Over the past few months, Turkey has become a major topic of interest. Recep Erdogan won re-election to the presidency in June 2018. This event was important because a referendum on a new constitution in 2017 gave the office of the president sweeping powers; the previous constitution was based on a parliamentary model which gave more power to the prime minister. According to the referendum, Erdogan could only exercise these new presidential powers after winning a new election.
Even before the election, there were signs the economy was overheating. Inflation was increasing and the central bank was not raising rates in a manner consistent with quelling the inflationary pressure. Since the election, an economic crisis has developed, with falling financial asset prices and a sharp decline in the Turkish lira (TRY). In addition, Erdogan has found himself in a contest of wills with President Trump over Americans detained in Turkey. This has led to punitive trade tariffs and threats of additional sanctions.
The goal of this report is to place the current crisis within the context of Turkey’s evolution and development. Part I will examine Turkey’s geopolitics and history. Part II will discuss economic factors, including the impact of foreign debt on Turkey’s economy and financial system. We will highlight the impact of the 2016 coup and analyze the causes of the current crisis in Turkey. From there, we will offer a discussion on the debt problem and Turkey’s options for resolving the crisis. As always, we will conclude with market ramifications.
[Posted: 9:30 AM EDT] It’s Monday…back to the salt mines! It’s a “green” day so far this morning—equities are higher, but so are longer duration Treasury prices and beleaguered metals are even bouncing a bit higher. The dollar is a bit lower. Here is what we are watching today:
Turkey update: The TRY is lower this morning despite news that the country has set up a currency swap line with Qatar.[1] Turkey’s financial markets will be closed this week for holiday. There doesn’t appear to be much evidence of a thaw between Ankara and Washington. According to reports, Turkey has offered to release Pastor Brunson in return for the U.S. dropping the investigation into state-owned Halkbank, which has been fined for violating sanctions with Iran.[2] The Trump administration’s position is becoming clear—the U.S. doesn’t intend to give Turkey anything for releasing Brunson.[3] This puts Turkey and President Erdogan in a tough spot as Turkey will need U.S. help to extricate itself from a difficult economic position. The U.S. appears ready to force Turkey to back down and lose face, something that Erdogan will try desperately to avoid. This suggests to us that although the TRY is very cheap, it may take a while before Turkey becomes an attractive investment venue. At the same time, we do note that the credit rating agencies have downgraded Turkey.[4] Since they often make this type of move when all the bad news is known, paradoxically, this could be a good sign.
Oh, woe, Venezuela: The Maduro government administration is taking some steps to manage the nearly unmanageable situation of hyperinflation. Today, the country is releasing a new currency, the “sovereign bolivar,” which has lopped off five zeros (instead of the three announced earlier).[5] This is a fairly common tactic, often seen in South America. It really never works by itself. The new currency will be tied to the state-issued cryptocurrency, called the “petro,”[6] which has had a checkered history. Maduro also announced the Orinoco Basin oil reserves will be transferred to the central bank and will be included in the country’s foreign reserves.
Official reserves plus gold are approaching $7.5 bn; although, in theory, a country can add any assets to foreign reserves, the key issue is liquidity. Those oil reserves are not liquid and the fastest way to make them liquid would be to allow foreign firms to move in and develop them. That isn’t likely. In response to this news, Venezuelans spent the weekend converting their bolivars to stuff. Maduro did announce a 3,000% increase in the minimum wage but didn’t set a start date. The longer he waits (in a nation with 1,000,000% inflation,[7] waiting is deadly), the less impact it will have.[8] Another indication of how bad things have gotten is that the U.S. Navy has sent the USNS Comfort, a hospital ship, to the coast of Colombia to assist that country with the crush of refugees coming from Venezuela.[9] Finally, as we reported last week, Maduro did confirm that gasoline prices will be allowed to rise to market levels.[10] This decision is perhaps the most politically risky one he has made and indicates the degree to which conditions have deteriorated.
