Don't Mess with Turkey

Doug Nolan

July 20 – Financial Times (Eric Platt): “The Turkish lira weakened a new record low against the greenback on Wednesday after the country was cut deeper into junk territory by Standard & Poor’s, with analysts warning Ankara faced unpredictable capital flows that could constrain its levered economy following last week’s failed coup attempt… The rating agency also lowered its opinion of Turkey’s local currency debt one notch to double-B plus, sweeping its lira obligations into junk as well. ‘In the aftermath of the failed coup, we believe that the risks to Turkey’s ability to roll over its external debt have increased,’ said Trevor Cullinan, an analyst with S&P. ‘We expect that given the political uncertainty, Turkey’s policymakers will likely stray from their commitment to enact reforms intended to wean the economy away from its dependence on foreign financing.’ Mr Cullinan said he expected Turkey would have to roll over more than two-fifths of its external debt over the next 12 months, worth roughly $177bn.”

July 20 – JNiMedia: “Erdogan blasted Standard & Poor’s downgrading of Turkey’s rating in the wake of the failed coup. ‘Why are you even interested in Turkey? We’re not part of you… Don’t ever try to mess with us,’ he said.”

Perhaps Standard & Poor’s and fellow rating agencies share keen interest because Turkey and Turkish corporations and financial institutions have over recent year been assertive borrowers in international markets. For the past decade, President Erdogan has championed Turkish economic renaissance, a powerful boom that has been fundamental to his popularity and ascending political power. Unfortunately, it morphed into a Credit-fueled Bubble, with all the associated financial, economic and social consequences. Turkish consumer debt has skyrocketed, fueled by aggressive bank lending. Meanwhile, Turkey’s financial institutions have borrowed aggressively in global inter-bank markets, with much of this debt short-term and denominated in foreign currencies.

The Turkish Credit Bubble gained important momentum as part of the post-2008 global EM funding boom. Estimates have as much as $300 billion having flowed into Turkey over recent years, inflows that accelerated with the 2013 sovereign rating upgrade to investment grade. As a NATO member, aspiring EU nation and key ally in the explosive Middle East, Turkey benefited greatly from the view that Europe, the U.S. and the world, more generally, would not tolerate crisis engulfing Turkey.

Erdogan and his AKP party have been huge beneficiaries of the global funding boom, both financially and politically. Now, with the tide having turned, previous bedfellows - the rating agencies and global finance - will be pilloried and villainized for political advantage. To be sure, they’re a precarious mix of C’s – coups, crackdowns, crackpots, Credit and confidence. It’s worth noting that the domestic purge has expanded past university deans to school teachers to to bank regulators.

Turkish stocks dropped 13.4% this week, the “worst week since 2008.” Turkish bank stocks were down 5% on Thursday’s debt downgrade, as sovereign yields surged 26 bps (from Bloomberg). For the week, Turkish sovereign CDS jumped 66 bps to 336 bps (from Reuters). Turkey’s lira declined 1.7% to another record low. In any other environment, Turkey would be facing a crisis of confidence along with a major test for its currency and banking system.

July 21 – Bloomberg (Ercan Ersoy): “Turkey’s failed coup is dealing yet another blow to the nation’s banks, which are already under pressure from rising bad debts and a slump in tourism. Istanbul-based lenders Yapi ve Kredi Bankasi AS and Sekerbank TAS canceled about $800 million of debt sales this week after the attempt to unseat President Recep Tayyip Erdogan and the ensuing political unrest spooked investors… The renewed tension in Turkey, which imposed a three-month state of emergency last night, is hampering access to the funding banks need to cover their short-term debt, while a slumping lira is increasing the risks of lending in foreign currency. The political instability has made a difficult year worse for banks as they contend with a 33% surge in bad loans and soaring bankruptcy filings. ‘Funding for Turkish banks could become more expensive, or even more difficult to access, given their large dependence on market funds and their exposure to the foreign-exchange market in a context where the local currency could be under pressure,’ Moody’s… said…”

July 21 – Fitch Ratings: “Turkish banks' dependence on foreign market access results from their high level of short-term external debt. We see the level of foreign-currency liquidity at Fitch-rated banks as generally adequate and broadly sufficient to cover short-term foreign-currency liabilities due within one year. However, any significant weakening in creditor sentiment, resulting in net capital outflows, would be likely to put banks' FX liquidity under some pressure, and would also probably result in further depreciation of the lira. At end-1Q16, banks accounted for $170 billion of Turkey's $416 billion external debt, with $100 billion of this (including both market funding and more stable sources) maturing within 12 months. The sharp drop in the lira following the attempted coup highlights the banking sector's exposure to foreign-currency lending risks, with FX-denominated loans making up around a third of the total sector portfolio.”

