Turkey: Sharp slide of the lira in May darkens economic prospects
On the brink of collapse
The Turkish lira (TRY) experienced a sharp and accelerating sell-off in May, triggered by a range of weak data and bad news. A drop in the Manufacturing PMI, rising inflation, large portfolio investment outflows, a downgrade by S&P, and especially a remark by President Erdogan that he would take greater influence on monetary policy if he wins the presidential election this month shook investor confidence substantially. Belatedly, after the TRY had fallen -20% in the month, the Central Bank of Turkey took some decisive measures in the last week of May. It hiked the key policy interest rate by 300bp to 16.5% in an emergency meeting; and it simplified the operational framework of monetary policy. For now, these measures have helped the TRY recover some lost ground, although it has remained volatile and well below April’s levels.
Chart1 Gross external financing requirement* (% of FX reserves)
Turkey’s persistently large current account deficit further rose to –USD55bn in the 12 months ending March 2018 (approx. -6% of GDP). These shortfalls are mostly financed through short-term capital inflows, which can be easily reversed in the event that investors lose confidence. This appears to have happened in the past few months, as indicated by the substantial net portfolio investment outflows of –USD2.4bn in March and by the repatriation of foreign assets by Turkish banks in Q1 (USD4.2bn). In March 2018, the short-term external debt on a remaining maturity basis stood at USD182bn, while official FX reserves had fallen to USD85bn from a recent peak of USD96bn in October 2017. As a result, Turkey has the highest gross external financing requirement (defined as sum of current account deficit and external debt maturing within the next 12 months) in relation to FX reserves among major EM (see Chart 1).
We believe that another rate hike in the region of 300bp is needed in order to calm down investors and facilitate a soft landing of the (previously overheating) economy. If it does not come, or too late, there is a risk of a hard landing. We have revised our soft landing scenario and now forecast full-year real GDP growth to slow down more markedly from +7.4% in 2017 to +3.7% in 2018 and +3% in 2019. The TRY is forecasted to lose -15% of its value against the USD on average in 2018 and -10% in 2019. This should result in an average CPI inflation of around 11% this year and 9.5% next year. Automatic stabilizers will widen the annual fiscal deficit to more than -3% of GDP and increase public debt to about 36% of GDP by end-2019. Still, public finances should remain manageable. The current account deficit will slightly narrow from today’s level but remain large at more than -5% of GDP.
In a ‘hard landing’ scenario, where interest rates would need to be hiked by 1000bp or so at some point, GDP growth would be corrected more sharply to about +2.8% in 2018 and +1.2% in 2019. Inflation would rise and remain in double digits until end-2019, while the fiscal deficit would rise to more than -5% of GDP and public debt would approach 40% of GDP. Meanwhile, the current account deficit would narrow markedly as imports would collapse.