Trade update: One of the “known/unknowns” is what is the eventual goal of the Trump administration’s trade policy? Is the goal to scare foreign nations to the negotiating table to get better deals or is the president bent on making the U.S. an autarky? Evidence for either position is available. Comments coming from China, for example, suggest that the CPC has concluded that the U.S. goal for American/Chinese trade policy is containment.[11] At the same time, there is growing talk that the U.S. and China will reach some sort of agreement by November.[12] And, there are reports that negotiations between the U.S. and Mexico are approaching an agreement as well,[13] although it may just be a bilateral agreement as Canada hasn’t been privy to these talks. Still, if the administration’s trade rhetoric is designed to force negotiations and it is working, we would look for a pop in equities. Equity indices have been marking time since peaking earlier this year, despite robust earnings. We have seen a drop in earnings multiples, which we believe is mostly due to worries over trade. If the Trump administration is really just trying to change global trading arrangements and not trying to destroy them, such an outcome should be a huge relief for investors.
Jackson Hole:The KC FRB will hold its annual meetings near the majestic Grand Tetons in Wyoming in the town of Jackson Hole. The full roster of speakers will be announced later in the week but Chair Powell is scheduled to speak on Friday. Previous Fed chairs have used this venue to make important policy announcements. We don’t expect this from Powell, but we would expect confirmation that the current path of policy will remain in place.
Last week, the Bureau of Labor Statistics released the CPI data for July. Inflation continues to rise; the overall rate rose 2.9% and the closely watched core rate (the rate less food and energy) rose to 2.4%, the highest rate since September 2008. Rising inflation raises policy concerns. In this week’s report, we will analyze these concerns.
The rise in interest rates will support the Federal Reserve tightening stance. To determine what the fed funds target rate “should” be, we use the Mankiw Rule model. The Mankiw Rule model attempts to determine the neutral rate for fed funds, which is a rate that is neither accommodative nor stimulative. Mankiw’s model is a variation of the Taylor Rule. The latter measures the neutral rate using core CPI and the difference between GDP and potential GDP, which is an estimate of slack in the economy. Potential GDP cannot be directly observed, only estimated. To overcome this problem with potential GDP, Mankiw used the unemployment rate as a proxy for economic slack. We have created four versions of the rule, one that follows the original construction by using the unemployment rate as a measure of slack, a second using the employment/population ratio, a third using involuntary part-time workers as a percentage of the total labor force and a fourth using yearly wage growth for non-supervisory workers.
Using the unemployment rate, the neutral rate is now 4.25%, up from last month’s estimate of 4.00%, reflecting the fall in the unemployment rate and the rise in inflation. Using the employment/population ratio, the neutral rate is 2.07%, up from 1.84%. Using involuntary part-time employment, the neutral rate is 4.00%, up from the last calculation of 3.68%. Using wage growth for non-supervisory workers, the neutral rate is 2.48%, roughly unchanged from the last report of 2.41%. All the variations show a rise in the neutral rate; two of them, the traditional one with the unemployment rate and the rate using involuntary part-time employment, are 4.00% or above. The other two calculations are showing more slack in the economy, although both still suggest the FOMC needs to raise rates further. The model based on the employment/ population ratio suggests one more hike of 25 bps to reach neutrality and three more times to achieve that level for the wage growth variation.
To determine the market’s projection for policy, we use the implied three-month LIBOR rate from the two-year deferred Eurodollar futures market. In the past, it has been a reliable measure of the terminal fed funds rate.
The top line on the chart shows the spread between the implied LIBOR rate and the fed funds target. We have placed vertical lines where the spread inverts and gray bars for recessions. In the 1990s, Chair Greenspan faced two periods when the spread inverted; both times he cut rates[1] and was able to extend the expansion. He was unable to avoid recession in 2001 despite aggressive cuts to fed funds, but that recession was considered to be unusually mild. The Bernanke Fed did not lower rates when the spread inverted in 2006, leading to a period of extended policy tightness which may have increased risk to the economy.
Despite the rise in inflation, the implied three-month LIBOR rate from the two-year deferred Eurodollar futures market did not rise; in fact the most recent reading is 2.95%, suggesting the FOMC should stop raising rates when the target reaches 3.00%. That still means five rate hikes are being discounted by the financial market. Assuming two more this year, the Eurodollar futures are suggesting three hikes would be on tap for 2019.
