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Trouble in Turkey: what does it mean for credit markets?

A currency crisis and a feud with the US has placed more pressure on the beleaguered Turkish economy in recent weeks. Hermes Credit assesses the country’s economic woes – and pockets of corporate strength and the opportunities they offer.

The Turkish lira has lost more than a third of its value against the dollar so far this year as a rift with the US – over the continued detention of an American pastor in Turkey – added to concerns about President Recep Tayyip Erdogan’s influence over monetary policy.

But cracks in the country’s economic foundation were already spreading before the spat with the US – and the Trump administration’s subsequent imposition of higher tariffs on imports of steel and aluminium from Turkey – accelerated the lira’s slide.

Figure 1: The US-Turkey feud has accelerated the lira’s tumble

Source: Bloomberg as at August 2018.

The fundamental problems in Turkey include: a gaping current account deficit, a high dependence on short-term foreign-currency borrowing, ineffective monetary policy that has held down interest rates amid soaring inflation (it stood at 15.9% in July) and concerns about central bank independence.  These problems have weighed negatively on investor sentiment – and this has been amplified by the imposition of sanctions and tariffs by the US in recent weeks.

As Turkey braces for further uncertainty, here are seven main issues that investors should keep in mind:

  1. At 137% of GDP, Turkey’s gross debt balance is lower than the emerging–market (EM) average of 162%1, but its build-up of FX debt since the global financial crisis (amounting to 70% of GDP, which is almost double the EM average), means that it is vulnerable to currency shocks.
  2. External financing requirements are high, at $232bn annually, and this could become problematic for Turkey because its foreign exchange reserves have been on a secular decline since 2014 (they are now only about $30bn on a net basis). Moreover, the country has one of the lowest reserve-adequacy ratios in EMs. The lira’s recent weakness will increase the ratio of external debt to GDP (currently 53%, of which 14% is short-term) and the current account deficit.
  3. Relations between Turkey and the West have frayed in recent years, most notably over its domestic and foreign policies. Earlier this month, Trump hit two Turkish government ministers with sanctions and announced plans to hike tariffs on imported steel and aluminium from Turkey as the feud over the detention of American pastor Andrew Brunson escalated. The tit-for-tat barbs between Erdogan and Trump may help to repair Turkey’s strained relations with the European Union (EU). After all, the EU is Turkey’s largest trading partner – and in the absence of support from the EU, trade tariffs from the US are unlikely to have a material impact on Turkey’s real economy.
  4. Capital controls will “never be on the agenda"2. That was the message from Turkish Finance Minister Berat Albayrak, Erdogan’s son-in-law, during a conference with foreign investors last week. He also added that Turkey has never implemented non-market measures.
  5. International Monetary Fund (IMF) support is also an unlikely option given Erdogan’s rhetoric about freeing Turkey from its past IMF debts, with its last instalment paid in May 2013. Last week, Albayrak said that the country is not in contact with the IMF, with the exception of routine, ongoing reviews.
  6. Qatar pledged $15bn of investment in Turkey, which is an increasingly important ally of the Gulf nation, last week. The support deal, which includes swap lines and direct investments, will facilitate bilateral trade in local currencies and support financial stability. Russia and China may also provide support: after Trump threatened to impose sanctions on Turkey last month, Albayrak announced that the Industrial and Commercial Bank of China would provide a $3.6bn loan package for the energy and transport sector. Meanwhile, the EU is unlikely to offer monetary assistance. However, it is emerging as a key diplomatic partner.
  7. An interest rate hike by the Turkish central bank would help in asserting its independence, but authorities have so far only focused on technical measures to try and stabilise the lira. Last week, the central bank suspended its weekly repo auction. By shutting banks off from borrowing at the benchmark repo rate, of 17.75%, and forcing them to borrow at the more expensive overnight lending rate – currently 19.25% – the central bank has effectively enacted a 150bp rate increase. However, this is not enough: the central bank could take further action by shutting off the overnight lending market and moving banks to the late liquidity window, which would result in another 150bp increase.

A buying opportunity?

But trouble brings opportunity, too.

Last week, the lira weakened 40% against the dollar, local bond yields pushed 300bp higher to 22.3% and sovereign credit spreads widened by 280bp, hitting 600bp – a level last seen during the 2008 credit crisis. Turkish corporate bond spreads also widened meaningfully, although they have now retreated from their worst levels. This has created opportunities for investors to gain exposure to companies with robust levers that can withstand the current macro environment, such as exporters and well-capitalised, domestically focused businesses.

Figure 2: The spread on Turkey’s five-year credit default swap climbs towards 2008 highs

Source: Bloomberg as at August 2018.

This is illustrated well by our exposure to Turk Telekom. While operating risks are likely to increase from their current levels, we believe that the company has many levers to preserve cash, such as cutting advertising spend, operating costs and capital expenditures. Also, even though financial risks have increased, we think that Turk Telecom’s short-term foreign-currency liabilities are sufficiently covered by its assets denominated in overseas currencies. Moreover, the company’s decision to not pay not a dividend to shareholders this year highlights its desire to delever its balance sheet during a period of heightened uncertainty.

We also believe that current holding Akbank, Turkey’s second-largest private bank, is a credit issuer that is well placed to perform well in the current market environment. To our mind, its strong profitability and capital buffers leave it among the best-positioned banks in the country to weather potential deterioration in asset-quality issues.

This document does not constitute a solicitation or offer to any person to buy or sell any related securities or financial instruments.

1 “IIF Global Debt Monitor” published by The Institute of International Finance in Q1 2018.

2 “Capital controls not on agenda, Turkey’s Albayrak says”, published by Reuters on 16 August 2018.

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