More from Bloomberg (Ercan Ersoy): ‘Downside risks for Turkish banks’ credit profiles and ratings have increased as a result of the country’s attempted military coup,’ Fitch… said. ‘Turkish banks’ credit profiles are sensitive to country risks, access to foreign credit markets and the lira exchange rate.’ Banks accounted for $170 billion of Turkey’s $416 billion external debt in the first quarter, with $100 billion maturing within a year, according to Fitch.”

The unfolding EM debacle is one of the saddest consequences arising from the U.S. mortgage finance Bubble - turned reflationary QE before transforming into the global government finance Bubble. Throws Trillions of loose finance at the emerging markets and rest assured there will be epic corruption, economic maladjustment and destabilizing social and geopolitical stress. As for corruption and malfeasance, China, Brazil, Russia, Turkey and Malaysia come quickly to mind. Yet it’s systemic, the upshot of what has become a hopelessly dysfunctional global system. Indeed, EM these days has regressed into one big highly synchronized and vacillating Bubble. That EM could now somehow be experiencing record inflows in the face of such financial, economic and social instability is remarkable. There is precedent.

Apparently unappreciated by contemporary central bankers, over-liquefied and speculative markets are by their nature mystifying. They will confound – and seem to revel in doing the exact opposite of what is expected. Bubble markets will undoubtedly behave in a manner that guarantee that the most damage is inflicted upon the largest number of participants. I was in awe as “money” flooded into GSE debt and MBS following the subprime eruption in 2007. The Bubble had been pierced, with Trillions of securities and assets mispriced throughout the markets. Yet speculative impulses and confidence that aggressive monetary stimulus was in the offing ensured prices became only further detached from reality. MBS yields sank 100 bps in the six months preceding early-2008, extending “Terminal Phase” excesses and ensuring risk markets turned highly correlated – and acutely vulnerable.

July 20 – Reuters (Karin Strohecker): “Developing countries have nearly tripled their external debt over the past decade, outpacing economic growth and increases in foreign exchange reserves - which could leave them open in the future to a ‘systemic crisis’, …Moody's said… Emerging market governments and companies around the globe have rushed in recent years to take advantage of rock-bottom global borrowing costs and investor hunger for yield. As a result, external debt jumped to $8.2 trillion in 2015 from $3.0 trillion in 2005, the Moody's report found, thanks largely to private-sector borrowing. The average ratio of external debt to gross domestic product jumped to 54% in 2015 from a decade-low of 40% in 2008. ‘External vulnerability has increased significantly in about 75% of emerging economies globally,’ the authors… wrote. The average ratio of external debt to reserves soared to more than 350% last year from just over 250% in 2007, the report added.”

July 22 – Bloomberg (Alastair Marsh and Siddharth Verma): “Investors are rushing into emerging-market debt so fast they've already beaten the record they set two weeks ago. Net inflows to funds that buy emerging-market bonds reached an all-time high in the week through July 20, according to Bank of America Corp. — $4.9 billion, to be precise. That's over a billion more than the previous record registered only two weeks before, indicating that the "great migration" into the asset class heralded by BlackRock Inc. is rapidly picking up pace… Almost the same amount of money's been poured into EM equity funds as into bonds. The $4.7 billion invested into EM stock markets over the same week amounts to the most in 12 months…”

A powerful short squeeze throughout EM has at this point morphed into self-reinforcing inflows. Recent outperformance has incited the mammoth – and fidgety - trend-following and performance-chasing Crowd. Of course, global QE and zero rates have been instrumental. Moreover, the policy-induced market dislocation that has created $12 Trillion of negative-yielding sovereign debt has unleashed another powerful round of global yield-chasing flows – right in the face of fundamental deterioration. Importantly, EM outperformance has worked to further synchronize global markets into one big highly-correlated speculative melee, a Bubble resting precariously on the simple faith that central banks have it all under control.

Chairman Greenspan used to posit (rationalize) that since real estate markets were a local phenomenon a national real estate Bubble was implausible. I countered that the Bubble was in mortgage finance and that a centralized mortgage finance Bubble was exerting a powerful nationwide inflationary dynamic. “Terminal Phase” excess proved so powerful that a tidal wave of inflationary finance essentially lifted all boats.

These days, a similar dynamic has taken hold on a global basis, across asset classes. It’s a backdrop that continues to wreak havoc upon active fund managers – those more likely to incorporate micro and macro analysis along with risk control. It’s an atypical backdrop that continues to reward passive “management,” unencumbered by analysis and risk management. 

And as “money” floods in to play high-dividend payers, high-yield, low-beta, “defensive”, “smart-beta,” and EM, an inflating market forces short-covering, the unwinding of hedges and capitulation “gotta jump aboard ‘cause I can’t afford to miss the rally” flows. It boils down to one singular speculative bet on “the market.” All-time highs into an alarming, faltering fundamental backdrop? It happened in late-2007. What others label “bull market” I see as market dislocation.

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