The differences in the Mankiw Rule variations mean that the projected 3.00% rate would likely signal recession if the proper measure of slack is either the employment/population ratio or wage growth variation. On the other hand, if the true measure of slack is the unemployment rate or involuntary part-time variation, then the Fed is running the risk of either triggering an inflation problem or inflating an asset bubble. How do we know which is the best measure of slack? There really is no good way to know for sure but if forced to choose we would select the wage growth variation as probably the best gauge. Why? Because overly tight labor markets should push wages higher and the fact that wage growth remains sluggish probably means there are “pockets” of workers still being drawn into the labor force. The fact that the labor force is continuing to expand confirms this notion. The argument against the wage growth variation is the idea that the labor market has become an oligopsony, meaning that firms have market power over labor and are holding down wages despite the lack of workers. Although this is possible, we doubt this factor can hold down wages indefinitely.
If the wage growth variation is the correct measure of slack, we are still three tightening events away from neutrality. Thus, for the time being, the risk of the FOMC overtightening and triggering a recession is low. Nevertheless, the danger will rise by early next year and the risks of recession will rise appreciably by the second half of next year, assuming the Fed continues to ratchet rates higher. We continue to closely monitor this dynamic into next year.
[Posted: 9:30 AM EDT] Happy Friday! It’s a mixed market situation and somewhat less volatile than action earlier in the week. Here is what we are watching today:
End of quarterly earnings? President Trump tweeted[1] this morning that he is directing the SEC to study the costs and benefits of going to a biannual earnings reporting system. The concern is that businesses have become overly focused on short-term results and thus easing the pressure of the earnings focus might make businesses more concerned about longer term growth. To some extent, this is the argument made by private equity, whose proponents often argue that private firms can concentrate on long-term results even if their actions harm short-term earnings. Of course, the flip side is that a shareholder is the owner and deserves to know how his business is doing. We doubt this goes anywhere; moving to a biannual reporting structure won’t necessarily change the term focus because the difference between three and six months isn’t all that significant. But, this tweet will dominate the news cycle at least for this morning.
Turkey update: The TRY has slumped this morning, which is probably to be expected given the lift in the past few days. Turkey’s financial markets will be closed next week for holiday, so traders are probably squaring positions. There doesn’t appear to be much evidence of a thaw. Treasury Secretary Mnuchin signaled yesterday that the U.S. has prepared new measures against Turkey.[2] President Trump’s position has clearly hardened as he indicates he won’t “pay anything” for the release of Pastor Brunson.[3] Turkey does appear to be trying to initiate some sort of resolution; the foreign minister stated that his nation “does not wish to have problems with the U.S.”[4]
Iran sanctions: The administration is threatening to apply sanctions on all nations that buy Iranian oil after November 4, specifically including China.[5] This threat is a major escalation of tensions between the U.S. and China and probably explains the rise in oil prices this morning. In general, China has mostly ignored Iranian oil sanctions because it conducts business outside the dollar; Iran can sell to China but doesn’t receive dollars in return. To make sanctions effective, the U.S. has to penalize China as if it were buying oil in dollars. That would give the U.S. the power to deny China access to the U.S. banking system. If China were to comply (which we view as a long shot), the pressure on Iran would be significant and would likely trigger an aggressive response.[6] Most of Iran’s responses would be bullish for crude oil.
[6] To read our discussion of potential responses, see WGRs, Iran Sanctions and Potential Responses: Part I (7/30/18), Part II (8/6/18), and Part III (8/13/18).
[Posted: 9:30 AM EDT] A bit of risk-on has returned this morning. Trade hopes appear to be the key reason. The dollar is a bit weaker, while equities and commodities are higher as are Treasury yields. Here is what we are watching today:
China trade talks: China is sending the Commerce Ministry’s Vice Minister Wang Shouwen to Washington for what are being described as “low level” trade talks.[1] China announced measures to liberalize foreign participation in its finance sector in a bid to find allies among U.S. financial firms. The U.S. side will be represented by David Malpass, the undersecretary for international affairs at the Treasury. Given the low profile of these talks, we would be surprised if much comes from them, but the fact that talks are occurring at all is being taken optimistically.
