Stockwatch: Is Turkey a fully-fledged black swan?

Its impact on global stockmarkets was brief, but Turkey could be a 'canary in the coalmine' and is certainly worth analyst Edmond Jackson discussing whether it warrants a switch out of risk assets. 

The Turkish debt crisis story broke briefly in mid-August, sending stocks momentarily into a down-spin, as if the proverbial black swan had floated into view to threaten global financial stability.  A plunging lira was made worse by the US slapping sanctions on Turkey for detaining an American pastor, and Turkey's President added to a sense of chaos by urging citizens to dump euros/dollars and buy lira.  

Briefly, it appeared this NATO member could drift further into Russia's embrace, its debts spreading contagion akin to the 1997 Asian currency crisis.  Then, no sooner had a 'black swan' arrived than it drifted away, or a more considered view of its feathers suggested they are hardly pure black.  

Media focus shifted to the possibility of President Trump's impeachment, Turkish debt has disappeared off wavelengths and US stocks regained record highs.  Yet it may also reflect short attention spans nowadays, while danger remains.  How serious a problem is Turkey?

Gross example of the $4 trillion global carry trade 

Turkey's woes originate in central banks loosening monetary policy after the 2008 crisis, spurring investors to take more risk, hence boost economic activity, quite like an old-fashioned Keynesian public works programme.  

Investors borrowed cheaply in US dollars and Japanese yen, to buy high-yielding emerging market debt instruments linked to things like infrastructure development, pocketing the difference in a 'carry trade'.   

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Turkey is a relatively extreme example within this $4 trillion tide of capital, its economic boom since 2008 based on foreign capital inflows and ultra-low interest rates which led to rapid credit growth and soaring asset prices. Debt as a percentage of GDP rose from just under 90% in 2008 to about 140% by end-2017. It’s likely much higher now given the lira's halving in value, also with the US dollar edging up as the Federal Reserve raises interest rates.  Societe Generale estimates Turkey has $180 billion of near-term external debt at borrowing costs are 25% higher simply due to lira weakness.

Consumer credit expanded five-fold from 2010, driving 70% of Turkey's economic output, in which context the central bank lifted its benchmark interest rate from 8% to 17.75% last May.  Economists contradict each other on what Turkey should do next: I've read one argue that unless it revitalises stalled credit, then it faces a slump, meanwhile another reckons the risk of wider financial contagion depends whether Turkey "takes its medicine now".  

It's unclear whether a financial bust is already baked in? Doom-mongers note parallels between the 'skyscraper index' of building activity that applied globally e.g. in 1929 and 2007, with Turkey in 2018.  Also, the way Thailand became dependent on foreign credit ahead of the 1997 Asian financial crisis.

Consensus view: Turkey's problems are manageable

Initially, it appears yet another example of a heavily indebted country with a plunging currency, that prompts fears of contagion, but which results in an expensive, globally-financed bailout.  Developing countries like this usually have quite limited trade and financial links, so country-based crises tend to be specific and less likely to contaminate neighbouring nations, with financial risks centred on lenders involved.

Kristin Forbes, an MIT economist who used to be on the Bank of England's monetary policy committee, summed up this view in a TV interview, saying:

"Most countries don't have serious trade or financial exposure to Turkey, and where banks are involved it’s manageable.  General deleveraging since the 2008 crisis has substantially reduced the risk of contagion." 

But she hedged her remarks adding:

"The era of cheap money is ending as central banks raise interest rates, hence there are heightened risks for countries with high current account deficits and reliance on foreign borrowing – such as Turkey, Argentina, South Africa and Indonesia."  

Investors anyway tend to take their guide more from financial deeds than words, e.g. as summarised by market prices, and if credit default swaps (CDS's) are a reliable guide then they presently imply just a one-in-three chance of Turkey defaulting on its debt over the next five years.  It will be interesting to see just how efficient such an indicator proves.

Where Turkey differs, and needs watching

Most national debt crises are dominated by government borrowing but Turkey's credit binge is private commercial and consumer debt.  A new finance minister intends various disciplines - including tighter monetary policy - which in principle is good for mitigating contagion risk, but in practice last May's drastic rate hike may follow through with over-borrowed firms defaulting.  

US investors own nearly 25% of Turkish bonds and over half of Turkish equities, while loans are thought to originate mainly from subsidiaries of European banks.  Altogether they have lent some $150 billion equivalent to Turkey; Spanish banks accounting for about $80 billion thus likely to experience defaults.  

Their alleged get-out is to walk away from local affiliates and write off losses, estimated to involve only about 10% of the banks’ equity, collectively.  Thus, while their shareholders would suffer temporarily, such write-offs are thought not to risk the banks’ solvency or need intervention.

That latter point is especially relevant given the International Monetary Fund would face 'moral hazard' of bailing out the private sector, i.e. endorsing future reckless borrowing/lending anywhere.  

President Erdogan's behaviour is a significant dynamic too.  It comes across as erratic, e.g. his repeated calls for Turks to support the lira and win a "war of independence", which sounds about as futile as Chancellor Lamont fighting speculators in the 1992 sterling crisis.  

It also reflects a deepening row with the US, begging the question whether Turkey's alliances are changing. There have been instances of Turkey getting closer to Russia, which ought not to affect its chances of an IMF bailout, although continued antagonism with the US won't help Turkey economically.

So, quite how this mess will be resolved is an open question.

Canary in the coalmine, of wider debt issues?

The Institute of International Finance estimates corporations have some $5.5 trillion debt globally, based in foreign currencies, though mainly US dollars.  An 'Austrian economics' view of this Roman feast of debt is Turkey being a crucial first main pillar that’s teetering. 

If it does fall, then it is liable to prompt change in investors' risk appetite and liquidity preference, initially towards emerging markets, spreading into developed country stockmarkets – effectively a bursting of asset bubbles that were pumped up since 2008 by cheap credit. Central banks would have few means to cope with another crisis, given interest rates are already very low, other than possibly re-launch QE.  

Obviously, this bearish argument has been rehearsed numerous times, including summertime market jitters back in 2011 that started with fears over the US debt ceiling and morphed by year-end towards eurozone debt; and several times thereafter Greece was allegedly poised to bring down the financial system.  And yet stocks have proved a superior asset class.

Keeping with the ornithological metaphor then, Turkey may have an aspect of "canary in the coalmine", though I don't as yet see it justifying a switch out of risk assets.  Even the private debt element of its crisis could prove containable.  

It's still all a reminder of how central bank actions since 2008 have resulted in distortions and bubbles, able to deflate noisily.  So, pay attention to Turkey this autumn, its uncertainties may yet cause trouble, especially if coinciding with Italy rebuking the eurozone over its own debt crisis. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.