2017 Preview: The lira and Turkey’s risky debt

2017 Preview: The lira and Turkey’s risky debt

2016 was a difficult year for Turkey. The country faced multiple political and economic problems, ranging from a failed coup in June to long-standing structural economic problems. In the coming year, Turkey is likely to face problems in the same areas it did in 2016 – volatile growth rates, high-levels of international debt, and political fights over monetary policy.

Growing concerns

The year 2016 was marked by a dramatic increase in security risk for Turkey, with threats emanating at both a domestic and regional level. The military coup attempt in July 2016 did much to harm the country’s stability, with the ensuing crackdown not only limited to opposition members within Turkish civil society, having purged thousands of government workers, military personnel, academics and businesses — resulting in condemnation and increasing doubtful accessions talks with the European Union.

The subsequent security vacuum from the widespread purges, alongside Turkey’s increased presence in Syria, have resulted in an ever-increasing number of attacks from ISIS and PKK militants, intensifying instability in the country’s southeast, and resulting in numerous attacks across its major cities — most recently the assassination of a Russian ambassador in Ankara, and the mass shooting at a nightclub in Istanbul on New Year’s Day.

The country’s mounting insecurity have majorly impacted its tourism industry, down by 40% from 2015, with the number of foreign arrivals dropping by more than 21%. This has had a substantial impact to its economy, with tourism contributing 12.9% of its GDP in 2015.

Turkey’s fragile security environment is only one of its growing concerns. Increased turbulence from the country’s political volatilities following the attempted military coup, have exposed its vulnerabilities to global capital flows, with foreign investment departing the country at an unprecedented pace.

Moreover, imminent changes to international politics and monetary policy are set to further beleaguer the country in 2017. These developments will not only compound Turkey’s fragile domestic environment, but perhaps stability at a regional level too.

A dependency on debt

Erdoğan’s Justice and Development Party (AKP) oversaw the rapid expansion of the Turkish economy between 2002 and 2007, when GDP expanded an average 6.7% annually. However, due to the 2008 global financial crisis, Turkey’s GDP shrunk by 4.5%. The AKP managed to increase growth in 2010 and 2011. However, such a recovery was unstable and precarious at best, having been built upon a flood of near zero-interest foreign capital, coming in from developed economies undergoing policies of quantitative in order to combat their own recessions.

The value of such capital to the economy is fleeting and unstable at best, departing to short-term bays such as banks, stocks or bonds—coming in when times are good, and bolting for the door once they turn bad. Without this enormous influx of foreign investment, Turkey would not have averaged 3.3% growth between 2012 and 2016. With global interest rates on the rise due to an expected expansionist fiscal policy imposed in the US, Turkey and other emerging markets who took full advantage during the times of excess liquidity will have a high price to pay.

Much of Turkey’s borrowing has been done in US dollars. A rise in the dollar’s value will substantially hurt Turkey’s ability to service its debt, which in the worst-case could drastically sever the flow of foreign capital it relies on for economic growth. While Turkey’s Central Bank has had some success in reducing its deficit, the same cannot be said for its private nonbank sector which owes close to $210bn in foreign currency liabilities. Thus, the economic recovery made possible from this unchecked credit boom became not only a massive dependency, but also a huge debt vulnerability to the Turkish economy.

Furthermore, pervasive structural issues such as Turkey’s high rate of unemployment and inflation, low-rate of savings amongst its domestic population, dependency on energy imports, increasingly volatile growth trajectory (required to be at least 3.5% to finance debt), and banks low profitability will continue to leave the country at the whim of international currency markets.

The IMF forecasts that in 2017 Turkey’s current-account deficit will rise from 4.4% to 5.6%, with real GDP growth declining from 3.3% in 2016 to 3% in 2017. Furthermore, $95bn of Turkey’s $430bn debt is expected to rollover within the next 12 months — a difficult task for an economy increasingly-pressed for cash flows within a politically volatile environment.

Turkish President Tayyip Erdogan election

Political risks of the lira

Following the election of Trump and mounting security risks, the lira’s value has dropped dramatically, falling by as a much of a fifth of its value by the end of 2016—a telling sign of the country’s liabilities to US currency. Alongside these declines, the Turkish economy contracted by 1.8%, putting Erdoğan and the Central Bank at increasingly divisive odds on how to best handle the situation.

The absence of unity and direction amongst Turkey’s economic leadership over the country’s monetary policy has done little to ease the worries of investors. The lira’s recent devaluation has put Erdoğan and the central bank increasingly at odds over how to best handle the situation. While this debate has endured over the years, the stakes are now arguably at their highest.

The lira’s recent slump prompted Erdoğan to call on Turkish citizens and businesses to stockpile lira and gold in order to halt the “economic sabotage” carried out by the country’s enemies, as well as break the “tyranny of the dollar”.  Resisting the demands of Erdoğan, the Central Bank responded by raising interest rates for the first time in over three years.

A self-proclaimed “enemy” of high interest, Erdoğan wants the Central Bank to reduce borrowing costs, viewing interest as a tool used by foreign powers to keep the Turkish economy weak. Low interest is argued as being necessary to spur waning growth, a policy largely focused on appeasing the general populace.