The Italian bridge problem: Last week, a span in Italy collapsed; reports vary but there may be as many as 40 fatalities. This tragedy is rapidly becoming a political problem for the Five-Star Movement, the left-wing populist party in the governing coalition. According to reports, leaders in the party strongly opposed plans to refurbish and upgrade the bridge, apparently for environmental reasons.[2] The party described safety fears about the bridge as “children’s tales.”[3] In the wake of the bridge’s collapse, Five-Star leaders are scrambling to contain the damage. The League, the right-wing populist party in the coalition, is a strong supporter of infrastructure projects and will likely use the event to further marginalize its coalition partner. If the scandal broadens, it would not be a huge shock to see Berlusconi’s party try to crack the coalition which would further move the government to the right.
Turkey update: Turkey was able to secure $15 bn of direct foreign investment from Qatar.[4] Although helpful, it won’t be nearly enough to bail out Turkey. Unfortunately, by supporting the Muslim Brotherhood and opposing the blockade on Qatar, Turkey probably won’t be getting any help from the other Gulf States. The U.S. is showing no signs of backing down; VP Pence warned of additional measures if Turkey doesn’t release Andrew Brunson.[5] And, the U.S. has indicated the steel tariffs will remain even if Brunson is freed[6] (which begs the question as to why Erdogan would release Brunson if he doesn’t get anything in return).
For some perspective, we built a purchasing power parity model for the TRY. Here is a chart of the results.
Purchasing power parity values exchange rates based on relative inflation; the idea is that in a higher inflation nation, the exchange rate will depreciate to make prices equal. It is far from perfect as a valuation model because not all goods are tradeable and completely harmonized inflation indices are not really available. But, at extremes, it is a useful tool. We are using the monthly average exchange rate in this model. At present, the current exchange rate is nearly six standard errors from parity, meaning the TRY is incredibly cheap. Once this crisis passes, Turkey’s exports will be very competitive…if they can avoid permanent trade impediments.
More on the BOJ: A former BOJ member told Reuters that the central bank may allow the 10-year JGB yield to rise up to 40 bps, in effect, creating a platform for “stealth” rate hikes.[7] Hideo Hayakawa indicated the bank would let rates rise as long as it doesn’t trigger an unwelcome appreciation of the JPY. That is probably not possible; the yen is deeply undervalued and any sign of tightening, especially of this magnitude, would likely trigger a jump in the exchange rate.
China returning to form: Since the Great Financial Crisis, China has been dealing with oppositional policy goals. On the one hand, it wants to tame its massive debt situation, which was caused by maintaining growth after global export markets weakened in the aftermath of the crisis. At the same time, it wants to maintain high growth rates. Addressing one problem exacerbates the other so we have tended to see moves to reduce debt until growth slows and then the government fosters additional investment spending (adding to the debt) to lift growth back to target. According to Reuters, China is at it again, addressing weakening growth by increasing infrastructure investment.[8] This will alleviate the immediate growth problem at the cost of worsening the debt problem.
Wonder where the tax cuts are going? So did we. Apparently, we are dining out.
This chart shows retail sales at restaurants. At the beginning of the year, sales were rising 1.4% per year. In June, they were up 9.5%. And, we aren’t spending it at fast food restaurants, either. Full service restaurant sales are up 13.6%.
Energy recap: U.S. crude oil inventories unexpectedly rose 6.8 mb compared to market expectations of a 2.5 mb draw.
This chart shows current crude oil inventories, both over the long term and the last decade. We have added the estimated level of lease stocks to maintain the consistency of the data. As the chart shows, inventories remain historically high but have declined significantly since March 2017. We would consider the overhang closed if stocks fall under 400 mb. This week’s increase in inventories was quite unexpected, especially given that refinery utilization jumped to 98.1% of capacity, up from 96.6% last week. Oil imports rose sharply, to 9.0 mbpd, up over 1.0 mbpd from the prior week. And, oil exports fell modestly as well. We do note that U.S. production rose 0.4 mbpd to 10.9 mbpd.
