Too little, too late?

By Don Quijones, Spain, UK, & Mexico, editor at WOLF STREET.

Desperation is rising in Turkey’s banking sector following months of escalating political and financial instability. Benchmark interest rates have been hiked 10 percentage points so far this year to over 17%, making it much more expensive for companies and families to service their debt. But even that hasn’t stopped the Turkish Lira from plunging almost 25% since March.

“Turkey is going through its first currency crisis of the floating era,” explained Dani Rodik, a Turkish economist and professor at Harvard University. “All the previous ones were when the rate was fixed or managed, and hence unfolded much more quickly. This one is stretched over time, and the government prefers to ignore it.”

The latest spark of concern was the U.S. government’s decision at the weekend to declare sanctions against two Turkish cabinet ministers over the detention of an American pastor. The Trump administration said it was also reviewing Turkey’s duty-free access to the U.S. market, which could affect $1.7 billion of Turkish exports. Bloomberg reported that the US has prepared a broader list of Turkish entities and individuals that could be subject to further sanctions.

On Monday the Lira shed 5.5% of its value to a record low of 5.46 against the dollar, before recovering slightly following intervention from the Bank of Turkey. The central bank changed its rules to loosen the upper limit of banks’ reserve requirements in a desperate bid to support the crumbling currency. The bank announced it was reducing the maximum amount of foreign currency lenders can park at the regulator as part of their required reserves.

The move will provide lenders with an additional $2.2 billion of funds, the bank said. But that pales in comparison with the money lenders are losing as a result of the plunging currency, capital flight, rising inflation — now at 16%, its highest level since 2004 — and surging non-performing loans.

Highly leveraged companies currently face a potent cocktail of soaring borrowing costs and a plunging Lira. As the local currency weakens against the dollar and the euro, it gets harder and harder for local companies to service foreign currency bonds. That’s how a currency crisis becomes a debt crisis.

Turkish companies are sitting on $337 billion in debt. With as much as $100 billion in debt scheduled to come due over the course of the next year, Turkish banks are under growing pressure to restructure foreign-currency denominated corporate loans as those companies struggle to service them.

The banks have proposed rules to accelerate the restructuring of company debt and allow lenders to avoid booking these loans as “non-performing loans,” a move that may help prevent defaults from piling up. As has happened in Italy since Europe’s sovereign debt crisis, the banks will try to extend loans indefinitely in order to avoid gaping holes developing on their balance sheets.

But it may already be too late. The downgrades, both sovereign and corporate, are coming thick and fast. On July 20, Fitch Ratings downgraded the Long-Term Foreign Currency Issuer Default Ratings (LTFC IDRs) of 24 Turkish banks and their subsidiaries, in many cases by two notches. The agency also slashed Turkey’s sovereign rating deeper into junk territory, downgrading its Long-Term Foreign-Currency Issuer Default Rating (IDR) to ‘BB’ from ‘BB+’ with a negative outlook. Moody’s also downgraded the ratings of 17 banks in July.

These downgrades will make it even more costly for Turkish banks and the Turkish government to raise funds, with the yield on Turkey’s benchmark 10-year bond soaring to an eye-watering 19% on Tuesday. Many investors, already concerned about President Recep Tayyip Erdogan’s growing influence over economic and monetary policy in Turkey, are now even more leery about investing in the country.

If investors continue to ditch the lira, it will get even harder for corporations to repay their large stacks of dollar-denominated debt, further worrying investors about the state of the nation’s economy and giving them another reason to dump the currency. Also, the more the Lira weakens, the more difficult it will become for Turkey to finance its bloated current account deficit.

Erdogan is likely to double down on his high-risk economic policy, which involves pressuring Turkey’s already struggling banks to increase their lending into a dangerously over-heating economy while refusing to allow Turkey’s central bank to raise its policy rate in order to cool down the economy and shore up the plunging Lira. If Erdogan continues along this path toward total dominance over Turkey’s economy while systematically destroying its currency, there is a very real danger that Turkey could enter structural default, warns Saxo Bank’s head of FX strategy, John Hardy.

While Turkey’s economy is not big enough to cause a global crisis of its own making, it is big enough and connected enough to set off contagion effects in other places, including other struggling emerging economies, as well as banks in France, Spain, Italy, the U.S. and the UK, whose exposure to Turkey’s banking system is particularly pronounced. By Don Quijones

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