What next for Turkey?

In spite of the retracement of assets from their peak of stress on August 13, we do not think that Turkey is out of the woods yet.

It has been a tumultuous few weeks for Turkey: The Turkish lira plunged past 7 against the USD overnight on August 12, as markets worried about the stewardship of the country. The crisis escalated after the US imposed tariffs on Turkish steel and aluminum products in support of an American pastor detained in Turkey. In response, Turkish President Recep Tayyip Erdogan announced a boycott of American electronic products and increased tariffs on American cars, alcohol and cigarettes. Soon after, Turkey’s banking regulator curbed the ability of Turkish banks to supply lira to the market, effectively curtailing short-selling. There were also headlines regarding a pledge from Qatar of an investment package totaling $15 billion, but no details as of yet regarding the nature or the timing of any disbursements. These two measures helped the lira reverse some losses. However, new tariff warnings from the US on August 17 sent the lira tumbling again.

We see the recent retracement in Turkish assets as mostly driven by an engineered technical squeeze in the Turkish lira as opposed to fundamental developments. The government’s measure to stop local market participants from short selling the lira pushed the 3-month forward-implied yields to 31.5% (at 2 pm New York time on August 15, according to Bloomberg), a sign that the market doesn’t see the measures as fundamentally addressing the pressure on the currency. Indeed, we think the measures will only dissuade speculative positions from triggering an imminent currency crisis, but the funding roll risk on local banks and the risk of a deposit run remains latent. Local bank exposures to domestic non-tradable sectors such as construction, which have taken USD loans from local banks, pose doubts about the quality of the bank assets.

We believe the depreciation of the Turkish lira could be enough to significantly reduce, or even potentially eliminate, the current account deficit in the coming months. This may substantially reduce the country’s financing needs and slow the currency depreciation under the most optimistic, muddle-through scenario.

However, the risk of bank runs remains elevated, and we are concerned that should the situation continue to deteriorate, an acceleration of capital outflows could more than offset improvements in the current account. In the event of a deposit run or capital flight, the risk of capital controls materializing would increase.

Figure 1: The ups and downs of the Turkish Lira

Source: Bloomberg, as of August 17, 2018.