As the seasonal chart below shows, inventories are late in the seasonal withdrawal period. This week’s rise in stocks was obviously inconsistent with seasonal patterns. If the usual seasonal pattern plays out, mid-September inventories will be 407 mb.
(Source: DOE, CIM)
Based on inventories alone, oil prices are near the fair value price of $69.50. Meanwhile, the EUR/WTI model generates a fair value of $57.34. Together (which is a more sound methodology), fair value is $61.08, meaning that current prices are well above fair value. The combination of a stronger dollar and unexpectedly high crude oil inventories is bearish. We were rather surprised by this week’s build but it may be due to unusually low stockpiles at the delivery hub in Cushing, OK. Stocks at the hub fell to 21.8 mb last week, an unusually low level.
There have been discussions in the media about these low stocks causing potential delivery problems. The tanks cannot be completely drained without causing problems; the DOE estimates that 15.0 mb is probably the working minimum. Thus, the jump in imports may be designed to address this shortfall at Cushing and thus isn’t really a build in inventory for immediate use. We will be watching this in the coming weeks to see if imports remain elevated to boost Cushing stocks.
[Posted: 9:30 AM EDT] Risk-off has returned with a vengeance this morning. Despite a continued lift in the Turkish lira (TRY), global equity markets are lower. Some of this decline is being driven by a stronger dollar and cratering commodity prices. Here is what we are watching today:
Contagion fears:[1] The current weakness in emerging markets has raised fears that another 1997 is looming. In 1997, the Asian Economic Crisis, which started in Thailand, spread throughout Asia and into South America. It even led to the Russian Debt Default in 1998. Our position is that another event of similar magnitude isn’t likely because most emerging economies now use floating exchange rates. In the late 1990s, most emerging economies used fixed exchange rates that gave emerging market borrowers confidence that they could borrow in hard currencies at lower interest rates without fear that debt service costs would rise due to currency weakness. Unfortunately, the pegs were not sustainable and debt service costs soared when the currencies reset, forcing a whole series of countries to go to the IMF for support.
To compare the 1997 situation, we will use Indonesia as an example. First, in 1997, the rupiah was overvalued.
This chart shows a purchasing power parity model for the Indonesian rupiah; parity is based on relative inflation rates between Indonesia and the U.S. The currency is quoted in rupiah/USD, which means a higher number indicates a weaker currency. Before the crisis, the exchange rate was fixed at roughly 2,500 per dollar. The parity rate was closer to 3,800 per dollar. When the crisis hit, the country allowed its currency to float; it depreciated rapidly, hitting 14,000 before settling in around 8,000. Because currencies are so basic to the functioning of an economy and are difficult to value, there is often a tendency to overshoot parity during a crisis. Although this hurts initially, the currency weakness does tend to improve export competitiveness and sow the seeds of recovery. And, that’s what we saw with Indonesia.
This chart shows Indonesia’s current account as a percentage of GDP and the exchange rate. Immediately after the currency collapse, the current account swung into surplus and remained in surplus until 2012. The currency has steadily weakened since the country began running current account deficits. Because the currency floats, Indonesia avoids the discrete drops in the exchange rate that we saw in 1997. In addition, Indonesian borrowers who want to take out loans in hard currency have a better idea of their funding costs because the weaker exchange rate that coincided with the current account deficit offers a more accurate picture of future borrowing costs.
Although the use of floating exchange rates should prevent the discrete collapses that characterized the 1997 Asian Economic Crisis, it doesn’t mean that problems won’t develop. We note that Indonesia unexpectedly raised rates 25 bps to 5.25% overnight in a bid to stabilize the currency. Fears of broader emerging market weakness, triggered by the stronger dollar, trade concerns and Fed tightening, are legitimate concerns. But, we don’t expect a repeat of 1997; if we are correct in this assessment, we shouldn’t see the sudden collapses in exchange rates that we saw during that earlier event. That doesn’t mean we won’t see further pressure, but the “glide path” lower should be more manageable.
