As the crisis develops, and with neither Trump nor Erdogan willing to back down, it seems increasingly possible the capital controls may be needed to sustain the Turkish economy.
The past week in financial markets has been dominated by events surrounding Turkey, with the banking sector and the broader economy seeming to follow the currency to the brink, as Erdogan continues to eschew policy orthodoxy. The lira has fallen as much as 50% over the past year and as moves accelerated, the price of senior Turkish bank debt has tumbled towards 50 cents on the dollar and sovereign CDS spreads have moved north of 500bps. With Turkey running a current account deficit of 4% of GDP it has needed to attract capital from overseas, but foreign flows have recently been running in the opposite direction and the growing spat between Trump and Erdogan is only exacerbating this. This trend is compounded by a reluctance to raise Turkish interest rates, even as inflation rises and the currency falls, with volatility increasing and risks escalating. Consequently, we might expect overseas banks and investors to continue to pare exposure and this will likely see the Turkish sovereign needing to be the banking sector’s lender of last resort as the economy veers into recession, thus exposing the sovereign balance sheet. With ministers declaring that they would never be knocking on the door of the IMF again, it seems increasingly possible the capital controls may be needed to sustain Turkey at this point and indeed steps taken in recent days, effectively terminating the forward foreign exchange market, can be seen as a move in this direction. Ultimately, this may imply Turkey needing to move its current account to a surplus and this will mean a massive contraction in consumption, a sharp economic downturn and a rapid escalation in nonperforming loans (NPLs) across the banking sector. Despite assurances from the Turkish finance minister Albayrak during a well-attended investor call that they would not implement capital controls, Turkey did shut down the FX forward market which could raise a red flag with index providers. It seems like the country is in a tough spot and needs all the friends it can get and so the approach or Erdogan accusing others and imposing sanctions on the US are unlikely to prove very productive.
Elsewhere, contagion risks from Turkey have impacted other emerging markets with most high yielders and consensus long positions coming under material pressure in recent days. Volatility has been elevated and those countries with large current account deficits and substantial short-term funding needs appear the most exposed in our view. Thin liquidity has also impacted price action during August and fund redemptions and liquidations ‒ including those in the GAM Absolute Return Bond range. By contrast, moves across developed markets have been much more muted. Treasury and Bund yields have rallied slightly and credit spreads have pushed somewhat wider. However, with the US S&P remaining robust and strong demand for new US corporate issues (including a $50bn book for a jumbo issue from United Technologies this week), moves have been relatively contained and markets relatively quiet. We would note that Turkey is a relatively large economy with $450 billion in total debt, but the bulk of this is in domestic hands and even under an adverse scenario for the Turkish economy it is not clear that this will have a significant impact to the broader global economic trajectory. Although European banks have been something of a worry, Turkish exposures are via ring-fenced locally capitalised subsidiaries and unless European banks choose to extend further capital, then their exposures are mostly contained.
Spreads in the European periphery were one part of the market where spreads have moved more materially wider in recent days. The tragedy of the motorway bridge collapse in Genoa led to calls for increased infrastructure spending from Lega’s Salvini in an acrimonious atmosphere. Italy continues to be subject to pressure related to upcoming budget worries, yet in a week when finance minister Tria, prime minister Conte and 5 Star party head Di Maio have all asserted that increased spending would not violate the 3% fiscal deficit cap and seek to ensure debt/GDP remains on a declining trend, we feel that there may be too much pessimism in Italian government bond (BTPs). Specifically, we see Italian credit spreads pricing implied Italexit risks more that debt sustainability and default risks per se and we this risk of currency break-up as exaggerated. Meanwhile, in a week devoid of much good news, Greece saw a two-notch credit rating upgrade from Fitch underscoring the positive direction of travel concerning Greek credit quality.
Looking forward, we would note that Turkey will have public holidays next week and so markets will be closed, and this will put the spotlight on other markets. It will be interesting to see if Erdogan will back down and release US pastor Brunson from house arrest. However, comments in recent days, imposing sanctions and boycotting iPhones point to an escalation of tensions rather than a compromise. Meanwhile, it is hard to see why Trump would want to back down. If anything his ability to bring Turkey to its knees may only serve to embolden the Tweeter in Chief. It strikes us that the US Capitol is in Control and with Turkey refusing to knock on the IMF’s door; it is hard to extrapolate an easy or happy ending any time soon.
By Mark Dowding, BlueBay AM