The Turkish economy has been shrinking as a result of the economic and financial turmoil that has gripped the country since March 2018. In the third quarter of 2019, it experienced weak growth. However, despite the market movement and the positive growth seen since, the crisis continues to have an impact, and no real solution has yet been found. In contrast to the weak growth and relative stability of the Turkish lira, the high rates of unemployment and of inflation continue to have a negative effect on the economy.
Following the collapse in the value of the Turkish lira in August 2018, the government began to interfere directly in the financial markets, moving from free-market principles to those of a controlled free market. The authorities began to interfere in even the smallest financial transaction mechanisms, and began to pressure banks to offer loans at lower-than-market rates. They imposed strict control over currency exchange transactions and foreign currency purchases by banks, and placed the dollar on the market in order to maintain the value of the lira. They imposed extreme restrictions on swap mechanisms in order to prevent the lira from entering foreign markets, thereby artificially raising its value, and the Central Bank became a non-neutral party in swap transactions, which allowed it to determine the exchange rate of the lira against the dollar.
These mechanisms, which are incompatible with the free exchange market system used by Turkey for many years, cannot be maintained for long. External developments and the weakness and instability of the economy’s internal mechanisms threaten the stability of the Turkish economy. This paper sheds light on these risks, which are divided into those with external economic causes and those with internal causes, in addition to internal and external political causes.
The main internal causes that pose a risk to the economic and financial situation in Turkey are as follows:
1. High proportion of bad and unrecoverable debt held by banks
The below chart shows the percentage of bad debts (overdue or uncollectable) held by Turkish banks. It indicates that Turkey has returned to a similar situation as that seen between 2004 and 2009. However, this graph, which is based on official government sources, does not include the debts held by the energy and construction sectors. The government attaches great importance to these sectors and has pressured banks to reschedule their debts, meaning that the graph shows a more positive picture than the reality. Government banks also hide the true percentage of bad debt for political reasons. The government is pressuring State-affiliated banks to relieve businesspersons close to the government from paying their debts on time and to grant them a grace period longer than that allowed by the law. According to the graph, bad debts account for a total of 5.2% of all debt.
If there were real transparency in the statistics and if the political system did not interfere in the work of government banks, economists predict that the real percentage would be between 8% and 10%, as was the case in 2003. In the event of continued economic recession, companies with a good financial status may not be able to collect their dues from companies that have suffered financial troubles. As a result, the collapse may spread like an infection, as happened previously when certain sectors failed financially.
2. High hard-currency foreign debt in the private sector
The ruling government of the Justice and Development Party (AKP) in Turkey has adopted a method of reducing government debt by transferring it to the private sector through various privatization operations, with the aim of attracting voters with a government “free of debts and foreign dependency”. All large-scale and infrastructure projects that the government has financed through foreign loans have been transferred to the private sector, with a guarantee from the Ministry of Treasury and Finance of receiving a large profit margin. Private sector debt has therefore escalated rapidly over the past decade, reaching a peak of $223 billion before the most recent financial crash in February 2018. It has since receded to $167 billion. Taking into account the fact that growth in Turkey has always been driven by foreign borrowing, owing to the lack of reserves, it is clear that the drop in foreign debt is the result of a reduction in foreign borrowing over the past two years. The government has also acquired a number of private companies in exchange for the payment of foreign debts. This solution prevented a major collapse in the private sector and a sudden massive nationwide economic crisis. This has led not only to a significant slowdown of growth in Turkey, but also to considerable economic contraction. In 2019, foreign debt exceeded 59.1% of national income. While growth slowly returned in the third quarter of 2019, the situation remains precarious.
Public sector companies must reach a solution with the banks to pay off their foreign debts, by identifying a foreign or domestic lender with reasonable interest rates, otherwise these companies will become bankrupt. Two years ago, the government established a “sovereign fund”, to which it transferred ownership of all public sector entities and government banks so that the fund could serve as a guarantor for future foreign borrowing in order to receive reasonable interest rates. The inclusion of all public sector companies under a single administration led to significant losses over the past two years, however, owing to widespread corruption and clientelism.
