Complex Made Simple

Macroeconomic storm clouds and geopolitics will weaken the Turkish lira!

The prospects for the Turkish economy and banking system appear grim given the ongoing economic and geopolitical turbulence.

Turkey’s current account deficit is the largest in Western Europe Turkey has decided to continue drilling for gas in the eastern Mediterranean in defiance of EU sanctions Turkish relations with the US, Germany, the EU, Egypt, Saudi Arabia and the Gulf states have plummeted to new lows

Turkish President Erdogan is vowing to deploy the Russian S-400 anti-aircraft missile system in defiance of US and NATO warnings. This is a milestone event in Turkish relations with Washington, Berlin and Brussels, the three world capitals most critical to the prospects of the Turkish economy and the lira. After all, 50% of Turkish exports are headed to Western Europe and German GDP growth has tanked a mere 0.5% in 2019. Moreover, Turkey’s current account deficit, the largest in Western Europe, is financed by offshore hot money flows from Wall Street, the City of London, Frankfurt and institutional investors in continental Europe. So any diplomatic rift in Turkish-NATO relations can have a traumatic impact on Turkish economic growth, access to potential private bank lending, potential IMF bailout funds and the lira’s exchange rate against the US dollar.

The prospects for the Turkish economy and banking system appear grim. The US Congress, Pentagon and the State Department are pressing the Trump White House to punish Ankara with economic sanctions since the deployment of the Russian S-400 air defense batteries compromises NATO’s military network against the Kremlin. Washington has banned the sale of the F-35 Stealth fighter to Turkey but not yet imposed sanctions.

President Erdogan’s decision to sack central bank governor Murat Çetinkaya at a time when the inflation rate is 16% and the lira has lost one third of its value against the US dollar, was a historic blunder. Turkey has lost the confidence of global investors at a time when its economy is on the precipice of recession and its financial markets in meltdown mode. The EU has sanctioned Turkey for drilling for offshore gas in the maritime borders of Cyprus, an island state it invaded in 1974 and divided with the establishment of a puppet northern enclave government not recognized by the UN or any other sovereign state in the world.

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Turkey has decided to continue drilling for gas in the eastern Mediterranean in defiance of EU sanctions. These sanctions mean the European Investment Bank will not be able to approve new loans to Turkey at a time when external debt repayments in the next two years exceed $177 billion. The geopolitics of offshore gas drilling in the eastern Mediterranean also pits President Erdogan against his critics in Greece, Egypt and Israel. The killing of a Turkish diplomat in Iraqi Kurdistan last week and the Russian-Syrian Baathist siege of Idlib means new security threats and refugee flows that will have a negative economic fallout.

President Erdogan has made a mockery of central bank independence by accusing one former governor of “treason” and arbitrarily sacking his successor after they dared to raise interest rates, which he calls “the mother and father of all evil”. Erdogan argues that high interest rates are the cause of high inflation, a bizarre inversion of economic orthodoxy. President Erdogan’s credibility in international financial markets was not helped by his appointment of his son in law as Finance Minister, a tradition that dates back to the Damad Pashas appointed as grand vizier after they married the daughter of the Ottoman sultan.

Murat Uysal, the new Turkish central bank governor, has wasted no time in carrying out President Erdogan’s order to cut interest rates. Governor Uysal, in office since July 6, said “there is room for maneuver in monetary policy”, central bank terms for an imminent interest rate cut. Ironically, Murat Ulysal has a point since the policy rate is 24% while June inflation fell to 15.7%. Turkish lira denominated government bonds now offer a 8% real rate of return to foreign investors.

Yet the prospect of US sanctions over the Russian S-400 deployment, EU sanctions over the Cyprus offshore gas drilling dispute and the sacking of an incumbent central bank governor has unnerved global investor confidence in Turkish assets. It did not help that President Erdogan’s handpicked candidate, ex AKP Prime Minister Binali Yildirim, lost the Istanbul mayoral election (and a $4 billion patronage budget) to the secular Kemalist opposition by 800,000 votes. Gridlock between Ankara and Istanbul is, of course, lira negative.

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The central bank is also suspected of using currency swaps with state owned Turkish banks to camouflage a fall in its foreign exchange reserves. Global credit rating agency Fitch downgraded Turkey’s sovereign credit rating, citing the Presidential sacking of Governor Çetinkaya. Turkish debt is deep sovereign junk at BB- with a negative outlook. Standard and Poor’s rates Turkish government debt at B+ and Moodys is at B-, four levels below investment grade. If President Erdogan pressures Governor Uysal into premature, aggressive rate cuts, expect another plunge in the Turkish lira to 6.4 against the US dollar by year end 2019. An escalation of tensions in the Gulf after Iran’s seizure of a British flagged oil tanker will trigger Turkish lira selling against the Norwegian kroner, a traditional FX hedge against Middle East tensions.

Turkey, a member of NATO, is now allied to Putin’s Russia, a critical adversary of the West. The procurement of the S-400 air defense system, which can shoot down the same F-16’s insurgent Turkish Air Force pilots used to bomb the Presidential palace in Ankara in the July 2016 abortive coup, means President Erdogan has crossed a geopolitical Rubicon in his embrace of fellow, anti-West autocrat in the Kremlin.

Turkish relations with the US, Germany, the EU, Egypt, Saudi Arabia and the Gulf states (ex Qatar) have plummeted to new lows. This is ironic – as Tsarist and Soviet Russia was once the historic foe of the Turkish state for centuries. Hostility to the West now unites the autocratic Presidents Erdogan and Putin, even though they backed opposing sides in the Syrian civil war. Geopolitics amplifies the macro storm clouds that now threaten the Turkish lira, trading at 5.65 as I write.

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