Monday 13 August 2018

A capitulation point in Turkey?

If the media and financial market consensus is to be believed, Turkey is currently in the midst of a veritable financial crisis. Yet in truth, there is no such crisis at present - at least not yet - and although one is certainly possible, that outcome is far from assured. What we actually have at the moment is merely a crisis of confidence (and, perhaps, in domestic civil/political liberties), and for the former, is one that may already be close to peaking. While it is impossible to definitively call any sort of capitulation point, the below chart of the USD/TRY certainly appears to indicate to me that we are either at or very close to the proverbial capitulation point.

It is difficult to find a single media article at the moment that has anything at all positive to say on Turkey - the narrative is instead profoundly and unrelentingly negative. This is often an excellent contrary indicator. Indeed, the coverage is so one-sided at present that it is little wonder leaders of sometimes-rogue nations such as Turkey's are occasionally mislead into thinking there is some kind of Western conspiracy at play attempting to engineer the country's downfall.

The truth is that, like any complex issue, careful, nuanced, and balanced thinking is required, and as is often the case, there are two sides to every story. This does not mean many of the concerns popularly referenced about Turkey are wrong or invalid - it is just that they don't tell the full story.

Background to the current malaise

So what the hell is going on in Turkey? In short - believe it or not - the root cause of the problem is that country has been growing too fast (for the comfort of financial markets). Turkey's economy grew about 7% last year - amongst the fastest in the world - although is already sharply slowing. This has created concerns because Erdogan has insisted on keeping the gas-pedal firmly to the floor, and has shown a too-relaxed attitude towards controlling inflation and rising external imbalances. Pointedly, he has resisted the implementation of drastically tighter monetary policy. Inflation, which averaged an already-elevated high-single-digits over the past decade, has recently increased to 15%. These pressure points are also being exacerbated by a strengthening USD, rising rates and tightening dollar liquidity.

Erdogan has not helped matters by arguing that the key to battling inflation is lower rates, not higher rates - something that has further undermined confidence - particularly because Erdogan's recent efforts to entrench himself in power will make his removal difficult, even if he steers the country into the proverbial abyss. Erdogan has also recently used his strengthened grip on power to appoint relatives and those sympathetic to his views to important financial posts (notably his son-in-law as the minister of finance), and central bank independence is now also widely believed to have been undermined/politicised. A hyperinflationary doom loop is feared.

In addition, rapid economic growth over the past decade has resulted in an increase in the country's all-important current account deficit to 6% of GDP, as well as the accumulation of corporate foreign indebtedness of some 30-40% of GDP. Reflecting this sizable and persistent current account deficit, Turkish bank LDRs (loan to deposit ratios) are generally in the 110-140% range - below the 100% comfort level - and banks therefore have some reliance on international wholesale funding markets to cover the gap. If access to these markets were to be suddenly cut off, a domestic credit crunch could be triggered as banks scramble to shore-up liquidity to repay maturing wholesale funding lines. In addition, corporates could struggle to repay foreign-denominated debt, causing a surge in non-performing loans and bond defaults. Analogies to the Asian Financial Crisis in 1997-98 appear stark.

Furthermore, Erdogan's increasingly autocratic tendencies and the undermining of domestic liberal democratic norms has also rattled confidence - particularly due to Erdogan's background as an Islamist - as he has pushed to undermine Turkey's hitherto secular formal institutions and values. Recently, headlines were made after Turkey detained a US pastor as well, and refused to repatriate him back to the US. This has provoked diplomatic sanctions from the US, and may also have contributed to Turkey being singled out for higher aluminium and steel import tariffs by Trump in recent days as well. All these negative headlines have added to the pervasive sense of malaise.

The problem with the media

The problem with the media is that it often presents a very unrepresentative view of what is really going on, and promotes an accentuated focus on isolated or near term events that several years from now will be long forgotten. Sensational headlines grab eyeballs, but they don't necessarily reflect reality in an impartial, balanced way. An obvious example is the fact that the incidence of violent crime has halved in most places in the world over the past 20yrs, and yet the media reportage of violent crime has remained the same. Consequently, many people's perception of the incidence of violent crime is out of line with the reality. Many people also fear death by terrorist attack or plane crash more than they do cancer or a car accident - a statistical irrationality that reflects biased media reporting.

Failure is also often more spectacular than success. Success is often a long, drawn out process of incremental improvement sustained over a long period of time, whereas failures, accidents, or setbacks can often be sudden and dramatic. Human beings are also risk averse and so are attuned to pay attention to danger. This is why the media is full of stories about civil wars, disease outbreaks, financial turmoil, violent crime and terrorism, despite the fact that the world has been getting steadily richer and safer, and we have seen a record decline in poverty and disease over the past 20-30 years.

