Turkey – A Rolling Challenge

Turkey – A Rolling Challenge

Turkish asset prices have come under heavy pressure recently, and the Turkish lira fell to a record low against the U.S. dollar in January. Investors seem focused on three mutually reinforcing factors: Turkey’s large foreign currency refinancing needs, balance sheet mismatches across the corporate sector and insufficient foreign currency reserves. Complicating matters, the political environment constrains, and even resists, economic adjustment.

But the triggers for the latest sell-off in Turkish assets have been internal political developments and changes in the external environment, including the Federal Reserve’s interest rate normalization and uncertainties surrounding the new U.S. administration’s policies, which have exposed Turkey’s fragilities.

What happens next will be a function of Turkey’s policy response and how the external environment unfolds. Turkey needs to restore confidence so that foreign investors keep rolling its large foreign currency financing needs and begin buying lira-denominated assets again, and so that locals avoid dollarization and stop front-running dollar purchases ahead of scheduled debt payments.

Building confidence in Turkey

Restoring confidence for foreign investors is challenging given Turkey’s large foreign exchange (FX) refinancing needs. We calculate that Turkey has about $200 billion in gross FX needs in the next 12 months, including amortization of long-term debt, rolling of short-term debt and financing of the current account deficit. These numbers assume dollarization by locals stays low. While Turkey has traditionally been able to raise this kind of financing (per the latest balance-of-payments data in November, the rollover ratios on FX lines for banks and corporates were still above 100%, albeit declining), the reality is this can no longer be taken as a given.

If rollover lines were to decline as they did in 2008-2009, we think the funding gap could be met by a combination of Turkish residents repatriating assets, banks releasing some of their U.S. dollar holdings at the central bank – Turkish banks are allowed to meet reserve requirement ratios on lira deposits with U.S. dollars, which count as part of FX gross reserves – and also with some (net) FX reserve depletion. While Turkey would be able to meet its obligations, the country would come out with a severely debilitated balance sheet.

Meanwhile, the Turkish people need to have confidence that the lira will stop depreciating, while foreign investors need to find lira assets sufficiently attractive to return to the Turkish market. For that to happen, we think central bank policy will need to play a critical role. In the past, most notably in January 2014 but also in 2011 and 2006, Turkey’s central bank acted belatedly via emergency interest rate hikes. This time around, with the economy contracting, the political realities are possibly more complex; President Recep Tayyip Erdoğan, who has continued to consolidate power after the coup attempt in July, is a vocal proponent of low rates to spur growth.

Nevertheless, we think rate hikes will eventually come. Bond investors are betting on it, judging by the flattening of the Turkish yield curve. Unfortunately for Turkey, competition for funds amid a Fed tightening cycle is fierce – ex-ante real rates in South Africa, Brazil and Russia are running in the 2%–8% range – which means any adjustment in Turkey would need to be severe in order to be effective.

The external environment could also play a role in stabilizing Turkish markets. Time and again, positive external turns have aided Turkey, especially when investors have been eager for yield. The same could happen now, although we think the road ahead may be considerably different from the past, in part due to the potential for new policies and the rate-hiking cycle in the U.S. Still, Turkey’s systemic and geopolitical importance make the country a strong candidate for external support, which could eventually provide a backstop to the credit deterioration.

Investment takeaways

From an investment perspective, we are looking for confidence signals to emerge before investing more heavily in Turkish assets. We are cognizant of the positioning backdrop on Turkish assets – with the offshore community universally cautious on Turkey – and of the risk of big price movements in this environment. But unless decisive action is taken, any rally in prices will be seen by the market/locals as an opportunity to buy more dollars, and the negative cycle could continue.

Francesc Balcells is a portfolio manager focused on emerging markets.