3. Budget deficit and the Treasury’s role in paying off the deficit
Following the collapse of the Turkish lira during the summer 2018 crisis, the Central Bank was forced to raise interest rates significantly to 24%. As the Treasury does not want to borrow at such a high rate of interest, it turned to short-term loans to ease the burden of the high interest rate. As a result, however, the Treasury has accumulated a large amount of debt that will have to be recycled in 2020. This has pushed President Erdoğan to interfere directly in the markets in order to rapidly lower the interest rate in Turkey, in violation of all financial and economic laws. It is predicted that the Treasury will need to borrow 264 billion Turkish lira ($45 billion at the current exchange rate) in 2020.
For political reasons, the government has failed to exercise fiscal discipline over its budget for the past three years. Since the start of the Turkish economic crisis two years ago, the Treasury’s tax revenues have declined, prompting the government to issue laws to increase it its revenues, such as the financial allowance for enlisting in the armed forces, and amnesty for buildings that violate construction codes in exchange for paying a fine. The government currently has no new projects to increase its financial returns, however, meaning that it will have to borrow once again (further debt in addition to that required to recycle the domestic debt mentioned in the previous section), possibly up to 290–322 billion Turkish lira ($50–55 billion), which will make the process of government borrowing in 2020 very difficult.
4. Direct intervention in the interest rate that is pushing depositors to buy dollars
Another internal risk is that the government may lose control of the mechanism that it invented to support the value of the Turkish lira and maintain its stability by secretly selling the dollar to government banks through the sovereignty fund. The mechanism can be described as follows:
When the Central Bank offers dollars for sale on the domestic market, it must notify all banks by announcing an auction for sale according to supply and demand. The law does not allow government or private banks to sell more than 20% of their total reserves in dollars. Currently, through the mechanism, the Central Bank is transferring dollars to the sovereign fund at the price determined by the Central Bank without announcing the sale or opening it to bids. The sovereign fund deposits the amount in dollars in its accounts in government banks, which in turn sell the amounts in dollars at the same price. This occurs even with large amounts that exceed 20% of their total reserves, in violation of the law. All these operations are carried out in secret without being announced. Consequently, large amounts in dollars are being made available at an exchange rate determined by the Central Bank, thereby allowing it to control the value of the lira. This constitutes direct intervention in the market, and ignores the fact that the market is supposed to be free and that the value of the dollar should be determined according to supply and demand. In order for this transaction to take place without a hitch, however, the same value in dollars must be returned to the Central Bank. In this case, the citizens or companies who have bought the amounts made available in dollars redeposit them in their accounts in government and private banks, with the exception of a small percentage which they keep at home or transfer abroad. The Central Bank repurchases these amounts in dollars through swap transactions of 1 to 12 months, and pays the banks a low level of interest in Turkish lira.
While this process, which some economists consider a way of “circumventing” transparency in the financial system, appears to be a useful way of maintaining the value of the dollar, it suffers from two problems:
First, part of the amount in dollars offered for sale by the Central Bank in this way does not return to the bank, as those who buy the dollars, as mentioned above, keep a proportion of the sum at home or send it abroad (Turkish companies pay foreign debts and invoices in dollars). According to 2019 figures, the Central Bank put up $32.8 billion for sale in this way, of which only $14.6 billion was returned to it. This means that, as the process continues, the Central Bank is gradually losing its dollar reserves. This process therefore cannot continue for long. In addition, according to official figures, while the Central Bank’s dollar and gold reserves amounted to $108 billion at the start of 2020, only some $35 billion remain after subtracting the amounts owned by the banks and deposited in the Central Bank. This year, the Central Bank must undergo the same process as described above, meaning that it will lose even more dollars. By the end of 2020, the Central Bank’s reserves will be reduced to $20 billion, which is critically low.
