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Turkey's economic crisis

April 2019

Turkey teetering on the brink?

Turkey is on the verge of a balance of payments crisis unless it delivers policy reforms.

The big squeeze

After last year’s August currency crisis, the Turkish lira hit the headlines again in late March with a surge in its implied overnight forward rate and exchange rate. The reasons behind this flash rally are convoluted but effectively it was led by short positioning as well as quasi capital controls introduced by the government last summer.

The bout of market volatility came just as local elections saw the incumbent AKP government of President Erdogan lose some of its power, especially in major urban centres. 

How will the administration react to this setback – should we expect a swing into great economic populism or more of a progressive reformist agenda? Until there is clarity, concerned investors are likely to exert continued downward pressure on the currency.

FIg. 1: Turkey implied overnight forward rate & exchange rate 
Turkey implied overnight forward rate & exchange rate

Source: Pictet Asset Management, CEIC, Datastream, April 2019

A tangled web

Turkey has the second highest inflation in developing markets after its equally troubled EM 'twin' - Argentina. Even though our indicators show Turkish inflation may have peaked for now, we think precarious economic conditions and political uncertainty mean the risk of a full-fledged balance of payments crisis remains.

This fragility is expressed in Turkey’s volatile current account which, as shown below, has flipped back into deficit. Further significant depreciation in the Turkish lira risks a negative feedback loop that will further widen the economic recession.

Fig. 2: TURKEY's current account breakdown
Turkey's current account breakdown

Source: Pictet Asset Management, CEIC, Datastream, January 2019

Running out of road?

Further fragility is evident in Turkey’s FX reserves, which are equivalent to just four months of imports. By contrast Brazil has 25 months and China 16 months.
Fig. 3: Turkey FX reserves to MONTHS OF imports
Turkey FX reserves to months of imports

Source: Pictet Asset Management, CEIC, Datastream, January 2019

Growing dollar reliance

Another concern is the increasing dollarisation of loans in the economy (see left-hand chart below). However, this is currently being more than tracked by an increase in dollar deposits, as the right chart shows, which implies the risk of currency mismatch remains muted for now.
FIg. 4A (lhs): Turkey banks local & foreign currency loans / Fig. 4B (rhs): Turkey banks local & foreign currency deposits 
Turkey banks local & foreign currency loans

Source: Pictet Asset Management, CEIC, Datastream, February 2019

Where now politically?

Overall, we see the outcome of the recent elections as rather mixed in terms of investment opportunities. At the margin, given the weaker AKP position we could see a switch to a more market-friendly environment where authorities start implementing some of the highly needed short-term and structural policy reforms. If this happens then Turkey might avoid tumbling into the abyss of greater economic crisis.

What about markets?

Looking at 18 previous episodes of currency crisis* in emerging markets below shows that it typically takes four to six quarters on average for GDP to recover to the level before the onset of any currency crisis. Meanwhile in terms of equity markets our backtest shows on average they bottom for 4 quarters before entering a steep recovery phase.

This would suggest that Turkey (and Argentina) possibly have at least two more quarters to endure before a recovery in either GDP or equity markets begins. A continuation of the political crisis and/or failure to address necessary structural reforms will only push this process further out into the future.
Fig. 5A (lhs): EM real GDP before & after currency crises / Fig 5b (rhs): EM stock markets before & after currency crises
EM real GDP before & after currency crises

Source: Pictet Asset Management, CEIC, Datastream. *Our definition of a currency crisis is where Real trade-weighted exchange rate down more than 10% q/q. By this framework there have been 18 episodes since the early 90s: Argentina (02), Brazil (99), Bulgaria (97), Colombia (99), Egypt (03), India (93), Indonesia (97), Korea (97), Malaysia (97), Mexico (95), Philippines (97), Romania (99), Russia (98), South Africa (04), Turkey (94 & 02), Ukraine (98)