SHUTTERSTOCK/LUCIANO MORTULA - LGM
In March, Turkey’s electorate sent a clear message to their President: the economy isn’t working for them. The opposition alliance won five of Turkey’s six biggest cities, including the capital, Ankara, and Istanbul, the economic capital.
Despite only losing Istanbul by a slim margin, Erdogan has annulled the results and scheduled a rerun for 23 June 2019, wooing voters with initiatives to fix the economy and a promise to adhere to free market rules. The fact that the lira lost 10 per cent of its value on the news suggests the markets aren’t convinced.
In fact, no one seems reassured. In May, Turkey’s benchmark index of confidence dropped to its lowest reading since October last year, according to the Turkish Statistical Institute. Any figure below 100 reflects pessimism about the future--the index dropped to 77.5 in May from 84.7 in April.
While Erdogan can choose to ignore what the ballot box is saying, he cannot afford to lose investors’ goodwill. Turkey is reliant on foreign investment and its financial situation is becoming precarious.
Last year, the value of the lira plunged nearly 30 per cent against the dollar, sending inflation soaring by nearly 20 per cent. Ankara’s planned purchase of S-400 missiles from Russia is fuelling tensions with the US.
A government spending spree to reverse the economic contraction drained reserves, resulting in a record deficit. S&P, which sent Turkey deeper into junk territory last year, has little faith in Turkey’s institutions. “There are limited checks and balances between government bodies, raising questions about Turkey’s ability to address the challenging environment for its financial sector and the broader economy,” it said.
“Following the June 2018 elections, power remains firmly in the hands of the executive branch, with future policy responses difficult to predict.” The authorities have repeatedly ruled out a loan from the IMF, which would come with conditions unpalatable to an autocratic president.
At a press briefing, Gerry Rice, Director, IMF Communications Department, said, “We continue to monitor the economic situation there very closely, and as we’ve said before we recommend a comprehensive, clearly communicated policy package to secure macroeconomic and financial stability.
“We’ve received no indication from the Turkish authorities that they are contemplating a request for financial assistance from the IMF, so the recommendations that I just talked about, they do not come in that context.”
Shortly after its local elections, the Government unveiled a plan to curry favour with disillusioned voters. The Turkish Finance and Treasury Minister said that the Government will inject fresh capital into state-owned lenders and oversee the formation of two funds to shoulder some bad loans in the biggest move to bolster its banks since the financial crisis of 2001, Bloomberg reported.
The Turkish Government will issue TRL 28 billion ($4.9 billion) of bonds and place them at state banks. It marks the second time that the Government has acted to shore up its lenders after last year’s currency crisis.
Bloomberg quoted Hakan Ozyildiz, a former Deputy Undersecretary at the Finance Ministry, as saying, “This plan will increase the debt burden on the Treasury, in 2001, the same type of bonds was issued to cover the
The newswire reported that the treasury chief’s road map also includes programmes to reorganise soured real estate and energy borrowings through debt and equity swaps. Banks will purge non-performing loans and transfer them to the two funds, which will be run by banks as well as local and international investors.
“The non-performing loans ratio of 4.2 per cent is considered a very good level by our counterparts as well as, we are taking a step that will further enhance the quality of assets of the sector,” added Albayrak.
However, outside observers have been less impressed with the Government’s sticking plaster solutions. “While the Government has fiscal space for counter-cyclical policies, the nature of some measures, notably interventions in the food retail market and ramped up lending by state banks and reported pressure on private sector pricing policy risk creating distortions if maintained and raise questions over the broader policy stance,” Fitch said.
“The new economic reform plan published shortly after the elections did not refer to these policy measures and lacked detail but did provide approximate timelines for individual initiatives.”
Some of the structural measures in the plan have been welcomed by the private sector, particularly reforms to the insolvency process and politically difficult pension and severance pay reform.
The post-election period could be more conducive to economic reform that would begin to tackle long-standing structural weaknesses, although Fitch remains cautious about the prospect of meaningful progress. Despite government efforts, S&P believes that output in 2019 will contract by 0.5 per cent in real terms amid tight financing conditions and elevated inflation.
“In our view, Turkey’s response to financial, and balance of payments, pressures has so far been largely ad hoc, focused more on relieving symptoms rather than on resolving the fundamental economic vulnerabilities,” it said. That is not to say that Turkey doesn’t have advantages to play on.
Moody’s recently highlighted the country’s high economic strength, reflecting the Turkish economy’s large size, high diversification, relatively high per-capita income and young population which underpins the economy’s large–albeit diminishing– growth potential. Fitch, however, echoes that Turkey’s institutional strength is low.
The country is battling weak external finances, low foreign reserves and high net external debt, elevated inflation, a track record of economic volatility, and political and geopolitical risks. The most damaging economic ailment has been the weakening lira, caused by external financing vulnerabilities and aggravated by political and geopolitical developments.
According to Fitch, the only cure is a rapid correction in the current account deficit. However, significant uncertainties remain around the outlook for economic recovery and inflation, economic policy implementation, and the impact on the public finances and banking sector.
