Turkish independence fight

The imbalances, which impeded Turkey’s economy for year, finally surfaced. The consolidated power and the country’s populist politics have led to the overheating of the economy with double digits in inflation. There has been no economic counter-balance mechanism left, even the central bank seemingly lost its independence and serves political interests instead. The era of easy money left its mark in Turkey as well, as people tried to increase their wealth through cheap borrowing. The economy was running an average of 5 percent annual current account deficit for the last one and a half decades. As any economy, Turkey was able to keep up this long due to cheap financing from abroad and hoarded foreign-currency debt. According to the latest figures – bear in mind that statisticians work with a lag – the economy owed a grand total of 400 billion USD debt to the rest of the world at the end of the last financial year. Data published by the Central Bank of the Republic of Turkey shows similar figures. Their calculations indicate a 460 and 400 billion USD net debt at the end of last December and March respectively. The differences in the figures are explained by different methods of measurement, currency movements, and trends in external trade and financing.

The currency almost doesn’t matter

Recently it has become a widely debated topic, whether the denomination of debt makes a difference. Let’s see what difference it makes if an economy uses its own currency in external financing.

In the case of foreign currency debt, the falling value of domestic currency will simultaneously drive up debt servicing. Simply put, the value of the instalments measured in local currency will increase, as several Hungarian households experienced it during the 2008/9 financial crisis. On the contrary, if the debt is denominated in local currency, a fall in its value will have no immediate effect on repayment. Instead foreign investors will have to witness the erosion of their investments. As a consequence, investors will be unwilling to or reluctant to finance the economy’s deficit, unless risk are covered in a form of higher returns. What is common in both cases is that the era of overconsumption must come to an end, one way or another. Contemporary Turkey experiences the first scenario with high dollar denominated debt.

Fighting the foreigners

One of the most intriguing topics surrounding the situation is the reaction of the populist leadership. According to the official, strongly populist explanation, everything could be fine except that evil foreign forces are attacking the economy. President Erdogan ‘called his people to arms’ by asking the true patriots to sell their dollar and gold to buy lira and defend the currency. What makes this case interesting is its ‘quicksand nature’.

The Turkish economy is a net debtor, even their own central bank admits it. The data compiled by the BIS-IMF-OECD-World Bank group – all evil Westerners though – showed a 400 billion USD external debt at the end of the last year, of which 160 billion was due within a year. This short-term amount must be paid, unless the economy can refinance itself. The databases above also indicate the official reserves (85 billion USD), deposits in foreign banks (35 billion USD), gold reserves (27 billion USD), and hard currency cash (1.4 billion USD) held by locals. In the scenario of a successful ‘call to arms’, when everybody exchanges what they hold, there is still an 11.6 billion USD gap which must be refinanced. However, who will provide credit for someone without and collateral?

As long as a hypothetical country has 5 dollars and 10 dollars in debt, the investors could feel relatively safe. There is half a dollar for each of them, or two investors for each dollar asset. As long as nobody flees the market there is no reason to fear. However, as soon as capital flight begins, things tend to get a little bit more, and then eventually very risky. As more and more dollars are being exchanged, there will be less and less remaining dollars to meet future withdrawals on a per investor basis. On the one hand, providers of the funds can get nervous and tempted to flee themselves. On the other hand, Turkey will have less and less ammunition remaining to defend the exchange rate.

The Turkish situation looks as a giant, international game of musical chairs. After more and more people took their seats, the ones still circulating have to compete for a relatively smaller and smaller number of chairs. The ones standing at the end of the song will risk not having any chairs (dollars) remaining. The Turkish debtors could still buy some from the market, however, with adverse trends in the exchange rate, it is questionable whether they can. Bankruptcies, restructurings, and hair-cuts are more likely to be in play.

Under such circumstances the leadership should admit that the song is fading, and aim for the lesser of the evils. They should implement capital controls, start negotiations – either with monetary organization or their creditors – and buy time for themselves. Unfortunately, the leadership decided to encourage everyone to give away their dollars. It looks just like quicksand: the more you are struggling to escape, the lower you sink in it.

Bad times coming

The recent developments can be relevant even for those who have no direct exposure to the Turkish markets. First of all, the country’s geographical location makes it an interesting case. For people migrating from the Middle-East or Central-Asia the road towards Europe leads through Turkey. Due to the agreement between the EU and Turkey, the country already hosts millions of refugees, mainly from the war-torn Syria. Political instability in the country would result in a scenario similar to the fall of North-African regimes and the mass migration followed.

Secondly, the financial turbulence will likely spread to other emerging economies. Turkish assets are usually bundled together with other developing economies’ assets in the region. A sudden selloff of these funds will inevitably mean that the countries in these groups will also come under temporary financial pressure.

Even though the long-term political and policy implications are less clear, there is one certain factor. Due to the long-existing imbalances building up in the economy, recession and rebalancing seems inevitable. Economic tightening is imminent, whether it arrives in the form of domestic policies or deteriorating international financial conditions. The average Turkish citizen must save more and consume less, which is not a positive outlook for personal and household welfare. More effort with lesser results will possibly make the voters think about the circumstances which led to this situation.

Although political change seems certain, the direction is questionable. It would be too early to call this an end of the current regime. Further populist political rhetoric could easily divert attention to foreigners once again. Given that markets are pricing the future, banks with significant Turkish exposure, like Banco Bilbao or UniCredit will see the effects of an economic turnaround sooner than a Turkish household. Domestic producers, on the other hand, will almost certainly be among the beneficiaries of the trend due to lower competition from imported goods.

The developing recession is worthy to follow. On the short-run volatility on the financial markets might offer some good buying opportunities amid a globally expensive market. However, on the longer-run Turkey’s shifting political attitude towards the West will be a determinant aspect of macro-investments.