Turkey: The TRY did rebound overnight after the Erdogan administration halved the limit on total forex swaps to 25% of banks’ shareholder equity. Although this won’t stop Turkish citizens who want to protect their liquidity from buying dollars, it will reduce the ability of professional investors to short the currency with leverage to gain from further weakness.
(Source: Bloomberg)
As this chart shows, the TRY bounced overnight. We doubt this action can be maintained but it does appear the shorts are worried about a recovery; in other words, if Turkey releases the pastor or boosts interest rates, the shorts could be caught. Thus, we are seeing what should be described as skittish market action.
[Posted: 9:30 AM EDT] We are seeing some risk-on behavior this morning; the Turkish lira is higher but it looks more like a deceased feline rebound rather than anything of substance. Here is what we are watching today:
Turkey: As noted above, the TRY is higher this morning, rebounding about 6%, after Turkish President Erdogan gave a speech calling for a boycott of U.S. technology products. Erdogan reiterated a strong stance against the weak lira and rising inflation but offered nothing that would end the crisis. He continues to avoid orthodox measures, such as a jump in interest rates or going to the IMF for a bailout package. National Security Advisor Bolton met with the Turkish ambassador to the U.S., Serdar Kilic, at the White House at the request of the Turkish official.[1] According to reports, the meeting was over the detained U.S. pastor, Andrew Brunson. We suspect Turkey has concluded that the benefit of holding Brunson isn’t worth the cost but is struggling to hand him over to the U.S. without looking weak. At the same time, we doubt President Trump has any interest in allowing Erdogan a face-saving exit. Thus, the tensions continue. So, for today, we are seeing a respite but there is no sign of steps to resolve the crisis.
Turkey’s government issues bonds denominated in lira and U.S. dollars. We note that yields on both instruments have increased but, more importantly, the spread has widened well more than normal. As the chart below shows, for most of the past seven years, the spread between the two instruments was 500 bps. The spread is now out over 1,200 bps, a reflection of worries about the future path of Turkish policy.
(Source: Bloomberg)
A terrorist act at Parliament: It appears a man in the U.K. used his vehicle to strike several people in front of the Parliament building before crashing his car into protective barriers. There have been no reported fatalities but several injuries. Scotland Yard is treating the event as a terrorist act. This may have been a spur of the moment attack; we note Parliament is not in session and most MPs are off for the summer. Thus, the potential disruption to government was low.
The Iran standoff continues: Ayatollah Khamenei announced today that he is forbidding Iranian officials from any negotiations with the U.S.[2] Interestingly enough, Khamenei acknowledged the economy’s poor performance but blamed domestic mismanagement and corruption as the cause. In other words, sanctions are not really a problem but the Rouhani government is inept. We have recently discussed Iran’s options in a three-part series in our Weekly Geopolitical Reports.[3] We note that Khamenei said today that Iran would not start a war with the U.S. and he isn’t worried that the U.S. would attack Iran. Khamenei’s stance looks like he is betting that sanctions won’t be all that difficult to deal with and non-compliant nations, like Russia and China, will offer enough support to keep the Iranian economy going. The comments also suggest he is preparing the country for slower growth and appealing to nationalism.
China critical of defense act: Yesterday’s signing of the new defense act has drawn criticism from China as the Committee on Foreign Investment in the United States (CFIUS) has been strengthened as part of that new legislation.[4] The Chinese feel (correctly) that the investment scrutiny is targeted at them. In addition, the new law calls for strengthening Taiwan’s defense, which is seen as a direct threat against China.
Maduro recommends a risky step:According to reports,[5] Venezuelan President Maduro is calling for an end to gasoline subsidies due to their increased cost to the government’s budget. With rapidly rising inflation, the gasoline subsidy has led to severe distortions. Venezuelan gasoline costs about $0.01 per liter,[6] the lowest in the world. The going price in Colombia is $0.80 per liter, so naturally there is a brisk business in smuggling Venezuelan gasoline to its neighbor. Many OPEC nations subsidize gasoline prices; it is seen as a national perk. History shows that raising the price of gasoline can cause internal unrest. Given that conditions are already difficult, this action may lead to widespread problems. We don’t disagree with the action but see it as a major risk.
