Turkey’s recent debt rating cuts are stoking fears of the potential for a hard landing due to a depreciating lira, a private credit boom, and rising inflation.
In an exclusive interview with Bloomberg, Turkey’s President Recep Tayyip Erdogan issued an ominous warning by stating that he intends to tighten his grip on the country’s monetary policy, if he were to win the upcoming 24 June snap elections.
“When the people fall into difficulties because of monetary policies, who are they going to hold accountable? They’ll hold the president accountable. Since they’ll ask the president about it, we have to give off the image of a president who is influential on monetary policies. That may make some uncomfortable. But we have to do it” The president said.
The comments sent the country’s embattled currency, the lira, plunging to a record low against the dollar, with bond yields the highest in eight years.
Ever since the country’s failed coup attempt last year, Erdogan has clamped down on state banks, calling them to cut interest rates in an attempt to catalyse the country’s growth.
This push has seen a credit boom with bank loans growing double digits, paired with macro headwinds against the country’s economy such as rising commodity prices and increasing interest rates.
In light of a “deteriorating inflation outlook” and “long-term depreciation and volatility” of the country’s exchange rate, Standard & Poor’s slashed its sovereign debt rating on Turkey moving the country’s rating one notch lower to highly speculative territory from “BB/B,” to “BB-/B.”
The downgrade could have a severe impact on Turkey’s ability to raise capital in the markets. Now investors view the country as a riskier play. As the country’s credit rating moves closer to junk territory, countries have fewer options to rescue the economy, and investors demand higher risk premium in return.
This latest surprise ratings cut comes months after rival ratings agency, Fitch shuttered its Istanbul outpost citing a “desire to maintain an optimal office network structure and sufficient level of resources in each geographic location in which it operates.”
But, according to The Hurriyet, the most likely reason behind the shuttering was likely a result of the country quickly pivoting away from EU values of separation of powers and freedom of expression.
A freedom of expression that Fitch deemed necessary to write impartial country reports of which country credit ratings actions are based off of.
In the face of a plummeting lira, inflation has been steadily increasing month-on-month, with April’s inflation rate clocking in at 10.85%. The spike in inflation coincided with significant price hikes in consumer discretionary goods, namely clothing, footwear and household furnishings.
By not increasing rates, whilst clamping down on the country’s inflation, Turkey’s current account losses have widened and thus driving the lira to record lows in recent weeks.
Its central bank is in a difficult position – it needs to tighten, but how can it? With Erdogan holding rallies to celebrate his hawkish position against interest rates, inflation will likely to be a pressing issue going forward.
Alnus Yatirim, Istanbul-based broker, noted in a client briefing: “God help Turkey. We’re faced with a central bank that is watching the market when it needs to lead and direct it.”
Bracing for a hard landing
The inflationary pressures have stoked fears of a hard landing. A hard landing precipitates when a country shifts from growth to slow-growth to flat, right before a recession, likely caused when a government intervenes through monetary policy in an attempt to curb inflation.
Multiple instances of hard landings can be seen in the 20th century, namely in Spain as well as recent fears of such an event occurring in China.
Spain’s economy suffered a hard landing, which proved especially challenging to resuscitate during the European debt crisis that hit the region in late 2009. With rising wages outpacing productivity gains as well as inflation exceeding those of other Eurozone countries, the Spanish economy rapidly contracted.
The Spanish government attempted to clamp down on inflation through austerity measures, widespread worker demonstrations manifested throughout the country.
More recently, China’s slowing growth has driven the government to mitigate the risk for the country to experience a hard landing.
With a highly leveraged property market, inefficient capital allocation in state-owned-enterprises and a recent surge in nonperforming loans, Beijing has recently changed course, focusing now on reining in cheap credit and promoting environmentally beneficial policies.
The government has also assiduously tempered the use of financial leverage and curbed the country’s frothy property markets as of late.
Like Spain and China, Turkey’s rising current account deficit coupled with imbalances in the country’s economy, a result of surging inflation and a frothy credit-fuelled market, puts the country at high risk of a hard landing.
The ongoing losses sustained by the Turkish lira coupled with the country’s permanent state of emergency will likely put downward pressure on the lira as well as the export-oriented economy’s sovereign rating in the foreseeable future.