Turkey’s lumbering lira

Turkey’s eight per cent inflation rate is at least 300 basis points above its central bank’s target. But the same central bank has been publicly berated and pressured by President Erdogan for not lowering interest rates, an act of political interference that erodes the legitimacy and independence of governor Erdem Basçi.

Despite the 50 per cent fall in Brent crude, Turkey’s current account deficit is six per cent, financed by borrowing short-term capital from abroad that makes the country vulnerable to offshore hot money capital flows.

The Gezi Park protests in Istanbul destroyed the ruling AKP’s record of political invincibility even though Erdogan won three general elections in 2002, 2007 and 2011. Turkey’s economic growth rate has plummeted from seven per cent in the first decade of AKP rule to a mediocre three per cent now. Turkey’s savings rate is a mere 14 per cent of GDP, and its banking system is saddled with a $300 billion consumer debt time bomb.

I had flagged the Turkish lira as a strategic short when skews in London foreign exchange option markets suggested that the smart money was bailing out of the lira. So it has not surprised me that the Turkish lira sank to record lows below 2.60 against the US dollar, down 12 per cent in 2015 alone.

The Asye Bank takeover and Citicorp’s decision to sell its strategic stake in Akbank, with a $800 million loss, both illustrate the deep fault lines in Turkish finance. The Turkish lira’s depreciation will accelerate once the Yellen Fed tightens US monetary policy this autumn. This makes a Turkish lira rate near 2.80 all too possible.

The Turkish lira’s free fall has created the risks of an “Asian flu” style financial crisis two months before June parliamentary elections. Turkish corporates have gone on a borrowing binge in the Euro markets and are burdened with $90 billion in maturing debt in 2015 to 16 alone.

This means that the risk of a major corporate default is now almost certain this summer or autumn. Turkish capex, consumer confidence and industrial output could lead to economic contraction by late 2015.

Turkish construction firm profits have been gutted by the geopolitical shocks of the Arab Spring, notably in Libya, Egypt and Iraqi Kurdistan. Gulf investors have lost billions of dollars in Turkish debt, property and equities since 2011. Moody’s has warned that Turkish bank non-performing loans will spike in 2015.

Prime Minister Ahmet Davutoglu’s four per cent growth target is simply no longer credible. A default by a Turkish bank, construction firm or industrial conglomerate could ignite the next stage of the currency crisis.

The Turkish lira’s meltdown has ended President Erdogan’s ambition to promote Istanbul as an international financial centre. The Turkish stock market is valued at only $230 billion, a fraction of the valuations commended by emerging markets such as India, South Africa, Taiwan and the Philippines. At 2.65, the Turkish lira has now collapsed even before the first Fed rate hike has begun. If the Kurdish PDD receives 10 per cent of the vote in the June parliamentary election, it could undermine the AKP’s legislative power.

The meltdown in the Turkish lira reflects the rising political, inflation and banking risk in a country once viewed by offshore fund managers as the “Anatolian tiger on the Bosphorus”. As long as Ankara’s central bank is hostage to President Erdogan’s political diktat and structural reforms do not narrow the current account deficit, Turkey will remain vulnerable to offshore funding risk and currency crises.

The Turkish central bank has now fallen below $40 billion and Turkish corporates have amassed $180 billion in US dollar debt. The Turkish lira’s fate could well be similar to the Mexican peso in 1994, the Thai baht in 1997 and the Indonesian rupiah in 1998.

When politicians promote irrational economic policies, a currency meltdown is inevitable. Erdogan’s Turkey has learnt this lesson the hard way.