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Turkish economy in troubled waters with no land in sight

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Global Monetary Conditions to Tighten

Global inflationary pressures have taken the central stage in recent months. Although at one point FED officials argued otherwise, according to New York FED economists US inflation is acknowledged to be a broad based phenomenon. Global commodity prices skyrocketed and show no sign of return in the near future. FED already started to communicate faster and bigger rate hikes. Policy normalization will include quantitative tightening. The Fed’s asset holdings — mostly Treasuries and mortgage bonds backed by government agencies — more than doubled during the pandemic, to about $8.9 trillion from $4.2 trillion. In the March meeting, the minutes of which were released in April, Fed officials discussed shrinking the balance sheet at a maximum monthly pace of $60 billion in Treasuries and $35 billion in mortgage-backed securities — in line with market expectations and nearly double the peak rate of $50 billion a month the last time the Fed trimmed its balance sheet from 2017 to 2019. When global monetary conditions tighten investors lose their appetite for risky assets.

Growth Rebalancing with Unsustainable Dynamics in Charge

Consumer confidence indicators provide an indication of future developments of households’ consumption and saving, based upon answers regarding their expected financial situation, their sentiment about the general economic situation, unemployment and capability of savings. Turkish consumer confidence indicator hovers at multi year lows. On the other hand exporters continue to enjoy favorable conditions. As a result rebalancing in growth continues. This rebalancing trajectory is threatened by unsustainable dynamics in charge: managed floating foreign currency regime and negative real rates in Turkey.

Negative real rate environment in Turkey is the main driver of new money demand under unachored inflation expectations. Market participants expect inflation to stay at elevated levels according to survey data. Annualized three month average inflation reached 100 percent which signals for worse to come.

Economic agents demand for new money if they expect higher inflation. According to Richard Cantillon, the beneficiaries from the expansion of the money supply are the first recipients of the new money. As new money is created by banks, those who have the best access to bank credit benefit the most. If real rates are in deep negative like Turkey, it is not a suprise to see huge money demand. Annualized four week Turkish lira loan growth will eventually destabilize an unstable economy.

How to Finance Current Account Deficit?

It is obvious in Turkey’s case that negative real rates and accelerated loan growth become a poisonous mix for the external balance. Domestic economic agents prefer to purchase foreign currency linked assets in a front loaded fashion amid uncertainty in global prices. Turkey finances current account deficit in 2 ways: first, absorbing banking system’s foreign currency liquidity and second, borrowing from international capital markets. Foreign debtors are not willing to accept Turkish risk despite high risk premium offered by the markets. Given the latest development in US, also it is going to be very costly to borrow from international markets under current macroeconomic policy framework. On the other hand Central Bank of Turkey already utilized 40 Billion USD from local banks in the form of swap arrangement. Recently, Central bank introduced foreign currency deposit guarantee scheme to continue financing current account deficit with banking system’s liquidity. In summer period,there will be some relief with income from tourism sector to current account, but Turkey needs to tackle with external balance at the soonest possible.

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Warning Signs For Turkey as Outstanding Eurobond Duration Shortens

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A Eurobond is a debt instrument that’s denominated in hard currency other than the home currency of the country or market in which it is issued. Access to international markets depends on the perceived credit risk, often measured by a country’s credit rating. An international rating of B- is generally considered the minimum for issuance in the international capital markets. Investors are driven by yields and, in the current low rate environment, have been accepting more credit risk, pricing in default risks. In addition, many investors actively or passively track market indices, or benchmark their investments against them; if a bond qualifies for inclusion in an index it can therefore generate some ‘automatic’ demand.

The key drivers to issue Eurobonds centered around the ease at which funds can be raised, the lack ofconditionality in their use, and the drive to signal financial strength.

Turkey in International Markets

Turkish Treasury has taken international borrowing very seriously and has been one of the biggest suppliers for years. Currently, Turkey has 85 Billion USD outstanding Eurobond.