Media coverage can also result in narratives being taken to the extreme, as echo-chambers develop. Turkey is a nation of 80m people, most of whom get up every day, go to work, and run businesses. The long term value of all this economic activity is not suddenly impaired by 5-10% due to the US protesting the detention of one US pastor (something that tanked the currency and Turkish markets to approximately that degree). That is nothing but noise in the broader scheme of things, and it promotes a focus on relatively trivial issues to the neglect of the bigger picture.

The best way to counter this biased narrative is to look at the raw facts/data, and to consider the counter-arguments. I have attempted to do so below. It doesn't mean the bearish narrative will prove wrong - it merely means that it might prove wrong, which is a fundamental difference. Importantly, I have not seen any of these arguments appear in a single widely-circulated media article or commentary/analysis on Turkey of late. This fact alone suggests to me Turkey is probably oversold.

So why are markets (potentially) wrong?

Financial crises almost invariably require the banking system to become insolvent or illiquid. Without bank failures, it's not really a crisis - just (at worst) a plain vanilla recession. So what are some of the pertinent facts with respect to the Turkish banking sector?

Firstly, Turkey's banks currently have relatively healthy capital ratios and high levels of organic profitability. Despite the putative crisis (albeit that the full impact is yet to be felt), most booked record profits in 2Q18, solid asset quality trends, and continue to pay healthy dividends. Furthermore, importantly, many of the largest, most systemically important Turkish banks are backed by strong shareholders - many of whom are also important sources of related-party wholesale financing. Turkiye Garanti Bankasi, for instance, is majority owned by Spain's BBVA, who has provided them with wholesale funding lines, while Yapi Kredi is majority owned by Italy's UniCredit and domestic conglomerate KC Holdings. The latter is in a net cash position at the holding company level, and Unicredit and KC have recently already injected additional capital into Yapi. BBVA has already publicly stated that it has no concerns about Garanti's financial condition.

One of the main vulnerabilities of the banks comes from their high LDRs (loan to deposit ratios) - often in the 110-130% range. However, near term maturities of international wholesale financing are not significant, and noted, several banks have the capacity to tap wholesale lines from their European parents (most of whom have too much liquidity). The crisis would only present if those parents pulled their wholesale lines, but why would they? LDRs also do not include shareholders equity - the most stable form of financing of all. LDRs fall materially when equity is included alongside deposits.

Another vulnerability is that currency depreciation will increase banking system RWAs (risk-weighted assets) as Fx loans are redenominated into lira. Set against a relatively stable capital base, this will potentially pressure capital ratios. However, a lot of the Turkish banks have capital buffers (as well as Fx hedges) which will help mitigate the impact, and it's not yet clear where the lira will settle after current financial panic recedes. And in a worst case, capital raisings ought to be possible, given the strong financial condition of both the largest banks and their key shareholders.

Lastly (with respect to the banks), what about the repayability of foreign-denominated debt lent to their customers? That remains to be seen. However, much depends on who it was lent to (exporters or domestic-focused businesses?), and how much of it is hedged. The gross exposure of 30-40% of GDP almost never has netted from it the level of hedged borrowings, including natural hedges that come from offshore revenues. Turkey is a significant exporter into Europe (and has many very competitive, well run companies operating in the export space), and many of the country's largest listed companies who have foreign-currency borrowings have either significant export revenues and/or material hedges in place against existing debt (or foreign debt levels that are relatively low compared to the core cash-flows of their domestic businesses). Opacity here is high, but it is at least possible that fears of massive defaults are overstated. In short, there is a decent chance Turkey's major banks not only survive the cycle, but make it through profitably as well.

This is particularly the case because the leverage of many of the Turkish banks is actually quite low, and their level of core profitability quite high. Turkiye Garanti Bankasi, for instance, is leveraged only 7x (vs. closer to 15-20x in the developed world), and its annual pre-provision operating profits are 6.5% of its loan book. The company could there write off almost 20% of its loan book over three years and still operate at break even levels. The company has also been reducing its Fx lending for the past five years. Asset quality impairment will have to be grave indeed to imperil its survival.

Moving on, what about Turkey's (perceived) lack of willingness to tighten domestic monetary policy? Quickly forgotten has been the fact that the central bank tightened by 600bp in April, and short rates are currently 17.75%. That's not exactly loose, and it is still above the rate of inflation (i.e. real rates are still positive). Market's reacted in July to the central bank keeping rates flat as if they had aggressively cut. And yet what politician anywhere in the world would want to hammer the electorate and domestic economy with significantly higher interest rates than are strictly necessary?

