Turkey had a disastrous year in 2018. A gaping external deficit sent the lira into freefall, causing distress by sending the cost of companies’ and banks’ foreign debt soaring. In turn, this caused credit growth to collapse, a construction boom to turn to bust and the country to slide into deep recession.
This growth collapse was expected by many – including ourselves – to establish the foundation for a sustainable recovery. The sharp contraction in domestic demand sent imports crashing, while the competitiveness boost from the currency’s devaluation further helped restore Turkey’s current account from deep deficit – the biggest of any emerging market – into surplus.
Chart 1: Turkey Purchasing Managers' Index and Industrial Production
This conforms to a pattern we have repeatedly seen across emerging markets (EM): recessions are a reliable cure for a big external payment deficit. By the start of this year, foreign exchange reserves appeared to be recovering, inflation looked to have peaked and the economy was clearly rebalancing. The decision of the Central Bank not to cut interest rates in March was regarded as confirmation that economic policy would remain orthodox. Reassuringly, the banking sector has been able to consistently roll over its huge stock of syndicated lending, with Akbank – a major private lender – successfully borrowing USD 700 million even at the end of the month.
Chart 2: Turkey monthly trade balance and current account
The government’s commitment to an orthodox path, of sticking with tight money to bring inflation under control, has been patchy. While the sharp rise in the fiscal deficit looks defensible given low government debt levels and the scale of the slowdown, other aspects of economic policy are more troubling.
Chart 3: Turkey gross FX assets in USD
While private banks’ lending has collapsed, the state-owned sector has seen a much smaller fall. Although state banks lent more and later in the boom phase, they are reporting bad loans at a far lower level than are the private banks. Combined, these two facts indicate that the state banks are being used to shield politically-favoured sectors from recession, as well as creating more liquidity than is safe for a country with Turkey’s low level of currency reserves. Meanwhile the sharp drop in currency reserves suggests the government has been intervening to prevent the currency finding an equilibrium level, almost certainly for political reasons ahead of local elections.
Chart 4: Turkey credit growth
When investors took fright, the authorities failed to tighten policy (for example, by raising interest rates); instead, the government appears to have informally instructed Turkish banks not to lend to foreigners. As a result, foreigners who required lira (to settle trades) were forced to borrow from the tiny pool of offshore lira. The result was a huge rise in offshore lira rates (which hit 1300% on Wednesday 27 March), but also a short-lived stabilisation of the lira, as selling foreign currency became the only way for foreigners to source lira.
The violent adjustment was not echoed onshore. Even as the offshore lira rate (and cross-currency swap rates) spiralled, onshore rates remained unchanged. But the turbulence threatens to discredit the offshore lira market, reduce liquidity in lira markets and cut off a potential source of funding to Turkish institutions. This, in turn, may have caused the government to back down, with the offshore overnight rate dropping to a relatively modest 50% on Thursday 28 March. Unfortunately, this resulted in more lira slippage, with the currency off over 4% versus the dollar.
Continued normalisation is expected after the local elections. The market’s immediate response to a defeat for the governing AKP, especially in Istanbul and/or Ankara, would likely be negative, as this could increase government recklessness as it tries to shore up its popularity. The events of late March (including President Erdogan’s return to his “high interest rates cause inflation” hobbyhorse) are a major blow to those of us who believed Turkey would be able to pursue the painful path to conventional stabilisation.
Looking forward, we believe Turkey urgently needs to signal a return to orthodoxy to stabilise the financial system. The lira will likely cheapen further, at least temporarily, but the transformation of the balance of payments should help. If the government instead pursues more backdoor expansion via the state banks, persuades the Central Bank to cut interest rates or otherwise jeopardises the progress already made, the consequences could be severe. While we believe Turkey does not present significant sovereign default risk, nor that another 2018-scale drop in the lira is in prospect, the country’s thin stock of foreign reserves leaves very little room for error, and scope for catastrophe remains. The key things we will be monitoring are the conduct of policy, the level of foreign exchange reserves and lending by the public banks. For the external sector, Turkey is very vulnerable to a stronger oil price. While Turkish assets are cheap by any measure, and unlike last year the balance of payments is healthy, the country is unlikely to be able to deviate from orthodox policy for long without severe consequences.
Elsewhere in the asset class, there are a number of interesting opportunities presenting themselves.
Argentina was another country that had very similar balance of payment problems in 2018; the difference in Argentina was that the government was borrowing externally rather than the private sector. There has been rebalancing of the economy, although the strength of this rebalancing is measured as Argentina is a fairly closed economy and there would need to be a bigger change in imports to generate a 1 or 2% correction of GDP. While our view of Argentina is more favourable than it was last year, we still have concerns about the presidential elections taking place this coming October, as well as its higher exposure to global commodity prices. Our core concern, though, is that it is a much less liquid market than others in this asset class. On a more positive note it is now running high real interest rates, with 50% nominal interest rates; we think Argentina is unlikely to be caught running excessively loose monetary policy again.
Brazil is another interesting story. Possibly for the first time in my career locals are more optimistic on its prospects than foreigners. From an external perspective, many observers have reservations about new president Bolsonaro, given the damage populism has done elsewhere in the world. But Brazilian investors appear to be much more positive, especially given pension and social security reform is a huge priority. To us, Brazil's key vulnerability is its substantial government debt to GDP. While it is at about the same level as that of the UK, the UK government pays roughly zero real interest rates, whereas in Brazil the government pays around 5.5%. This means Brazil really needs to start running a primary fiscal surplus in order to achieve debt sustainability. That is why the plans of the new Brazilian finance team, headed by Paulo Guedes, are seen as positive domestically and why we have seen a huge improvement and a drop in real yields in the financing of the Brazilian deficit.
Russia remains an enigma. Its government debt, in single digits, is one of the healthiest in the world and it has a current account surplus. Inflation has been coming down and it has a strong central bank. In terms of the pure macro environment we think Russia looks extremely healthy. Our key concern, though, is the imposition of sanctions by the US; as a result we still see some vulnerability. The key to Russia is to monitor external developments – last year Russia repeatedly sold off on bad news about sanctions. The Russian market has performed well so far this year but it can be one of those binary situations not seen in many other places, where exogenous events can make it either a good or a bad investment and often nothing in between.
In Mexico, we think the good news is not yet priced in. Last year the key concerns were in the form of two acronyms: NAFTA and AMLO, NAFTA referring to the renegotiation of the free trade area with North America, and AMLO the name by which new president Andrés Manuel López Obrador, who was elected last year, is often referenced. We believe the news on NAFTA was more important. Mexico has a high real interest rate and a cheap currency, which on the negative side has pushed inflation higher, but on the positive side has meant the trade balance is stable. That combination of cheap valuations and overall good news flow makes it look attractive in our view.
Meanwhile across central Europe we are closely watching the four countries of Poland, Hungary, the Czech Republic and Romania. In our view Romania is probably the weakest of the four, but across the region these countries are at a vulnerable point in the cycle. They have populist governments which are not inclined to exercise monetary discipline; we think there is a danger inflation could pick up and that the currencies run into devaluation.
While macro events are at the core of our thinking, country analysis forms an important part of our investment process. It is often the most beaten up of countries, such as Argentina, which may present the next investment opportunity.