Revisiting Turkey’s external vulnerabilities - Capital Economics
Emerging Europe Economics

Revisiting Turkey’s external vulnerabilities

Emerging Europe Economics Update
Written by Jason Tuvey

The Turkish lira has held up relatively well amid the coronavirus-related sell-off in EM currencies, but the country’s large external debts leave it vulnerable if external financing conditions continue to tighten. A sharper sell-off in the currency would limit the scope for further interest rate cuts.

  • The Turkish lira has held up relatively well amid the coronavirus-related sell-off in EM currencies, but the country’s large external debts leave it vulnerable if external financing conditions continue to tighten. A sharper sell-off in the currency would limit the scope for further interest rate cuts.
  • As the coronavirus outbreak has started to spread in Turkey, the authorities have stepped up containment measures in recent days – yesterday, President Erdogan advised people to stay at home for at least three weeks. This will lead to severe disruptions to economic activity and comes at the same time that a downturn in the global economy will hit export-oriented sectors and travel restrictions will lead to a slump in the tourism industry. The overall result is that the Turkish economy looks set to contract sharply in Q2.
  • One of the major indirect effects on Turkey’s economy is likely to come via the tightening external financing conditions. The spreads of dollar-denominated bonds of the Turkish government, corporates and banks over US Treasuries have widened sharply over the past couple of weeks. Those of the government and corporates are now above their peak during the 2018 currency crisis. (See Chart 1.)
  • In the past, investors’ concerns have focussed on Turkey’s large current account deficit. But the current account has improved markedly since the 2018 currency crisis and the country posted a current account surplus last year, equal to 1.1% of GDP, for the first time since 2001. One consequence is that the lira no longer appears to be fundamentally misaligned.
  • Nonetheless, Turkey’s large external debts mean that it is still extremely vulnerable to bouts of investor risk aversion. Around $172bn of external debt (equal to 23% of GDP) needs to be serviced over the next year. This is split evenly between banks and corporates. If borrowing costs become prohibitively expensive, corporates and banks may find it difficult to rollover these debts. Banks are in a much weaker position to withstand this than in 2018 and at the very least would be forced to tighten credit conditions. (See here.)
  • Worryingly, foreign exchange reserve coverage is low meaning that there would be little scope for the authorities to intervene. Indeed, the ratio of short-term external debt to the central bank’s gross foreign exchange reserves is larger in Turkey than in any other major EM. (See Chart 2.) And that’s based on the most favourable measure of reserves. Once the CBRT’s large FX liabilities are stripped out, net foreign exchange reserves are much lower, at just $36bn.
  • The lira has, so far, held up surprisingly well since fears over the spread of the coronavirus intensified – it is down by around 4% against the dollar since the start of this month, which compares favourably with many other EM currencies. This allowed the central bank to respond to the mounting downside risks to the economy by cutting interest rates by 100bp earlier this week. But if external financing conditions continue to tighten, pressure on the currency is likely to mount and this would limit the scope for further easing.

Chart 1: Turkey 5-year Dollar Denominated Bond Spreads over US Treasuries (bp)

Chart 2: Short-term External Debt (% of FX Reserves)

Sources: Refinitiv, Capital Economics

Sources: Refinitiv, Capital Economics



Jason Tuvey, Senior Emerging Markets Economist, jason.tuvey@capitaleconomics.com

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