On August 21, 2020 one of the three major international credit rating agencies, Fitch Ratings, revised its outlook on Turkey’s long-term issuer default rating (IDR) from stable to negative, affirming it at ‘BB-’, three notches below investment grade. As justified by observed drivers in the Turkish economy, the main afflicted chapters were seen in the country’s “depletion of foreign exchange reserves, weak monetary policy credibility, negative real interest rates, and sizeable current account deficit partly fueled by a strong credit stimulus”.
Aside from the bare economic reasoning behind the decision, political and managerial inadequacies in monetary and fiscal policy had also been noted as constraints on the Turkish economy, with particular reference to political pressures on independent institutions, the limited independence of the Central Bank of the Republic of Turkey (CBRT), slow response times to changes in the market, political intervention in the floating foreign exchange (FX) regime, and social and geopolitical risks. Of the wide range of weakly performing economic indicators, the four most alarming were the sharp decrease in Turkey’s swap-excluded FX reserves, its strong credit stimulus without checks on inflation balances, its sweeping current account deficit, and the ongoing deterioration of its floating FX regime (due to political interventions).
Inflation Theory à la Erdogan
In line with Erdogan’s unorthodox economic claim that lower interest rates bring about lower inflation, the CBRT has consistently lowered interest rates, from 19.75% in July 2019 to 8.25% in July 2020. At the same time, Turkey’s inflation-excluded real interest rates dropped from 8.5% in July 2019 to -3.5% in July 2020. This sharp decrease in interest rates catalyzed not only rising inflation but also an increase in Turkey’s long-term liabilities.
The government’s insistence on maintaining low interest rates had already begun to ignite an explosion of loan growth even before coronavirus hit the global economy. However, COVID-19 related expansionary measures have opened a new chapter in Turkish banks’ credit expansion journey. State banks in particular have been used as a channel of relief measures, whereby consumer and business support credits are poured into market accounts for almost half of the loans granted in the first half of 2020. Turkish private banks, however, hesitated to inject cheap credit into the market because of the associated risks. Here, in contrast to state banks, private banks’ total credit volume actually decreased in the first quarter of 2020. Nonetheless, the Banking Regulation and Supervision Agency of Turkey (BRSA) has now forced all banks to adopt a 100% Active Ratio (AR)* in their asset turnover mechanisms. This imposed regulation and strong credit stimulus have indirectly facilitated a decrease in the banking sector’s profitability, directly increased the risk of non-performing loans, increased inflation, and pushed forward the fall of the Turkish lira (TRY) against foreign currencies. The main rationale behind this regulation has been to force private banks to inject as much credit as possible into the market in proportion to the assets they hold.
Intervention in Financial Markets and Collapsing FX Reserves
Although Turkey’s Finance Minister Berat Albayrak claimed that “if you are not paid by in dollars and if you don’t have any debt in dollars, don’t mind the increase in the dollar,” the AKP government has tried desperately to halt the devaluation of the TRY against the dollar and euro. This endeavor is heavily informed by the underlying structure of the Turkish economy and the ruling party’s desire to manage public opinion on its handling of the economy.
Turkey’s external debt stock hit a record high at 467 billion USD (57% of Turkey’s GDP) in 2018. This increase in short-term external debt stock, together with a rise in US-Turkey political tensions, triggered a currency crisis. Despite a partial restructuring of short-term debt and decreasing gross debt stock over two years, Turkey’s external gross debt stock is still more than 430 billion USD and its public debt stock is climbing to alarming levels. Turkey’s chronic current account deficit, its private and public sectors’ external debt stock, and its ever-increasing credit default swaps negate Mr. Albayrak’s claim that the value of the dollar is meaningless.
The other motivation to prevent a further decrease in the value of the TRY is related to the Turkish people’s perceptions of the government’s handling of the economy. Despite alarming debt levels especially at the corporate level, skyrocketing unemployment, and an inflation rate of 11.7% in July 2020, Turkish public opinion on the trends of the Turkish economy are mostly shaped by the TRY’s value against FX currencies. This is why following the currency and foreign debt crisis of August 2018, the ruling government employed all monetary and fiscal tools to create an illusion that would distract from the true state of the economy. This was done by maintaining the value of the TRY albeit at the expense of other economic elements. The Turkish government used state banks to sell very limited FX reserves in over-the-counter markets to be able to maintain the USD/TRY rate at the 5.5-6 level.
According to the Central Bank Monetary Policy Committee, Turkey’s gross FX reserves fell to 88 Billion USD from 106 billion USD since the beginning of 2020 despite an additional 40 billion FX swap at the same time. Paralleled by a decreasing trend in swap-excluded gross reserves, swap-excluded net reserves also decreased from 30 billion USD to -30 billion USD. According to international fund managers and risk analysts, the TRY is currently still overvalued because of the unorthodox interventions of the government in the FX market by limiting offshore swap channels and the collapse in CBRT’s FX reserves. Turkish authorities are now caught between the options of boosting the economy with low interest rates or keeping inflation and debt at acceptable levels by letting the economy freeze and halting the TRY’s free fall against foreign currencies.
Since coming to power, the AKP has been most successful at curbing inflation, which fell from an average of 66% between 1985 and 2002 to 11% between 2003 and 2020. Other economic indicators have seen only slight improvement under the AKP, including a decrease in unemployment, a more balanced current account deficit, and increases in GDP, GDP per capita, and overall economic growth rates. Nonetheless, the current deterioration of the Turkish economy has brought chronic issues of inflation and a plummeting Turkish lira back to the table.
Active Ratio (AR)* = (Credits + (Marketable Securities x 0,75) + (CBRT Swap x 0,5)) / (TRY Deposit + (FX Deposit x 1,75**))
CDS*: Credit Default Swaps (CDS), which measure the cost of insuring exposure to any country’s sovereign debt
PMI*: Purchasing Managers’ Index (PMI) is an indicator of economic health for manufacturing and service sectors