The Central Bank and its supporters argue that increased interest rates are a necessity to stabilize Turkey’s volatile currency and increasing inflation. While such a ‘correction’ is likely to negatively impact growth — potentially causing a recession — supporters argue that it is a less harmful option than letting the lira depreciate even further. This sort of depreciation would wreak major chaos on corporate and government balance sheets.

While Erdoğan has proclaimed his respect for the Central Bank’s autonomy, he has gone as far as to brand proponents of high interest as “traitors”, having used the post-coup environment to suggest that Gulenists may even be within the bank.

If the government and the central bank continue to be divided over policy they will certainly further weaken the country’s sovereign credit profile. Troubled loans have so far risen to their highest in seven years, with foreign-currency lending making up a third of total loans. Ratings agency Fitch has thus revised its outlook for the country’s banking sectors in 2017 from “stable” to “negative”.

By the close of 2016, investors responded to Turkey’s tumultuous environment by renewing foreign financing at their lowest levels since 2013, with almost every Turkish bank seeing a decline in participating lenders.

Investment fears

In emerging markets, investors are more likely to tolerate a country’s poor economic and financial fundamentals if  a calm and stable political environment exists. However, once the prospect for such an environment begins to sour, so does the risk appetite for investors — an increasingly common aftertaste for many considering the country’s increased volatility in 2016, with FDI flows to Turkey in 2016 reducing by 44.3% from 2015.

Obligated to mounting foreign currency liabilities, with interest rates on the rise; an energy importer, with the price of oil increasing; amongst an assortment of widespread structural issues—Turkey will seek to implement necessary reform to its finance and banking sectors in order to weather increasingly unfavourable global economic conditions.

The country’s dependence on foreign capital, intensified by the promises of populist rhetoric, will go head-to-head with the realities of rising domestic inflation and its depreciating currency, amidst a tightening of global monetary policy, with the Turkish government having to confront such issues in 2017.

While GDP is forecasted to average around 3.8% between 2016 and 2020, it is just 0.3% above the rate required to service its foreign currency liabilities. The reformist ardour seen early on during Erdoğan’s presidency would be a welcoming presence in the current state of Turkish affairs.

However, such zeal has seemingly been replaced by a more characteristically authoritarian outlook, with many observing the upcoming vote on the constitutional amendments, as well as the development of the government’s increasingly tumultuous relationship with the Central Bank.

A changing regional strategy

The year 2016 saw the drastic reversal of Turkey’s previously deteriorating relations with Russia—with sanctions having been previously placed on Turkey following the downing of a Russian jet over Syria in November 2015. Both countries now find each other as increasingly-essential strategic allies within region, with neither side wanting the normalization of such relations derailed, even in the wake of the recent assassination of a Russian ambassador in Ankara.

Recent developments have seen Turkey broker a ceasefire agreement with Russia over Syria—a major domestic security issue—as well as negotiate the possible use of the lira in the country’s energy trade with Russia, Iran and China—the government’s latest efforts to prop up the lira. Such manoeuvres may underline the growing unreliability of Turkey as a dependable ally to Western interests within the region, especially considering its obstructive attitude towards the migration.

It is estimated that 85% of FDI flowing into Turkey and 48% of its loans are from the West, with 30% of its outstanding foreign debts owed to European and US-based financial institutions. Therefore, such manoeuvres while perhaps beneficial to its security interests are conflicting with its economic ones. These developments are perhaps indicative of Turkey’s strategic repositioning away from the West’s sphere of influence interests and liabilities; happy to juggle and accommodate those of its own with other regional neighbours.

Looking ahead

Looking ahead to 2017, Turkey finds itself at the crossroads on how to best balance its short and long-term security, political and economic futures, having to weigh their often-incompatible considerations. This delicate balancing game by Erdoğan increases risks on multiple fronts for the already fragile Turkish state, dangerously close to the cliffs of a recession, with many apprehensive of Turkey as a destination for capital.

Without much needed reform to its economy, in addition to a  fresh outlook considerate of its various risks, backed by a delicate — and perhaps more candid — outlook towards its domestic and regional troubles; Turkey is likely to continue to suffer in 2017. Its transforming geopolitical allegiances within the region — away from the West — seemingly indicative that the prospects for such changes may not be on the horizon for the country.

Turkey will seek to implement necessary reform to its finance and banking sectors in 2017 to weather increasingly unfavourable global economic conditions to emerging markets. The country’s need to keep interest rates down to attract foreign capital, will come into conflict with the realities of rising domestic inflation and its depreciating currency. Erdogan’s populist strategy of using low interest rates to promote growth will only intensify this conflict.

While GDP is forecasted to average around 3.8% between 2016 and 2020, it is just 0.3% above the rate required to service its foreign currency liabilities. Many observers will be looking at the upcoming constitutional amendment vote as well the government’s tumultuous relationship with the Central Bank. Little imagination is required when hypothesizing dire forecasts in the wake of any further economic or political crises — particularly when the AKP’s success rests on continuous economic success.

About Author

Robert Veldhuizen

Robert Veldhuizen is a security risk analyst at Thomson Reuters and holds a BSc (Hons) Geography, Politics and International Relations degree from the University of London, Royal Holloway. He has substantive research interests in the diverse manifestations of political risk whether it regards security and foreign policy, investment, due diligence, or market entry; covering areas such as the Asia-Pacific and the Middle East and North Africa, where he has also both lived and traveled extensively.