Second, the total value of foreign debts that must be collected from the government and private sectors this year is expected to be $164 billion. As the maturity date of these debts approaches, the public and private sectors will need to purchase dollars from the Central Bank to send abroad, but, as we have seen, this sum exceeds the bank’s current reserves. If no solution can be found, Turkey may face a major obstacle that could lead to the complete destruction of the mechanism and to a crisis that topples the value of the Turkish lira.
5. Low interest rates on the Turkish lira
President Erdoğan sought to reduce interest rates quickly and dramatically in order to reduce the burden of domestic debt on the Treasury and stimulate domestic economic growth. Over the past six months, the bank interest rate has dropped from 24% to 11.25% in accordance with direct political orders, rather than the rules of the free money market. It was assumed, in the government’s economic plan, that this would be accompanied by a parallel decrease in the inflation rate. But the inflation rate, which had decreased as a result of direct government interference and repeated manipulation, rather than for any natural reasons, has risen again over the past two months to almost 11%, which means that the profitability of savings held in Turkish lira in local banks has been reduced to zero. While individuals who deposit money in Turkish banks will receive 11.25% interest after a year, the purchasing power of the Turkish lira will have decreased by 11% over the same period, meaning that nothing would be gained. Some individuals with money in Turkish banks have therefore withdrawn their cash in Turkish lira and bought dollars instead as a guarantee. Reserves in Turkey are therefore rapidly being converted from Turkish lira to dollars; the total dollar reserves held in Turkish banks in 2019 amounted to some $196 billion, a record figure that represents around 49% of the total financial reserves held by banks in the country. It is worth noting that, while economists have confirmed that this $196 billion figure exists on paper, this amount in dollars does not actually exist in Turkey because of the aforementioned mechanism.
Increasing international demand for investment in high-risk countries has, over the past two years, helped Turkey to alleviate its economic crisis, particularly when Turkey raised the interest rate to 24%. This attracted many foreign financial funds, which entered the Turkish market in order to take advantage of this highly profitable margin, regardless of the risks present in the Turkish economy. While a number of other countries in similarly critical situations have also benefited from this demand, including South Africa, Brazil, India, and Indonesia, Turkey was the country that reaped the smallest reward. The following table shows the degree to which these five countries benefited from such investment in a manner that reflected relatively positively on the value of their currencies. It clearly shows that the Turkish lira received the least benefit and experienced the greatest collapse in value against the dollar and against the rest of these currencies since March 2018.
The slight financial improvement that Turkey has seen, which has thus far prevented a major collapse in the economy, remains dependent on the continuation of this international situation and the continued interest of foreign funds in taking risks and investing in these countries. However, if the situation changes and foreign funds, in particular those from the United States, begin to sell their investments, it will lead to a major financial crisis in Turkey that will cause the Turkish lira to collapse. Turkey is also affected by the high rate of debt in China and by the trade war between China, the United States and the European Union. In addition to US funds and Chinese foreign debt, the Turkish markets also remain linked to the fortunes of Deutsche Bank and the Italian banks and the economic situation in Argentina and Hong Kong, as these are currently the largest investors in Turkey.
Risks related to Turkey’s domestic policies
Over the last decade, Turkey has experienced many major political shocks that have affected the economic situation, most recently the failed coup attempt. Numerous elections and political referendums have also been held in recent years, which has perpetuated a sense of instability among many investors. The Turkish government expects to enjoy a period of stability for the next three years until the next elections in late 2023 and has designed its economic program accordingly. However, there are numerous indicators in Turkey’s domestic policies that suggest that early elections may be held at any time. Furthermore, if the opposition parties and their alliances join forces, they may be able to overthrow President Erdoğan and his government. This would be a major political earthquake that would have various consequences for the economy, particularly if this change reveals deeper problems in the economy that have thus far remained hidden.
