Turkey's corporates need “the mother and father of all evil”

Turkey's lira is one of the worst-performing currencies this year. In the last 12 months, it has weakened some 40 per cent against the dollar and now hovers near all-time lows. A slide of this magnitude is especially worrisome when it comes to repaying debt that's denominated in non-domestic, “hard” currencies like the dollar or the euro. Emerging-market borrowers in Asia and Latin America learned this lesson in the 1990s. Turkey's private sector apparently has not. Through May 2019, the country's banks and corporations have billions of dollars of hard-currency debt coming due. Here is HSBC's Melis Metiner on the repayment schedule:

As the red shading indicates, the private sector is on the hook for most of it, with a $9bn bill to be paid in October. According to Metiner, banks are scheduled to repay $51bn over the next year, while the remaining $18.5bn sits on non-financial corporate balance sheets. These bills are coming due at a time when corporate indebtedness sits at 62 per cent of GDP, half of which is denominated in foreign currencies (dollars and euros, mostly). Of that, points out Ugras Ulku of the Institute of International Finance, *the bulk of the corporate sector’s $217bn in net FX open position is unhedged, triple the level in 2009:

Given the lira’s collapse, it appears increasingly unlikely that Turkey's corporates will be able to stick to their repayment schedules. That's why many of them have turned to the banks for some relief. Yildiz, the maker of Godiva chocolates and McVitie’s biscuits, restructured $6.5bn worth of short-term loans with several lenders in May. Two other giants–Otas and Bereket Energy–are doing the same with $4.8bn and $4bn worth of loans, respectively. Not all corporates have been so lucky, though. The number of loans past due, points out Michael Biggs of GAM, is increasing:

To contain this problem, an industry group for Turkish banks proposed new rules last week to accelerate the process of restructuring corporate debt. Turkish banks are not yet seeing waves of defaults (just 3 per cent of loans are considered non-performing) and total reserve coverage sits comfortably at 122 per cent. Still, in July Fitch downgraded the sector to below investment grade:

It is no longer appropriate to rate banks above the sovereign in Turkey. This view reflects our belief that, in case of a marked deterioration in Turkey's external finances, the risk of government intervention in the banking sector in the form of capital controls or restrictions will increasingly be equal to that of a sovereign default.

Inan Demir of Nomura says it's a “vicious circle”. Here's how he thinks it could play out:

...it is quite likely that Turkey’s foreign creditors could become concerned about the balance sheet health of Turkey’s private sector. These concerns, which would stem from TRY weakness in the first place, are likely to lead to a contraction in capital flows, which would put further pressure on the currency...If this negative feedback loop is not broken, we believe Turkey would be pushed dangerously close to a full blown balance of payments crisis.

A contraction in capital flows is particularly worrisome for Turkey's government, because it depends heavily on this kind of short-term “hot money” to fund its current account deficit. The gap has widened in recent years thanks to a kitchen sink of stimuli (interest rate cuts, loan guarantees, infrastructure spending and tax breaks) that President Recep Tayyip Erdogan put in place to bootstrap Turkey's economy after a failed coup in 2016. Domestic demand has risen significantly as a result, but without a simultaneous increase in exports. Foreign exchange reserves could help – if Turkey had them. Relative to its short-term external debt, Turkey’s FX reserves have declined to new lows, as the Institute of International Finance’s Ulku shows here:

Analysts agree that the only way to break this cycle and temper runaway inflation, which currently hovers near 16 per cent, is for the central bank to hike interest rates. That seems increasingly unlikely, given President Erdogan’s recent provocations. Just one month before the election that saw Erdogan consolidate power, he called interest rates “the mother and father of all evil“. And after his victory, Erdogan moved decisively to end the central bank’s independence, giving himself the power to appoint its new governor. He also named his son-in-law the country’s new finance minister. The central bank demurred from raising rates at its most recent meeting in July. Many see this as a sign that Erdogan’s takeover of the country's monetary policy is complete.

Erdogan has an alternative solution in mind. On Friday, he called on Turks to convert their dollars, euros and gold into lira. ”Do not fear“, he assured citizens, ”we will emerge victorious".

*Updated for clarity as not all of the corporate sector's net FX open position is unhedged.