The Trump administration withdrew from the Iranian nuclear deal earlier this year and plans to implement sanctions on the country in two phases, the first of which went into effect in early August with a second round in November. In Part I of this report, we introduced this topic and covered the first two potential responses from Iran, which were restarting the nuclear program and projecting power. Last week, we covered the threat to the Strait of Hormuz. This week, we will conclude with a discussion on the potential for Iran to deploy a cyberattack against the U.S. or use allies to end sanctions, along with the likelihood that Iran would enter into direct negotiations with Washington. We will conclude with market ramifications.
[Posted: 9:30 AM EDT] U.S. equity futures have grinded to unchanged, while global equity markets remain weak. The dollar is higher which is putting downward pressure on commodity markets. Treasuries are mostly steady. Here is what we are watching:
Talking Turkey: The Erdogan government announced a series of measures this morning that have clearly underwhelmed the financial markets.[1]
(Source: Bloomberg)
Above is the three-day chart of the Turkish lira (TRY). It did decline below the psychologically important TRY 7.0 level, then bounced and is currently moving sideways. However, it should be noted that the announced measures have not worked to boost the currency. The announced actions so far have included reduced reserve requirements for banks, as if the problem is being caused by lack of liquidity.
As the chart below shows, the TRY is in a freefall. There are really two paths the country could take to stop what Turkey is experiencing:
(Source: Bloomberg)
The orthodox plan is austerity. The central bank raises the overnight rate 500 bps to squeeze the shorts, and fiscal spending is cut dramatically. The subsequent drop in economic growth and the already weak currency usually leads to a rapid reversal in the current account deficit to stop the decline. The cost is usually a deep economic recession.
The heterodox alternative is twofold. One path is to effectively abandon the TRY and replace it with a currency board that issues TRY with a tie to dollars held in reserve.[2] Currency boards are effective in ending these currency routs at the cost of losing monetary sovereignty. Depending on which nation the currency board tracks (it is usually the dollar but could be the EUR), the monetary policy of Turkey would become indistinguishable from the monetary policy of the targeted currency used by the currency board. For the most part, authoritarian rulers are loath to give up sovereignty so this option isn’t likely. The other option would be capital controls, which is more likely. We would look for Erdogan to limit outflows through legislative measures. Given that Turkey’s foreign denominated debt is about 30% of GDP, debt service could become problematic and this has led to weakness in European banks and rising sovereign yields in periphery Eurozone countries. The chart below shows the rise in Italian 10-year yields.
(Source: Bloomberg)
The best argument for capital controls is that history tends to show that the driving force behind currency weakness usually comes from the citizens of the beleaguered nation. The citizens of the country in trouble have the best knowledge of actual conditions in the country. As citizens begin to realize the government is resisting orthodoxy, they move quickly to acquire hard currencies, exacerbating the depreciation in the local currency. Capital controls can slow this process.[3] We note that the finance minister (and Erdogan’s son-in-law) has warned Turks not to liquidate foreign currency accounts; the temptation to do so is that Turkey might seize these accounts to service foreign debt.
Our expectation is that Turkey will likely go the heterodox route and implement capital controls. At the same time, look for the Turkish leader to try to work out some sort of face-saving arrangement to get U.S. sanctions relief. That will be tricky for Erdogan; he has already played the “we can make new friends” card that worked so well during the Cold War.[4] Turkey, a key state in containing the Soviet Union, has fewer options that matter today. Yes, Turkey could reach out to Moscow for help but Russia is already in trouble. Iran might be helpful, too, but Ankara is wary of Iran’s power projection in the region. China could be accommodating but will extract onerous terms. In the end, Turkey will have to make a deal with President Trump. Unfortunately, much damage has been done. Even if Andrew Brunson is released immediately without conditions, faith in Turkey’s economic policy has been shattered and will take a long time to restore, even if the U.S. lowers sanctions pressure.
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