15Aug
On: August 15, 2018

Last Friday, the Turkish Lira dropped 14% in a single day. As of Monday close, the lira had fallen 19.5% since the start of Friday, and 45% ytd. Turkey’s president, Erdogan, called for all citizens to convert their foreign currency and gold to halt the slide, economists are worried the Turkish economy will slide into a massive crisis, and investors are about a financial contagion spreading to other emerging economies.

What events led to this crisis?

Twin deficits

Turkey had been one of the fastest-growing economies in recent years, with GDP growth (2017: 7.4%) outpacing even China and India. Substantial foreign borrowing was a key stimulant for the economy, with Turkey’s foreign debts standing at over 50% of GDP. As a result, Turkey’s fiscal and current account deficits inflated significantly over the past 5 years:

Turkey’s expanding twin deficits. Source: Bloomberg

Compounding the problem was Turkey’s low foreign reserves, much of it prone to domestic customer withdrawals, which left the Treasury unable to defend the currency.

Economic mismanagement

Foreign investors have also lost confidence in President Erdogan’s management of the economy. Erdogan had become increasingly autocratic in recent years, with recent elections grating him sweeping powers in government. Despite Erdogan’s persistent criticism of high interest rates, previous central bank governors has nonetheless kept hiking Turkey’s interest rate (currently 17.75%) to support the lira and manage runaway inflation (16% y/y in June 2018).

Post-election, Erdogan utilised his newly-granted powers to appoint his son-in-law, Albayrak, as central bank governor, who has steadfastly refused to hike interest rates despite the falling lira, foreign outflows, accelerating inflation and depleting reserves. With Erdogan convinced that lower interest rates are the solution to inflation, and rumours that capital controls may be imposed (refuted by Albayrak), foreign investors have pulled out their investments in droves.

US sanctions

The final straw leading to Friday’s lira collapse was US President Trump imposing sanctions and doubling tariffs on Turkey’s steel & aluminium imports, following a diplomatic spat in which Erdogan refused to release an American pastor, who is currently held under charges for espionage and terrorism. Fearing further sanctions paralysing their Turkish investments, foreign investors withdrew heavily on Friday, which further exacerbated the lira’s fall.

Turkey’s countermeasures

Despite the dire impact of the lira’s collapse, Erdogan has ruled out any interest rate hikes, calling himself the “enemy of interest rates”. The central bank has reduced the reserve requirement to free up banks’ liquidity, and has offered “unlimited liquidity” to banks. Interestingly, said liquidity is being offered at 150bps above the official interest rate, which is in essence a stealth rate hike.

However, most economists remain unconvinced that boosting liquidity would help the lira to recover, as none of the fundamental problems above were addressed. The consensus is that the interest rate would need a ~10% hike and US tensions to be de-escalated to begin restoring investor confidence.

Impact

The lira collapse had spill over effects on emerging markets (EM), with many EM currencies declining as investors fled to USD as a safe haven asset. The Argentinian Peso and South African Rand were hit particularly hard, with Argentina’s central bank forced to raise interest rates by 5% to 45% today to prevent another currency collapse. In Asia, we saw the Philippines increase interest rates by 0.5%, and Indonesian central bank intervened to defend their currency.

Though grouped under the EM basket, the Ringgit was one of the strongest EM currencies, only falling 0.34% to 4.09 against the USD. With relatively low deficits and low reliance on foreign borrowing due to strong local demand, Malaysia is in a relatively good position to weather this crisis.

Our view

As a result of flight to safety and hikes in US interest rates, we expect USD to continue strengthen. We reiterate our view that countries with twin deficit are more vulnerable and may have to resort to interest rate hikes to defend their currency and mitigate outflow of funds. Malaysia has a healthy current account surplus, expected at around 4-5% of GDP. We have not seen a lot of selling with MGS yields up 1-2 bps. Foreign holdings of our MGS is still considered on the low side at 40.5% compared to high of 45% earlier this year. We continue to see strong local support as evidenced by the strong tender of the 15-year MGS yesterday with book to cover of 2.7x for RM3 billion issuance. The market will also be further supported with Fitch’s affirmation of our rating at A – (stable) yesterday. We may take opportunity to buy in the market if we see selling in the market.