Turkey’s banks muddled through the currency crisis two years ago, but they are now in a weaker position to confront the economic and financial market fallout from the coronavirus outbreak. At the very least, the recent sharp tightening of external financing conditions means that banks’ balance sheets are likely to shrink and a credit crunch will ensure. In a worst-case scenario, there could be a wave of bank defaults.
- Turkey’s banks muddled through the currency crisis two years ago, but they are now in a weaker position to confront the economic and financial market fallout from the coronavirus outbreak. At the very least, the recent sharp tightening of external financing conditions means that banks’ balance sheets are likely to shrink and a credit crunch will ensure. In a worst-case scenario, there could be a wave of bank defaults.
- The Turkish government has stepped up efforts to try to get on top of the country’s coronavirus outbreak in the past week or so but, with case numbers continuing to rise sharply, President Erdogan is under growing pressure to impose a full lockdown. Efforts to contain the virus, both in Turkey and globally, will cause severe damage to economic activity and we expect Turkey’s economy to contract by 2.0% this year.
- Turkey’s banks are particularly vulnerable to the economic and financial market fallout. After all, as we warned in a Focus last year, many of the vulnerabilities in Turkey’s banking sector have worsened since the 2018 currency crisis. There are a couple of key channels through which the banks will suffer.
- One is via a rise in non-performing loans (NPLs). As large swathes of the economy are effectively shut down and the global downturn hits export-oriented sectors, firms are likely to struggle to repay loans and household incomes will suffer as unemployment rises. This is likely to cause a deterioration in banks’ asset portfolios. Meanwhile, the fall in the lira – it is down by 10% against the dollar this year – will raise the local currency cost of servicing foreign currency debts. FX lending accounts for close to 40% of total credit.
- The government has stepped in to alleviate some of the pressures on firms, including granting a three-month moratorium on loan repayments, that will go some ways to limiting the rise in bad loans. And given that FX lending is subject to stringent criteria, we doubt that a weaker lira will be the direct catalyst of a sharp pick-up in NPLs – indeed, despite the falls in the currency in recent years, the proportion of FX loans that are considered to be non-performing is still relatively low at around 1%. (See Chart 1.)
- In any case, Turkey’s banks are well-positioned to cope with a fresh rise in non-performing loans. Capital ratios have risen over the past couple of years and we estimate that the NPL ratio would have to jump from 5.4% at present to 18% before tier 1 capital slipped below regulatory minimums. (See Chart 2.) Even then, with government debt still relatively low, policymakers have plenty to scope to step in to recapitalise banks.
- Arguably, though, the biggest threat stemming from the coronavirus outbreak is the greater risk of a wave of bank defaults. We highlighted Turkey’s large short-term external debts in a recent Update and around half of this, $80.9bn (10.6% of GDP), lies in the banking sector. (See Chart 3.) These debts leave banks vulnerable to a tightening of external financing conditions.
- Data from the banking regulator suggest that banks are not facing severe external funding strains just yet. But banks’ borrowing costs have spiked and are now close to their peak in 2018. (See Chart 4.) Back then, banks found these rates prohibitively expensive and rollover rates – that is the proportion of debts falling due that are replaced with new financing – fell sharply. (See Chart 5.) In order to repay debts, banks drew down their FX assets held at the central bank (CBRT) under the “reserve option mechanism”. (See Chart 6.)
- However, things are different this time. Worryingly, banks haven’t rebuilt their FX assets at the CBRT and these don’t even cover half of external debts due over the next year. What’s more, banks face a hefty repayment schedule in the next couple of months, with around $6bn of principal bond and loan repayments due in April and May. (See Chart 7.) There is a second wave of repayments in October and November.
- Admittedly, banks have other foreign currency assets available – banks’ total FX assets are fairly large at around $333bn. But these mostly consist of relatively illiquid FX-denominated loans. And while banks could sell lira-denominated assets in order to meet repayments, this would put further downward pressure on the currency and assets would probably have to be sold at depressed prices.
- All told, if external financing conditions remain tight over the coming weeks and months, banks will find it difficult to rollover their external debts and they are in a much weaker position to service these debts than they were two years ago. What’s more, the CBRT’s low foreign exchange reserves mean that it is not in a strong position to step in. (See Chart 8.) The chances of a wave of bank defaults in Turkey are growing. Even if this is avoided, banks’ balance sheets are likely to shrink and a severe credit crunch will follow.
Chart 1: Non-performing Loans (% of Total Loans)
Chart 2: Non-performing Loans & Tier 1 Capital
Chart 3: Banks’ Short-term External Debt
Chart 4: 5-year Dollar Denominated Bond Spreads
Chart 5: Banks’ External Debt Rollover Rate (%, 6m avg.)
Chart 6: Banks’ Short-term External Debt & FX Required Reserves at CBRT
Chart 7: Banks’ Principal Foreign Currency Debt Repayments ($bn)
Chart 8: Foreign Exchange Reserves ($bn)
Sources: CEIC, Refinitiv, Capital Economics
Jason Tuvey, Senior Emerging Markets Economist, firstname.lastname@example.org