The US and Turkey are at loggerheads over their Syria policy.
By Rutuja Morankar and Rajani Sinha
The global economy is grappling with risks like trade war, volatile crude oil prices, Brexit, to name a few. Another crisis situation that has been brewing for the last one year is the economic and political turmoil in Turkey, which faced a currency crisis in mid-2018. In a span of a fortnight, the Turkish lira depreciated sharply by 40%. The crisis spread over to other emerging market currencies and stocks. Adverse investor sentiment led to large sell-off from emerging markets. Capital inflows into EM economies fell to $2.2 billion in August 2018 from $13.7 billion in July 2018. Currencies like Argentinian peso and South African rand fell by 10% each, while the weakening in the rupee was relatively less in the period under review. The MSCI Emerging Market equity index also fell by 5%, triggered by the Turkey currency crisis.
Cut to May 2019, Turkey witnessed another sharp depreciation of the lira. The currency fell to a 7-month low of 6.2 to a dollar, weakening by over 15% since the beginning of the year. Investor sentiment for the Turkish economy is weak and there is social and political instability. So, what are the lingering risks affecting the Turkish economy?
For more than a decade, Turkey enjoyed the availability of cheap credit and foreign capital that fuelled high economic growth. GDP grew by an average of 5% in the last five years. This led to debt level in the economy accelerating. Turkey has an external debt-to-GDP ratio of 53.5%. More worrisome is the short-term debt of $177 billion, which is maturing in the next 12 months. While debt levels are high, Turkey’s forex reserves have been dwindling. Forex reserves at $60 billion are not enough to support currency in case of further deepening of crisis. The country has forex reserves to short-term debt ratio of 30%, which is quite low. The IMF advises this ratio to be maintained at 100%.
Sharp weakening of the currency as investor sentiments dwindle is pushing up dollar-denominated debt burden. This is adding to the stress on the indebted corporate sector, resulting in rising levels of banks’ non-performing loans. Sharp weakening of the currency has also resulted in higher import prices and double-digit inflation in the economy. Inflation is currently hovering around 20%. In response to rising inflation, the Central Bank (TCMB) tightened the key policy rate to 24% in September 2018 from 8% in May 2018. This has increased borrowing costs sharply, dampening growth.
Turkey entered into recession in Q4CY18 following two consecutive quarters of negative GDP growth. According to the IMF, Turkey will record negative growth of 2.4% on an annual basis in 2019. On the labour market side, the unemployment rate has risen to the highest since 2009, at 14.7%. This raises concerns that it may no longer have sufficient firepower to defend the lira in case of another sharp depreciation.
The US and Turkey are at loggerheads over their Syria policy. Last year, the US-Turkey relationship particularly soured over the detention of a US pastor by Turkey. The US responded by doubling tariffs on imports of steel and aluminium from Turkey. In March 2019, the US announced the removal of the Generalized System of Preferences (GSP) status of Turkey, which could adversely impact exports from Turkey. More recently, Turkey’s plan to purchase the Russian missile defence system has miffed the US (as the US claims it to be non-compatible with the NATO). The US is considering imposing sanctions on Turkey. The US-Turkey relationship will be crucial and an escalation of tensions is likely to weigh on the lira.
The Erdogan government, viewed as authoritarian, won a second term in the general elections held last year. However, it recently lost the mayoral election for Istanbul. The decision by the election commission to nullify Istanbul municipal elections and go for re-election in June led to mass protests and social unrest. Investors showed reduced faith in democratic institutions. President Erdogan’s party had also lost mayoral election in Ankara and some cities in south Turkey earlier during the year, which highlights reducing support for his government. The market is anticipating policy instability and conflict, domestically and in foreign affairs, which could dampen the economy and result in flight of capital.
In an attempt to stabilise the economy, the Turkish finance ministry announced reforms over the next 4-5 years. These include agricultural policy to keep food prices in check. The government is also infusing $5 bn to recapitalise state banks and taking off some bad loans from the balance sheet of banks. Two special funds are to be created to manage high debts in energy and construction sectors. Bad assets would be reduced through debt-to-equity swaps. There are plans to boost tourism, exports and improve judiciary regulations. Some reforms on pensions and taxes to improve consumption are under way. But these measures have failed to enthuse the investor .
To conclude, high debt is a big risk for Turkey, with low forex reserves and weakening currency. This could lead to downgrade of Turkey’s sovereign rating (which is currently B+ stable, four notches below investment grade). Debt default by Turkey would impact European banks, especially Spanish and Italian, due to a high exposure to Turkey debt. Further aggravation of the Turkey crisis could impact the investor sentiment for the EM basket. Resulting capital outflows would severely impact Brazil, South Africa, Argentina and, to some extent, India.
Authors are corporate economists based in Mumbai