Seven things to keep in mind about Turkey

This article first appeared in The Edge Financial Daily, on August 14, 2018.
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THE weekend gave Turkey and the world’s financial markets a much-needed breather after the country’s currency experienced a week of intense weakness and dizzying volatility. But it also builds expectations among traders of a decisive policy initiative that, if it proves insufficiently impressive, could lead to even more market disorder and, with that, the potential for wider economic and financial dislocations.

There are seven main issues that traders, investors, governments and central banks should keep in mind.

No 1 — Beyond foreign exchange.

Even though the focus these days is on how much the currency moves, Turkey’s predicament extends well beyond the foreign exchange market. Currencies overshoot quite often, especially in emerging economies, and not just on the way down. Such violent moves are often neither the driver of the underlying turmoil nor the end result. They are best thought off as a highly visible indicator, and one that can also contain important forward-leading signals.

No 2 — Imbalances have been around for a while.

By persistently stimulating its economy through credit and, more recently, the budget, Turkey has accumulated twin deficits — that is, imbalances in both its public sector budget and in the current account of the balance of payments. Funded by external borrowing and capital inflows, these have helped boost investment and growth. But the incremental income generated has been insufficient to curb the debt burden.
 
No 3 — The external environment has turned less hospitable.

Although financing needs remain considerable, Turkey is now facing a more challenging external environment. This will not change any time soon. As a result, inflows have become less abundant and more expensive.

When it comes to global liquidity, the world is in the midst of a transition away from a protracted period of loose financial conditions engineered by central banks. Some of the large monthly injections of cash resulting from central banks’ asset purchase programmes have either stopped (as in the case of the US Federal Reserve [Fed]) or are tapering (European Central Bank). The short end of the US yield curve has risen as the Fed has hiked rates several times, a policy path that it is unlikely to abandon any time soon with the continuing rise in inflation. And with policy, growth and rate differentials favouring the US, the likelihood of a further general strengthening of the dollar is considerable.

This has affected technically more fragile asset classes, especially emerging markets, which have experienced considerable capital outflows. Local- and foreign-currency denominated bonds and, therefore, currencies and risk spreads, have come under pressure.

This less accommodating external environment has been amplified for Turkey by its political spat with the US. With that came talk of a doubling of tariffs that the US applies to imports of metals from Turkey. Reaching some political resolution has become an important step in the short term to reduce some of the pressures on Turkey’s currency market.

No 4 — Investors have doubts about Turkey’s policy responses.

The country’s situation is further complicated by concerns about economic management. Amid significant political pressure, confidence is low that the central bank is in a position to deliver decisive market-based measures to stabilise the currency. Worries about political interference have been amplified by the appointment of the President Recep Tayyip Erdogan’s son-in-law to a key economic coordination and oversight role in the cabinet.

No 5 — The country lacks credible external anchors.

The conventional response for countries facing these or similar conditions is to look for one or more external anchors pending the strengthening of domestic policies. Usually, this entails a programme with the International Monetary Fund (IMF) that provides both financing and a seal of good housekeeping for domestic policies. That is what Argentina did earlier this year to counter the disorder in its own currency markets. And Turkey’s case for IMF support would, in theory, be strengthened by concerns about possible contagion.

But Turkey appears hesitant to approach the IMF, and for understandable reasons. Especially with US support far from guaranteed currently on the fund’s executive board, the Washington-based organisation is likely to require significant policy adjustments by Ankara, including some U-turns away from many of Erdogan’s key initiatives. There is another internal political dimension here. Bringing back the IMF could be seen as a return to the “bad old days” of the early 2000’s that, in fact, opened the way for the president and his ruling party.

Yet without the IMF, Turkey may be forced into an even bigger turn away from these initiatives. With or without the IMF, Turkey is likely to face a period of spending cuts, increased prices for public services, and higher taxes to reduce both internal and external deficits.

There are not many alternatives to the IMF. Other European governments and institutions are not likely to step up with anything that would materially alter Turkey’s funding needs. The same is true of most Gulf countries. China, while less burdened by political issues, is unlikely to engage quickly on the scale required. And the closer political ties with Russia, including a publicised call last Friday between Presidents Erdogan and Vladimir Putin, is unlikely to deliver much in terms of cash flow.

No 6 — Riding out the storm is an option, but not an attractive one.

Turkey could just step back and allow the currency to find its floor on its own. The question is not whether this would eventually happen — it would — but at what cost to the economy.

Already the sharp currency depreciation experienced this year has fuelled inflation, aggravated debt and currency mismatches, pressured local banks, undermined growth and worsened the prospects of many local businesses. Should this continue, it will set the stage for recession and crippling inflation, together with higher bankruptcies and corporate debt defaults. The result will also be greater demands for the government to support local banks and protect the most vulnerable segments of the population. 

No  7 — Growing chatter about capital and convertibility controls.

It is not a great surprise that there is now more talk domestically about the possibility of Turkey implementing capital controls to limit outflows and counter the dollarisation of the economy. This increases the incentive for the private sector (both local and foreign) to accelerate its disengagement from the local currency. With that comes even greater financial and economic pressure.

The bottom line for Turkey is not a pleasant one. Due to the coincidence of domestic and external pressures, the authorities have limited room for manoeuvre when it comes to policy formulation and financing, especially if they decide to continue to go it alone. It is becoming less and less likely that the government will be able to avoid some combination of higher interest rates, budgetary austerity, recourse to IMF financing and some forms of capital controls. Indeed, the longer it waits to tighten policies domestically and engage with the IMF, the greater the risk that all of this will come about.

Investors should brace for more volatility for the Turkish lira and bond spreads, as well as more technical contagion for other emerging markets. The spillover for the advanced world — particularly Europe — would only become consequential if the sources of contagion were to spread. — Bloomberg

Mohamed A El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as chief executive officer and co-chief investment officer. His books include The Only Game in Town and When Markets Collide.