Another danger posed to the economy is the continued lack of confidence among Turkish citizens in the government’s domestic and economic policies. The consumer confidence index has been declining for the past two years; while before the start of the crisis in March 2018 the index was at 72 points, as of January 2020 it had sunk to 56 points. This reflects the lack of trust among citizens in the government’s economic policies, which has led to a decline in consumption, an increasing reluctance among citizens to exchange cash, and an increasing unwillingness among companies to invest and expand. All this negatively affects the government’s attempts to increase economic growth and stimulate market movement. A further threat to the economy lies in the wave of popular anger at government policies, the increasing cost of living, widespread unemployment, regular revelations of major corruption within the ruling party, and the spread of images and reports revealing the opulent lifestyle led by the ruling class. This threatens lead to a social “explosion” and a desire among the public to overthrow the ruling political class.
Risks related to Turkey’s foreign policies
The political crisis with Washington sparked by the arrest of an American pastor in Turkey was also the cause of the economic and financial crisis that hit Turkey in summer 2018, after President Donald Trump threatened to destroy the Turkish economy unless the pastor was released promptly. This incident reveals the weakness of the Turkish economy, as a mere tweet from the US president was enough to send the value of the lira plummeting. It also demonstrates the close dependency of the Turkish economy on US banks and funds, which are able to directly affect the Turkish financial markets.
Consequently, any real future crisis in relations between Ankara and Washington could seriously harm the Turkish economy. The two countries already disagree on many issues, ranging from Turkey’s purchase of Russian S-400 missiles and the consequent sanctions imposed by the United States under the Countering America’s Adversaries Through Sanctions Act (CAATSA), to Turkey’s close relations with Russia, its general policies in the Middle East, including its military intervention in Syria and Libya, the escalation of tensions with Greece in the eastern Mediterranean, and the possibility that the European Union will impose sanctions on Turkey for such action. Nonetheless, the special relationship between Erdoğan and Trump has prevented relations between the two countries from deteriorating. In their analyses, the financial markets are focusing more on the relationship between these two men than on the relationship between their two countries.
Turkey was hit by a financial and economic crisis in 2018. It was able to avoid the worst of the consequences, however, thanks to the direct intervention of the Turkish government and the shift to applying the rules of a relatively controlled financial market rather than those of a free market. International financial conditions have also helped Turkey re-establish control. The repercussions of the crisis continue to be felt, however, and have not yet been addressed. The possibility of another explosion remains, especially if global financial funds change direction and reduce their level of investment in Turkey (currently part of a policy of investing in risky countries such as India, Argentina, and South Africa).
All attempts by the government to interfere directly in the markets by controlling the interest and inflation rates, buying up the debts of large companies, and pressuring banks to provide low-interest loans have failed to persuade citizens that the economic situation is improving. The government has therefore thus far failed to encourage citizens to participate in efforts to expand and grow the economy. The government is currently focusing on theoretical figures and results, which has done nothing to persuade citizens, who continue to experience high prices and widespread corruption and unemployment. Consequently, the government has depleted all of its reserves and assets in order to take control of the economy and present an image of stability. This is a failed investment, however, which will lead to a major crisis, especially as the government is acting as though short-term foreign investments in Turkish bonds and financial instruments will continue indefinitely; conversely, any change in international conditions would ruin the country’s current fragile economic stability.
There is a serious possibility that another economic and financial crisis will erupt in Turkey in the second half of 2020 or the first half of 2021, either as a result of changing international conditions and the reluctance to speculate on or make short-term investments in Turkish bonds, or because the government has exhausted its economic “solutions” for disguising the reality of the economic situation in Turkey, or as a result of domestic elections or a foreign crisis with the United States. Only when the crisis occurs will investment in Turkey be possible and profitable for foreign parties, provided that the Turkish government learns from its mistakes and, once the crisis is over, makes the required economic reforms.
Liran Antebi | 04 May 2021
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