Turkey continues to borrow from international markets. Latest Euro denominated 5 year Eurobond issuance of Turkish treasury in July 2021 was priced at  468 bps spread to Euro mid swaps. Interest spread has been between  200 bps to 800 bps in the last two decades.

Below is an example of a 30 year USD denominated bond which was issued in 2000 and will be due in 2030. This Eurobond is priced at +525 bps over US Treasury’s 2029 5,25% bond at the issuance. 

Who Owns Eurobonds?

Countries that are not able to raise long term funds in its domestic currency from international markets issue hard currency bonds. One of the reasons to borrow from international markets is to attract foreign portfolio investors.

Recent developments in ownership of Eurobonds suggest otherwise recently. Turkish banks and citizens are also clients of high yielding Eurobonds.  Eurobonds are good substitute of foreign currency deposits. As of May 2021, more than two third of Turkish foreign currency deposit holders have deposit balance above 100.000 USD in their bank accounts. In total, this means purchasing power of approximately 150 Billion USD. Turkish residents hold 42% of outstanding Turkish Eurobonds. Turkish banks hold 26 Billion USD amount of Eurobonds. Nonbank residents hold 11 Billion USD amount of Eurobonds. Eurobond ownership by Turkish bank and non bank residents almost doubled in the last 2 years. 

Maturity Shortening as a Risk

The original sin hypothesis was first defined as a situation “in which the domestic currency cannot be used to borrow abroad or to borrow long term even domestically” by Barry Eichengreen and Ricardo Hausmann in 1999. Original sin has important consequences. Countries with original sin that have net foreign debt will have a currency mismatch on their national balance sheets. Movements in the real exchange rate will then have aggregate wealth effects. In addition to original sin, debt intolerance is another term that needs to be understood well. Debt intolerance is a term coined by Carmen Reinhart, Kenneth Rogoff and Miguel Savastano referring to the inability of emerging markets to manage levels of external debt that, under the same circumstances, would be manageable for developed countries, making a direct analogy to lactose-intolerant individuals. It is already a well documented fact that the maturity structure of emerging market debt issuances correlates with their domestic conditions. That is, emerging markets issue long-term debts more in tranquil times, and issue short-term debts more when they are near crisis. Long-term spread is generally higher than short-term spread and this difference increases as the country approaches crisis (Broner, Lorenzoni and Schumukler (2005)). The refinancing challenges are often ignored at the time of issuance, since refinancing takes place in the distant future.

Duration of external debt bond stock continue shortening as Turkish Treasury is not willing to pay high interest rate spreads. On the other hand there is a lack of appetite by foreign investors to lend Turkish Treasury. Turkish residents become the main investors of Turksh Eurobonds. Given the high level of Turkey’s short term external debt, shortening maturity of external bond stock is not favorable in the long run.

Interest Rate Spread as a Sovereign Risk Indicator

Historically some governments defaulted on their foreign currency debt. Default risk is priced in terms of interest rate spread. The interest rate spread between Eurobonds and U.S. treasury securities should reflect sovereign default risk.

Default on sovereign bonds is mostly observed at the times of crises. IMF defines crisis period as follows in one of research notes:

  • Sovereign spreads above 1,000 basis points. Crisis periods are counted as those weeks during which sovereign spreads as measured by JP Morgan’s Emerging Markets Bond Index (EMBI) exceed 1,000 basis points on at least five consecutive trading days. Temporarily lower spreads during periods of up to 150 trading days are disregarded to avoid splitting crises into several events.
  • Sovereign ratings below B2/B. Crisis start dates are defined as downward rating revisions to or below B2 (Moody’s) or B (Standard and Poor’s, Fitch), respectively. Crisis end dates are defined as upward rating revisions to above B2/B. If ratings by more than one rating agency are available, we use the lowest rating to make the event window as wide as possible.

Below is the historical development on interest rate spread between due 01/15/2030 Turkey USD Bond and 05/15/2030 US Bond. Although Turkish sovereign risk deteoriated after 2018, it is still far away from crisis mode. Turkey needs to tackle short term external debt problem in order to cheapen cost of external borrowing.