officials point out that the vast bulk of the local corporate foreign currency debt is owed to domestic banks rather than foreign institutions.

The implication, while no one has said this directly, is that there is a greater ability to support these lenders to “sway” them not to cut off funding to their corporate clients than would be the case with foreign lenders, plus the financial institutions’ own FX reserves are believed to be in relatively decent shape. And in a worse-case scenario, although the intriguing specific notion of swap lines from the Central Bank to corporates is at the moment not on the table, there does, however, appear to be some precedent, we are told, for this type of assistance in Brazil.

While acknowledging the numerous political miscalculations and risks inherent specifically to Turkey, economic officials also characterize the current crisis as largely resulting from a freezing of portfolio inflows into Turkey, part of which is globally-driven risk aversion to EM markets in general, and as such beyond the government’s control. They insist they see no alarming signs of actual outflows from the country.

The central bank is expecting and hoping that the measures it has taken, along with a very real commitment, at least from its part institutionally, to fight further contagion with tighter policy if needed, will ease conditions in a matter of weeks. They acknowledge that there will be some lasting damage from the crisis, but they believe they can bring inflation closer to the 5% range in what will hopefully be seen as a more realistic, medium term 18 month time frame.

The Political Challenge to Erdogan

Turkey, even if the EM and global markets stabilize, still of course faces mounting challenges due to ongoing domestic political tensions and a looming political calendar. The first big political test will come this March, in the all-important race for mayor of Istanbul.

For now, the March 30 election is however pointing to a victory by Erdogan’s AKP candidate and incumbent Kadir Topbas, and that the Prime Minister’s forces will survive the challenge from Topbas’ more secularist, Kemalist opponent Mustafa Sarigul.

While this may not come as a pleasant surprise to more politically liberal and secularist, reform-oriented observers, it could,for financial markets, signal some continuity, and take some of the edge and desperation off the increasingly erratic Erdogan.

There have also been rumors that Erdogan may decide to “do a Putin/Medvedev deal” and secretly agree to run for the Presidency in the upcoming presidential elections this coming August, opening the door for his ally, current President Abdullah Gul,to take the Premiership.

We are told at this point, however, to discount any such theories and predictions. For one, as is publicly known, Erdogan was unable to pass constitutional reforms that would have added power to the Presidency at the expense of the premiership and parliamentary system, removing any attractiveness of such a switch.

In addition, and perhaps more intriguingly, Gul has been careful to tread what is perceived to be a conciliatory, “democratically neutral” line between Erdogan and Fethullah Gulen. The Presidential elections, in addition to the mayoral race, may therefore proceed without a major surprise, and Erdogan could stay on as Prime Minister until the parliamentary elections scheduled for June 2015.

While dangerous to predict the outcome of such a volatile political, and both domestically and globally financial, environment — and Erdogan has increasingly proven himself increasingly a bit “long in the tooth” as a leader — we would venture to suspect that the broader risk situation in Turkey may stabilize from here. That hinges on Erdogan himself acknowledging the need to allow the central bank policies to work their way through, and as much as he may complain, tone down the escalating vendettas that have been eroding his position even among his own party.

And with Turkey being seen more broadly as one of the more visible “canary in the coal mines” of the EM crisis, some stability there may bode a bit more favorably for the broader, extreme volatility and negative sentiment currently felt around global markets at this time. With little real appetite expected to emerge for fresh EM inflows even in a more stable environment, that will not however be a story thread that disappears in a day or week.

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