Turkey’s economic problems continue to go from bad to worse. Its foreign trade deficit has reached a monthly average of $8 billion this year. Amid soaring global energy prices this spring following Russia’s invasion of Ukraine, the country’s average gross energy imports fell from $3 billion to $4 billion a month to $7 billion. $8 billion. A reduction in energy imports and the recovery in tourism this summer have not made up for this, and the current account deficit, the difference between imports and exports for all types of goods and services, continues to widen. According to the latest figures, the deficit reached $6.5 billion in May and this trend could worsen in the fall. An annual deficit of $40 billion is projected for next year.
However, the foreign trade imbalance is not the only problem; a considerable amount of short-term external debt also looms on the horizon. A total of $182.4 billion in hard currency debt is due to be repaid or rolled over next year. The Turkish economy needs at least 220 billion dollars in the next 12 months. The appreciation of the dollar against the euro is also a factor that negatively affects Turkey’s external balance. While 58.4% of external debt and 71.2% of imports are in dollars, Turkey’s revenues from exports and tourism are mainly in euros. Consequently, all other things being equal, the external deficit increases again.
Capital inflows are minimal compared to outflows. Banks and large corporations still have direct access to external financing, but the Turkish Treasury is avoiding borrowing in international markets as the near-term outlook is negative for emerging market energy importers. Either way, the cost of new debt will be more than 10%, as 10-year US Treasury yields are close to 3% and Turkey’s perceived risk continues to rise. The premium for the credit default swap (CDS), paid annually to guarantee the repayment of eurobonds denominated in dollars at five years, fluctuates around 8.5%. In summary, external financing channels are still open, especially for companies and financial institutions, but the costs are very high. Market rates in the United States are not expected to fall given the 40-year high inflation rate (9.1%) and the Turkish government’s insistence on maintaining unusual economic policies (where the policy rate is 64.6% lower than inflation).
The gross foreign exchange and gold reserves of the Central Bank of the Republic of Turkey (CBRT) total $100.9 billion. When its foreign currency liabilities are omitted, net reserves are $7.5 billion. However, most of its reserves are not officially owned by the CBRT. Instead, $22.9 billion of them belong to other central banks, including those of Qatar, the United Arab Emirates, South Korea and China. Additionally, $38.9 billion of the reserves belong to commercial banks in Turkey. When these two items are deducted, along with existing swap agreements, net reserves are -$54.3 billion. As this clearly shows, the CBRT has almost no leeway to control the depreciation of the Turkish lira by selling foreign exchange reserves. Moreover, most of the $41.2 billion in gold reserves are stored in Turkey, not in a financial center like London or New York; it is therefore difficult to use them as collateral for borrowing. The recent improvement in relations with Saudi Arabia and reciprocal visits by Turkish and Saudi leaders have so far not provided any new resources, such as an exchange agreement, foreign direct investment or direct loans to the Turkish Treasury. .
In addition to the veiled policy of selling foreign exchange reserves, a new mechanism for exchange-protected deposits was introduced in December 2021. Although it did not initially attract much attention, pleas and Subsequent warnings to the corporate and financial sectors led to a significant increase in its size, reaching a total of $62.4 billion by early July. The main objective of this mechanism is to provide a guarantee to bank depositors who keep their savings in Turkish Lira (TL) in the event of a further depreciation of the local currency, the Turkish Treasury or the CBRT paying the excess between the variation of the rate exchange rate and yield. Although this considerably weakened the central government budget balance, financial stability was maintained in an environment of very low policy rates (14%). The current consumer inflation rate is 78.6%, the producer inflation rate is 138.3%, and market expectations for the consumer price index (CPI) for the 12 coming months are 40.2%. At first glance, this mechanism was only partially successful despite its significant side effects: it prevented further dollarization but failed to achieve the goal of converting a large number of exchange accounts into liras . More than half of total deposits in Turkey – 56.3% – are held in foreign currency or gold, and another 15.1% of them are in exchange-protected deposits. Thus, the total rate of dollarization of deposits reached a record level of 71.4%. Deposit interest rates of around 20% and a lack of trust in government are the main reasons for this.
