- Previous EM currency sell-offs of similar magnitudes often yielded high currency returns in subsequent years.
- Based on valuations, historical data from previous sell-off episodes and the economic rebalancing that is taking place; current exchange rate levels suggest attractive return expectations for long-term TRY (Turkish lira) currency investments.
- Elevated rates of inflation and the external debt profile are significant downside risks to this outlook. We list three tail-risk scenarios that could cause a shift from our baseline, and assess their likelihood and impact.
In this follow-up post of the Turkey’s Currency Crisis Series, see the previous post, we evaluate the outlook for the TRY.
We start with two significant downside risks: the inflation outlook and the external debt profile.
- The outlook for inflation, we believe, is the most significant downside risk concerning Turkish assets and the TRY in particular. Headline inflation at 24.5% – almost five times the inflation target of 5% – is unprecedented, even in the EM universe. Following the recent Central Bank decision, the policy rate is now around 1300 basis points higher compared to six months ago. This is likely to repress the impact of demand-pull forces in the inflationary outlook. However, bearing in mind the lagged impact of the currency depreciation on input prices, the headline figure is likely to peak in the coming months. This presents the risk of a shift in long-term inflation expectations, and therefore a potential headwind to expected returns in Turkish assets.
- Turkey’s external debt profile raised eyebrows following the currency crisis, in the fear that the repayment of this debt – which is heavily denominated in EUR and USD – could be under threat (Figure 5).
Our analysis shows that there has not been a significant increase in the stock of short-term external debt in recent years. The short-term to long-term debt ratio for both the financial and the private sector remain at what could be seen as historically normal levels (Figure 6 and Figure 7). Even though the reserves to short-term external debt ratio is still low in Turkey compared to the EM universe, we do not see systemic risks to the Turkish financial system as our base case scenario (see catastrophic scenario 3, below).
With this in mind, current levels could present an attractive long-term investment opportunity in the TRY, with above average expected returns.
First, our Balassa-adjusted PPP1 model shows that the TRY is relatively cheap compared to the overall EM universe and especially compared to its high-yielding peers like the Russian rouble or the South African rand (Figure 8).
Second, positive FX-implied real interest rates of around 6% vs the US dollar boosts the expected return, offering a strong carry opportunity.
Finally, previous EM sell-offs of similar magnitudes2 often yielded high currency returns in subsequent years based on two factors in play: attractive valuations and sharp rises in real interest rates, as EM central banks tend to follow a more hawkish policy stance in the aftermath of a crisis. Statistical evidence based on previous sell-off episodes signals that the FX spot rate does not necessarily recover back to pre sell-off levels, however carry does most of the work in delivering returns (Figure 9).
Having said that, we list three tail-risk scenarios for Turkey and the TRY that require monitoring and would cause a shift in the baseline scenario:
1-) Sovereign default:
Public debt-to-GDP is stable at around 30% since the late 2000s. The government budget deficit was at 1.5% of GDP in 2017. We believe that Turkey’s public debt profile is healthy and would not necessitate a default given that the government is able to generate enough revenues to meet its obligations, and considering the long-term negative implications of defaulting on its debt.
2-) Capital controls:
Capital controls would be a mechanical solution to the currency depreciation. However, for an economy with a structural Current Account deficit and therefore a financing need; executing capital controls could come with a painful correction for the domestic economy. Moreover, as Turkey is part of the EU Customs Union, trade makes up an important portion of its economy. This is advantageous from two angles given the recent political atmosphere. First, Turkey has access to one of the richest trade blocs with no barriers, which helps to speed up the rebalancing process in the economy (EU countries are the destination for 50% of Turkish exports). Second, the impact of the ongoing spat with the US on the economy is limited, as the majority of trade and capital flow relations are with EU countries. Therefore the domestic economy is less vulnerable to relations with the US, unless the US administration begins to show a strong willingness to cut Turkey from the international financial system. For now, this is not a major scenario in our view.
3-) Banking sector crisis:
The currency crisis becomes a threat to the banking sector. Defaults in the corporate sector and rising NPLs as a result of currency mismatches are likely to stretch the banks’ balance sheets. However, big private banks have foreign parents and access to about 35 bn USD of deposits held at the central bank as FX reserves – slightly below their short-term external debt – which could be injected into the system by regulatory changes in the Reserve Options Mechanism3. Moreover, public debt has declined from 75% of GDP to below 30% over the last 15 years. This provides room for the government to weather the storm by introducing additional measures, such as establishing a bad bank structure if/when needed. In addition, the major chunk of FX liabilities comes from locals’ deposits which make the solvency of the banking system less vulnerable to external shocks. Therefore, while the debt rollover performance of the banks will be important to watch in the next couple of months, our baseline scenario is that the Turkish banking system is likely to obtain market access, albeit at higher costs reflecting tighter global liquidity and a higher risk premium.
In summary; a rapidly rebalancing economy together with a highly undervalued and high-yielding currency might suggest a case for a long-term investment in the TRY, provided that the fundamentals are allowed to run their course and a catastrophic scenario is avoided. However, watching the nominal FX spot rate may be misleading in such an inflationary environment, as one would expect the currency to mechanically depreciate to over 7 per USD in a years’ time, just based on inflation differentials. Given the risks mentioned above; such a bold investment could be expected to be rewarded with a significantly high risk premium. But, bearing recent levels of volatility in mind, a TRY investment is not for the faint-hearted.
1 Balassa-adjusted PPP model takes into account the PPP measures in relative currency valuations and adjusts these by their relative productivities: As economies become more productive, increases in productivity in the tradable goods sector lead to wage increases which filter into the non-tradable sector raising prices and wages. The resulting price rises cannot be arbitraged out by the exchange rate, and this expresses itself as real exchange rate appreciation.
2 Russian rouble (2014), Hungarian forint (2011), Colombian peso (2015), Indian rupee (2013), Romanian leu (2010), Chinese renminbi (2009), Colombian peso (2007), Indian rupee (2006)
3 Reserve Options Mechanism is basically a mechanism that allows banks to keep a certain ratio of their TRY reserve requirements in FX and/or gold. The fraction of TRY required reserves that can be held in FX or gold is set by the reserve option ratio (ROR). The amount of FX or gold that can be held per unit of Turkish lira is called the reserve option coefficient (ROC). By changing the Reserve option coefficient, Central Bank can mechanically inject FX liquidity into the system.