The current account adjustment is perhaps the most pressing issue. On a rolling six-month basis, the current account posted a surplus of $2.7 billion at end-February, compared with a deficit of $32 billion a year earlier, according to Fitch. Gross foreign exchange reserves rose by $7 billion in the first two months of 2019, but fell to $96.3 billion in March ahead of elections, possibly reflecting efforts to keep the exchange rate stable ahead of the polls.
Fitch said that market concerns about the reserves position appear to have contributed to a renewed fall in the lira. Fitch forecasts that weak domestic demand and a further improvement in services exports will underpin a current account deficit of 0.7 per cent of GDP in 2019—the smallest since 2002.
However, maintaining any surplus is going to be challenging. “Despite the current account shifting into surplus, we believe Turkey’s balance-of-payments risks remain elevated and therefore constrain the sovereign ratings,” S&P warned. “This is principally due to the need to refinance a high stock of external private sector debt, which we estimate amounts to about 40 per cent of 2018 GDP.”
Servicing these debts translates into large external financing requirements. Fitch estimates the total external financial requirement, including short-term debt, at $173 billion in 2019, down from $212 billion in 2018.
The financing requirement means Turkey will remain vulnerable to global investor sentiment and financial conditions, domestic political and economic policy uncertainty and a pronounced deterioration in relations with the US. Almost half of this debt is maturing in the next 12 months, which is considerably risky given the limited foreign exchange reserves at the Central Bank of the Republic of Turkey (CBRT).
However, Turkey boasts a comparatively low net general government debt burden, thanks to past economic policies. This should give the government some wiggle-room as it toils to get its finances in under control.
Nevertheless, S&P warned that a combination of support for public-private partnerships, weaker economic growth, and possible external deleveraging in the private sector could rapidly erode what today appears to be a sound public balance sheet.
Turkey’s economic woes have manifested themselves in monster inflation which continues to wreak havoc. Inflation spiked, surpassing 25 per cent in October 2018 marking a 15-year high. Even though it is slowly losing its sting, inflation remained above 20 per cent in January 2019, according to S&P.
Weak domestic demand should put inflation on a downward path, but the PPI (Producer Price Index) remains high at 29.6 per cent, Fitch warned, and the impact of unwinding temporary tax and other price control measures is unclear.
Fitch forecasts inflation to average 14.2 per cent in 2019, the highest of any sovereign rated above the ‘B’ category. The policy rate was kept at 24 per cent in April and is rising in real terms. “High dollarisation and the increased role of state bank lending and informal pressure on bank interest rates may be undermining transmission channels,” the rating agency said.
In Fitch’s view, monetary policy credibility is weak and potential mis-steps put the economy at risk. As high inflation will erode incomes, S&P believes that consumption will likely decline by two per cent this year.
“In our view, Government initiatives to temporarily boost domestic demand through lower taxes will have only a limited effect,” it said. “In addition, we believe that headline inflation likely underestimates the full impact on consumer purchasing power.” For instance, food inflation exceeded 30 per cent toward the end of 2018, straining the budgets of lower income households.
Turkey’s banks have also been struggling to swim against the ride. Straining under piles of debt, authorities have pressured banks to lower borrowing costs and restructure loans to keep the economy moving. In February, Moody’s warned that these stunts were risky, and could negatively affect margins. S&P has also expressed its concerns.
“In our view, risks to the stability of the Turkish banking system have risen substantially over the last 12 months,” it said. “These stem from more difficult domestic and foreign financing conditions, and a likely deterioration in asset quality.” S&P revised its assessment of contingent liability risks to the state from the banking system to moderate from limited in August 2018. “So far, the authorities have not provided any concrete plans as to how they might deal with a deterioration in bank asset quality,” it said.
“The New Economy programme published in September 2018 lacked specific details on resolving banking sector problems bar a reference to an asset quality review.” Such a review was undertaken by Turkey’s Banking Regulation and Supervision Agency (BRSA) in December, but the details have not been made public.
Official nonperforming loans are around 4.5 per cent of system loans, according to S&P, which could underestimate existing credit risk. The rating agency forecasts that problem loans will increase, rising to double digits over the next two years. Turkey’s participation banks have also suffered, however the sector benefits from being politically important to the Government.
Fitch said that the market share of Turkey’s participation banks has remained broadly stable and growth is set to remain subdued in the short term due to the weaker growth outlook, the high interest-rate environment and asset quality pressures.
However, the segment continues to offer reasonable medium-term growth prospects “considering the strategic importance of participation banking to the Turkish authorities, its current low base, the recent establishment of two new state-owned banks and also of a centralised Shari’ah board, to facilitate product growth,” the rating agency said.
Participation banks’ non-performing financing (NPF) ratio was 3.8 per cent at the end of the third quarter of last year, above that of conventional banks’ (3.2 per cent), according to Fitch. Credit risk remains high due to SME exposure and to risky sectors such as construction.
Capitalisation is moderate but capital ratios are sensitive to Turkish lira depreciation, Fitch said. Segment internal capital generation is set to weaken. While the Turkish government may have hauled the economy out of a recession with temporary stimulus and rapid credit growth from state-owned banks, the illusion is unlikely to last.