Turkey's perilous game with markets may now have reached a breaking point

Investors in Turkey are no strangers to volatility that for years has plagued one of the Middle East’s largest economies. But not everyone may stick around this time.

The lira tumbled to a record low on Friday even though the central bank has spent billions over the past year propping it up. Earlier this week, the cost of borrowing money offshore jumped beyond 1,000%, the latest sign of dysfunction in Turkey’s money markets.

Authorities have resisted raising interest rates despite pressure on the currency to weaken further, prompting an outflow of foreign capital and leaving the economy vulnerable as its currency buckles.

The background

A credit binge lies at the heart of the turbulence. Even before the coronavirus pandemic hit Turkey, the central bank was deep into a front-loaded easing cycle, emboldened by President Recep Tayyip Erdogan’s growth-at-all-costs approach to the economy.

To soften the blow of the coronavirus pandemic, authorities then doubled down by engineering a campaign to get credit flowing through the economy. According to the central bank’s preferred metric, loan growth was an annual 40% over the past 13 weeks, and peaked at 50% in May, the fastest rate since at least 2008.

The explosion of credit has pushed the country’s current-account balance back into a deficit and risks fueling a fresh bout of inflation that has debased the lira over the years.

Why not raise rates?

For starters, there’s Erdogan’s unorthodox view that higher interest rates fuel price gains. Last year, he fired a central bank governor for not cutting borrowing costs.

There’s also the more pragmatic goal of job creation. Erdogan suffered his most stinging defeat in elections last year, when his party lost control of major municipalities, including the capital Ankara and commercial hub Istanbul.

With official unemployment near the highest level in more than a decade, the economic blow from the coronavirus pandemic could test the ruling AK Party’s popularity. The economy is set to shrink 4% in 2020, according to the median estimate of analysts surveyed by Bloomberg.

But isn’t keeping the lira in check just as important?

It is. In fact, it’s the most closely watched economic indicator in a country where more than $200 billion of household wealth and company savings are held in foreign currency.

It’s also an existential issue for many of the country’s companies, who sit on $289 billion of foreign-currency debt, equivalent to more than a third of economic of output. The economy as a whole has $169.5 billion of external debt to roll over the next 12 months.

So what’s the plan?

The authorities appear to have adopted a two-pronged approach aimed at getting the best of both worlds: low rates to boost growth and a stable lira.

They’ve tried to meet the heightened demand for foreign currency by spending the central bank’s reserves. As a result, its gross currency buffers have dropped by more than a third this year to $49.2 billion as of July 17. Including gold, they stand at $89.5 billion.

Meanwhile, they’ve restricted the flow of capital to stifle foreign investors’ ability to bet against the lira. Local banks were banned from lending more than 0.5% of their equity to counterparties offshore, essentially curbing the market’s ability to freely set the exchange rate.

How long can this go on for?

According to some analysts, there’s limited room for manoeuvre. Goldman Sachs Group Inc. estimates the central bank has spent $65 billion propping up the lira this year, which puts the difference between its foreign-currency assets and liabilities at a negative $41.3 billion as of the end of June.

That’s partly because it’s also borrowing dollars from local lenders to boost its coffers, essentially recycling dollars and euros that savers in Turkey have deposited with local lenders.

The tighter liquidity measures have stood in the way of a disorderly depreciation. But that’s come at a significant cost. While they’re in place, foreign investors will hesitate to bring money back into the country, because the cost of hedging or financing their positions can become prohibitively expensive and unpredictable.

On Tuesday, the cost of borrowing liras overnight spiked to over 1,000% as liquidity evaporated, leaving many investors no other option but to dump Turkish assets. The squeeze was so severe that several global banks failed to meet their lira obligations.

What happens next?

Some say the central bank will cave in and raise rates aggressively, as it ended up doing in 2018. But those hoping for such a move amid Thursday’s slide were disappointed. Instead, the regulator said it would roll back liquidity steps taken to support the economy during the global pandemic. The lira extended its retreat.

Still, there are signs officials may change their stance. State lenders were largely absent from the currency market on Thursday and appeared to be letting the lira float freely. Authorities also eased some of the currency-trading restrictions on foreigners and are reining in policies that fueled a credit binge.

There’s also the last-ditch option of resorting to some form of financial assistance from the International Monetary Fund, though Erdogan has ruled that out repeatedly.

Could a crisis affect other emerging markets?

Turkey is no longer an emerging-market darling. Trading volumes have dropped considerably and foreign investors are lightly positioned. The share of foreign ownership in the local-currency debt has dropped to record low of 4.2%, while Turkey’s weight in the benchmark MSCI equity index has almost halved in two years to just 0.4%.

Still, in dollar and other hard-currency debt indexes in emerging markets, only seven nations have bigger weightings than Turkey, and forced selling by passive funds could trigger a broader selloff. That would unnerve traders and could deter investment in other markets.