What often happens in markets is that complex issues are distilled down into a simpler, proxy issue. Instead of looking at it in a balanced way, people will say: (1) no July hike = no central bank independence and coming hyperinflation = sell; and (2) a hike = central bank independent and currency stability = buy. In reality, the situation is not that black and white. As noted, real rates are already positive, and investors are paying no regard to domestic political realities, including the genuine hardship significantly higher rates will impose on domestic households and businesses.

We saw the hypocrisy of the West quite starkly during the GFC - during its own crisis, the West refused to swallow the same medicine it had happily prescribed to emerging countries over the prior decades. Rather than implementing fiscal austerity and high real rates that exacerbate economic weakness and create a punishing recession, as the IMF has routinely required emerging countries in tough times to do, the West cut rates to zero, printed money, and engaged in massive fiscal stimulus. Compared to the western response, what Turkey has done is child's play - they have 'only' hiked rates an emergency 600bp! It's different, it seems, when the shoe is on the other foot, because Western commentators are more aware of (and empathetic to) the actual suffering caused to people by severe recessions and job losses (and the political realities of that). There is a fairly callous disregard of that when it is other countries experiencing the pain, and an apparent ignorance of domestic political constraints.

What about Ergodan's unrelenting desire to 'go for growth'? Only a few years ago, the world was gripped with a fear of inadequate demand and hence deflation. The world was 'turning Japanese', investors feared. Now markets are terrified of Turkey's excess demand. Any sort of imbalance is seen as a cause for certain, impending doom, instead of merely being an imbalance. It calls to mind Peter Lynch's brilliant observation about market's frequent tendency towards 'glass is half full' macro fears - one day markets are worried oil prices are going up so we are going to have a recession, and the next day markets are worried oil prices are going down so we are going to have recession!

Markets would prefer Turkey grew at 3% with 5% inflation than at 6% with 10% inflation, and yet both outcomes get you to the same place - one simply twice as fast as the other (two years for the former, one year for the latter). This highlights a profound problem of 'framing'. Inflation is important, and all else constant, is a negative, but it is not the only thing that matters. 

In addition, inflation is currently being exacerbated by a weakening lira (imported inflation) and rising oil prices - pressures that will recede in time if and when the lira stabilises. Imported inflation has a much greater impact on emerging market inflation rates than in the developed world, as developed economies have a higher share of GDP comprised of domestic services, where prices are generally unresponsive to currency movements, as compared to tradeables (food, energy, etc). Brazil's inflation, for instance, fell from 11% to 2% during 2016-18 as the Real stabilised and recovered.

What about Erdogan's insistence that lower rates are the key to lower inflation? Inflation is the result of aggregate demand exceeding aggregate supply, so in truth there are actually two ways to relieve inflationary pressures - lower demand or increase supply Aggressive investment to address supply shortfalls is a legitimate long term way to combat inflation, and affordable funding is essential to the maintenance of high rates of investment. By contrast, crunching demand is the best short term way to combat inflation. Most financial market participants only care about the short term, so it is clear what they would prefer. However, for someone with a long-term grip on power and whose legitimacy with the electorate rests on his promise to boost living standards, it is understandable why Erdogan would prefer to lean towards a supply-side rather than demand-side solution.

What about US sanctions? Quite frankly, I see the US response to the detention of a US pastor as punitive and hard to justify. How would the US react if the US arrested a Turkish muslim cleric in the US, and Turkey demanded his release and return forthwith, and threatened harsh sanctions for non-compliance. The US would say, 'screw you - this is our country and we make our own rules and do what we like, thanks very much'. No one likes being bossed around and Erdogan's defiant response is entirely understandable - indeed very much the human norm in the face of a foreign culture trying to force you to behave they way they would like you behave. The US has no jurisdiction to force other countries to implement policies and laws that they deem satisfactory.

Trump's announced additional tariffs on Turkish steel and aluminium imports are also ill-conceived and difficult to justify. While it is understandable that the US may seek to respond to 'competitive devaluation' of currencies to offset US tariffs with higher tariffs still, this policy is wholly unjustified in the case of Turkey. This is because (1) the lira is falling due to market forces, not policy intervention (indeed, the Turkish authorities do not want the lira to fall); and (2) because Turkey has its own imbalances to correct, in the form of trade and current account deficits, rather than mercantilist surpluses.

This sort of US unilateralism - following on the heels of trade policies and its withdrawal from the Iran nuclear deal, risks a backlash from traditional allies such as Europe, which might well side with Turkey. Erdogen's response that 'you're trading a NATO ally for a pastor' is quite pointed. Irrespective, Turkey's exports to the US are relatively limited - Turkey exports mostly into Europe - so these headlines are mostly just that - headlines.

And lastly, what about Erdogan's increasingly authoritarian regime? In truth, from an investing/financial perspective, illiberal political regimes only matter from the perspective that it is more difficult to remove ineffectual leaders from power. This is a major issue if you are a citizen of a country, as the stakes are very high, but as an investor, you can take your losses and move on.

