Liability mismatch in Turkey puts foreign banks in focus, watch emerging market bond indexes, analysts say
Investors outside of Turkey need to pay attention to the recent plunge in its currency to an all-time low versus the U.S. dollar as the country burns through its foreign-exchange reserves, analysts said.
One U.S. dollar fetched as many as 7.37 lira USDTRY, +0.73% earlier Friday, according to FactSet, amounting to a record low for the Turkish currency against the greenback. The lira has since bounced off the low, trading near 7.20 to the dollar in recent trade. The dollar is up more than 21% versus the currency in the year to date.
The lira’s slide comes despite the country spending billions in an attempt to shore up the currency amid fears weakness would stoke inflationary pressures. The country’s central bank has been averse to raising interest rates to defend the currency. Turkey’s president, Recep Tayyip Erdogan, has been harshly critical of high interest rates, puzzling economists by insisting that high rates fuel inflation.
This week, it appeared the authorities did make a policy shift, easing some of the lira restrictions put in place in June and July, allowing foreign banks to resume lira swaps, wrote economists at Oxford Economics. The moves came after overnight lira borrowing rates spiked briefly to 1,000% earlier this week in a sign of market distress. The analysts noted that the central bank also moved to roll back liquidity support measures.
“While these are welcome signs that the authorities are now more willing to tolerate [lira] volatility, they are not a valid substitute for the tighter monetary policy needed to restore confidence,” they said.
Meanwhile, the country’s foreign exchange reserves have been significantly drained. Turkey’s import coverage ratio as of the end of July stood at 2.8 months (based on $46.7bn in gross international reserves excluding gold), below the three months rule of thumb for minimum reserve adequacy, wrote Phoenix Kalen, analyst at Société Générale, in a Friday note.
Authorities have been able to maintain some stability by borrowing hard currency from the large pool of foreign currency deposits in domestic banks, noted analysts at Pavilion Global Markets. And with inflation having fallen from more than 25% last October to around 11.75% — a move partly due to the large drop in oil prices — Turkish residents have been comfortable “lending” their deposits to the central bank, they said.
But that could change as a rapid drop in the currency could stoke further inflation, the analysts noted, risking a bank run if economic conditions continue to deteriorate and confidence in the central bank’s ability to return the borrowed currency takes a hit.
Turkey’s lenders should pay attention, they said, noting that the country’s banks and corporates have to roll over $100 billion in debt in the next 12 months, with net external liabilities amounting to around $76 billion and accompanied by “significant currency mismatches” among borrowers.
As an example, they note that, according to data from the Bank for International Settlements, Turkish banks have $29 billion of dollar-denominated liabilities versus just $18 billion of dollar assets. They also have a shortfall of more than $4.6 billion between euro-denominated assets and liabilities. It’s worse for the nonbank sector, where borrowers have €19 billion in liabilities and just €3.6 billion in assets.
“The risk is that large currency mismatches, together with a ballooning current-account deficit and weaker currency, hinder the ability of firms to service their FX-debt,” the analysts wrote. “Spanish, Italian, and French banks have the largest claims on Turkish banks and subsidiaries. Not to be outdone, U.K. banks have more than $18 billion of loan guarantees outstanding.”
Elsewhere, the analysts noted that Turkey’s weight in emerging market equity indexes has diminished significantly, standing at just 0.35% of the MSCI Emerging Markets Index 891800, -1.56%, which is tracked by the popular EEM ETF EEM, -2.05%, versus around 1.05% in January 2018.
“On the face of it, this suggests that the direct impact of a selloff in Turkish assets on the broader EM equity complex should be limited. However, even when Turkish stocks had a 1% weight in the index, the correlation coefficient rose to 0.8,” they noted.
But they worry more about emerging market local-currency bond indices, where Turkey carries a 4.4% weight.
“Problems in one mismanaged EM usually portend weakness in others, and South Africa fits the bill,” they said, noting a 19% drop in foreign holdngs of South African bonds year to date alongside a drop in the rand USDZAR, +1.24%.
This perhaps explains the apprehension of foreign investors about dipping their toes back into emerging market bonds, they said, advising that investors should watch correlations with Brazilian bonds since they have the heaviest weight in EM bond indexes and are used as a proxy for the broader EM complex.
By: William Watts
William Watts is MarketWatch’s senior markets writer. Based in New York, Watts writes about stocks, bonds, currencies and commodities, including oil. He also writes about global macro issues and trading strategies. Before moving to New York, he reported for MarketWatch from Frankfurt, London and Washington, D.C.
Source: Market Watch