The government’s main goal is to win the next election, but the economy is making that increasingly difficult. Economic activity is slowing and more stimulus is needed to increase household purchasing power. There are two main tools to achieve this: additional government spending and real credit growth. However, both tools will not only promote economic growth but also create demand for foreign exchange as a serious side effect. Therefore, the government wants to open credit channels only to the real sector and close the doors to speculators borrowing TL and investing in FX.
New instructions have been announced by the Banking Regulation and Supervision Agency to limit access to cheap credit. Companies subject to the external audit requirement can borrow TL loans if their foreign currency financial assets do not exceed 10% of their sales or total assets. It is a sort of capital restriction for the real sector and a warning that tighter capital controls are likely. This decision has led to two distinct results: the first is to convert excess amounts of foreign currency into TL to obtain cheap loans and the second is to cancel investment plans as concerns about capital controls increase. Ministers and bureaucrats have repeatedly said there will be no stricter capital controls as the Turkish economy depends on imports of raw materials to produce its industrial exports. Nevertheless, the continuous extension of regulations and limitations of currency sources undermine these official statements and make them less convincing.
New public spending is another tool for promoting economic activity. There have been no new public investments or social transfers so far. The main reason for this is the dramatic increase in budgetary expenditure due to the depreciation of the Turkish Lira. Of central government debt, 67.7% is denominated in foreign currency or gold, while only 11.6% is linked to the CPI. Public-private partnership projects have payment guarantees denominated in foreign currencies. Salary increases for civil servants and pensioners are around 50% as both are semi-indexed to the CPI, but this is well below the current inflation rate of 78.6%. In short, rising costs translate into a deterioration of the budget balance in the absence of additional transfers and investments.
A substantial new budget, almost as large as the original annual budget at 86% the size, was proposed in June. That doesn’t mean new spending, though; instead, the government is trying to find more sources to finance its budget deficit. With households reluctant to buy government bonds given their 24% yields, only banks will participate in new bond issues. However, the banks’ demand depends on the amount of cheap loans that the CBRT provides to them, i.e., whether the CBRT will continue monetary expansion, which will cause the TL to depreciate sharply. If so, greater credit growth and new government spending will cause the Turkish lira to depreciate sharply.
Turkey is stuck between capital controls, TL depreciation and sluggish growth. The government must choose at least one of them, which means that tighter capital restrictions, a currency crisis or a loss of economic dynamism will be inevitable unless a major new source of foreign exchange is found. Insisting on the same policies will lead to a balance of payments crisis, ie the inability to repay foreign currency debts and pay bills for imported goods, as seen recently in Sri Lanka. The ruling party and its leader are known to be pragmatic and flexible when needed, but so far there has been no change in policy. This comes at a time when global conditions are only making things more difficult for Turkey.
Despite mid-year wage increases for civil servants, pensioners and minimum-wage earners, purchasing power is falling as Turkey spirals into inflation. The lack of necessary foreign exchange resources and the government’s desire to promote growth will lead not only to a new monetary crisis, but also to a balance of payments crisis. Turkey’s sovereign bond credit rating is the lowest since 2002 and rating agencies’ outlook is still negative.
If the government does not halt its current policies, the result will be a sudden shutdown, a sharp drop in production and a credit crunch, leading to a rapid reduction in lending. Therefore, in addition to runaway inflation and currency depreciation, economic activity will come to a halt, resulting in soaring unemployment. Recent opinion polls suggest that the re-election of the incumbent president is far from assured. Trying to avoid early elections will only increase social tension. The second half of the year will probably be disastrous for the Turkish economy and the political consequences will be dramatic and inevitable. It will be almost impossible to maintain economic stability until the elections scheduled for June 2023.
Mr. Murat Kubilay is an independent financial advisor on the Turkish economy and a non-resident researcher of the MEI’s Turkey program. The opinions expressed in this article are his own.
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