From the point of view of economics and investment, what actually matters is not the form of political representation, but what actual economic policies get implemented, and autocracies actually enjoy some advantages in this respect as they can (1) implement policies quickly without needing to win a broad-based coalition of support that caters to minority constituencies (such as the environmental lobby); and most importantly (2) they can think long term. The major failing of democracies is that they promote short term, populist policies that are focused on winning elections, and long term planning/leadership is often lacking. China has demonstrated what can be achieved with an ability to implement policies quickly, decisively, and with long term planning in mind.

Erdogan's legitimacy also rests mostly on his economic accomplishments. Since coming to power in the early 2000s, Turkey's economy has grown considerably and the average Turk is much better off economically than they were 20 years ago. This likely lies behind Erdogan's 'go for growth' policies. This is important, as in the long term, interests are aligned between investors, the citizenry, and Erdogan's political career. There is every possibility Turkey's economy outperforms expectations over the next 10 years as a result.

And this is before mentioning the positives?

Furthermore, all of the above arguments - none of which I have seen feature in a single media article - are merely potential refutations/balancing points that counter the negative narrative. Notable is that they don't even address any of the potential positives in Turkey.

The Lira, on a PPP (purchasing power parity) basis, was already cheap at 3.5 to the USD. A good friend of mine travelled to Istanbul earlier this year and was amazed at how modern the place was; how efficient the infrastructure; and how remarkably cheap the cost of living was. The currency is now at 7.0 - twice as cheap again! A cheap currency and the significant recent depreciation is going to be a significant economic stimulus to the Turkish economy, which has a large export sector focused on selling into the EU (an export market, by the way, where the economy continues to do relatively well), and also a growing tourism industry. An undervalued currency is likely to contribute to a significant decline in the current account deficit in coming quarters, and a booming export sector.

Also neglected to mention is the fact that a lot of Turkey's current account deficit has gone into financing infrastructure and other productive activities. It is one thing to borrow for consumption; it is quite another to borrow to invest, and it is actually not clear why it ought to be considered such a profound negative for a rapidly growing, capital hungry country to run a current account deficit. Investors are focusing only on the visible imbalances (foreign borrowing), while ignoring all the productivity-boosting investments that borrowing has enabled. The current account deficit has also recently been inflated by higher oil prices, but if oil prices continue to moderate from recent levels of US$80/bbl, this will also aid Turkey's external imbalances.

Lastly, so far at least, Turkey has not resorted to capital controls or trying to peg the lira and prevent its depreciation, as emerging market nations experiencing liquidity stresses and foreign currency turmoil are sometimes wont to do. This toleration of 'exchange rate flexibility' is a huge positive. Furthermore, despite all the criticism Erdogan's eccentric views on interest rates have garnered, as well as some of his recent appointments, both the stated economic policy goals of Turkey, as well as what they have actually implemented to date (rather than merely talked about), actually conform much more closely to orthodoxy than the impression the popular press would have one believe.

Conclusion - so what now?

A recession is probably coming in Turkey, and a crisis is also far from impossible. But despite the unequivocation being expressed by markets, the truth is that neither outcome is assured - particularly the latter. Markets have predicted 9 out of the last 4 recessions, so the saying goes, and false alarms are common. With that said, Turkey's imbalances are particularly high; its policy response unpredictable; and the Fed is also tightening liquidity, so disaster is certainly possible. Events are also somewhat path dependent. It therefore remains to be seen how things play out, and like most complex phenomena/systems, defies hard predictions.

So is this a buying opportunity? In my opinion, yes, even though we don't yet know what the outcome will be and significant losses are quite possible, because in my opinion the probabilities are being mispriced on account of an excessively one-sided narrative. When people are only focusing on the negatives, the probability of investors/commentators being positively surprised is significantly greater. Given the sentiment extremes that currently prevail, it likely will not take much for the lira to recover 10-20% - even a 100bp central bank hike at this point might well do the trick. You would have to imagine that they will be seriously considering implementing at least a token hike at present given the events of the past few days. And even if they don't, significant real currency depreciation will likely shrink the current account deficit anyway, which will facilitate greater currency stability.

There are a lot of well managed companies in Turkey, including several well-run banks, and there is a good chance many of them not only survive, but actually thrive in coming years. I have been accumulating shares in Turkiye Garanti Bankasi, KC Holdings, and Turkcell, in recent sessions, and have a combined portfolio exposure to Turkey of about 2.5-3.0% at present.


Disclaimer: None of the above should be construed as investment advice or an investment recommendation. Please do your own research and consult your financial adviser before taking any investment action.