By Frances Coppola
The Turkish lira’s dollar exchange rate fell precipitously in August 2018, reaching a historic low of 0.14 lira to 1 dollar.1 Many thought that Turkey’s currency crisis might spill over to other developing countries,2 but no other major developing country except Argentina suffered a currency collapse on that scale.3 The strong dollar may have triggered the lira’s fall, but the crisis had its roots in Turkey’s own economy. What were the economic characteristics that made Turkey’s currency so vulnerable?
In 2017, Turkey’s economy was growing strongly and its fiscal position was sound, with a primary government deficit of 1.5 percent of GDP and debt-to-GDP ratio of 28.5 percent.4 However, as noted in an April 2018 report by the International Monetary Fund, the country’s fast growth had resulted in growing private sector indebtedness, a widening current account deficit, and rising inflation. This combination increased Turkey’s vulnerability to a foreign exchange crisis.5
Part of the problem is corporate debt. In June 2018, Turkey’s corporate debt denominated in foreign currency stood at nearly $332 billion, less than a third of which was backed by FX-denominated assets. This created an FX financing gap of more than $200 billion, about a quarter of Turkey’s GDP. While the lira’s exchange rate remained stable, companies could fund their FX debt service obligations and refinance maturing debt by exchanging lira for dollars. But once the lira’s dollar exchange rate started to collapse, obtaining dollars became increasingly expensive, causing distress among indebted companies. “There will be a lot of quiet restructurings,” says Brad Setser of the Council on Foreign Relations, “and probably a few noisy defaults.”6
Turkey’s high corporate debt has caused problems before. In the winter of 2016/17, the lira fell by 8 percent, again partly due to a rising U.S. dollar. Highly indebted companies struggled to refinance their debts, disrupting international supply chains. However, the lira’s weakness proved short-lived, and the Turkish economy rebounded in 2017, reaching a GDP growth rate of 7 percent.7 It’s possible that it might rebound this time, too, although the lira’s exchange rate has fallen by considerably more than in 2016/17.
The lira’s fall has brought one benefit: Turkey’s current account deficit is narrowing sharply, according to the country’s central bank.8 Although this narrowing might be painful for Turkey’s businesses and their customers, it reduces the risk of a disastrous “sudden stop,” in which capital flees the country, rapidly draining FX reserves and causing widespread bank, corporate, and household defaults and bankruptcies.
But corporate debt may not be Turkey’s main problem. Many analysts think the real problem is the FX risk in the country’s banking sector. “The banks are the main reason why Turkey's currency crisis could morph into a funding crisis, one that leaves Turkey without sufficient reserves to avoid a major default,” CFR’s Setser says.9
It appears that Turkish banks have, for some years now, been funding a household credit boom by borrowing in dollars and euros and then swapping them for lira. In Turkey, banks are not allowed to provide foreign currency mortgages to households, so the FX risk from cross-currency funding of long-term real estate lending remains with the banks. As a result, the banks have large foreign currency liabilities on their balance sheets that are backed by assets denominated in lira. When the lira’s dollar exchange rate falls, the dollar value of those assets also falls, which threatens the banks’ solvency. To make matters worse, their capital buffers (“capital” for a bank equals assets minus liabilities, and for a solvent bank it is always positive) are also denominated in lira, so capital shrinks in dollar terms as the lira’s dollar exchange rate falls. This double whammy means that a large and sustained fall in the lira’s exchange rate can threaten the solvency of Turkey’s banks.10
But why have Turkish banks been funding in dollars and euros? The reason is that very low interest rates in the U.S. and Europe have made it worth their while. In effect, banks have been running a very large and persistent carry trade, with dollars and euros as the funding currencies and lira as the lending currency. The Turkish central bank has encouraged this carry trade by allowing banks to meet their reserve requirements by depositing foreign currencies at the central bank. This has helped Turkey increase its FX reserves, but it has also enabled the banks to lend more lira.11
This situation creates three problems. First, Turkish banks will need to refinance their foreign currency debt, and they may have difficulty doing that if the lira’s exchange rate is low. Refinancing syndicated loans can be particularly problematic, since they involve other banks. Some experts think that European banks whose bond yields have fallen due to fears of contagion from Turkey might be reluctant to refinance Turkish foreign-currency syndicated loans.12
Second, worries about the ability of Turkey’s banks to service their FX debts could prompt depositors to remove foreign currency deposits. In August 2018, prompted by the lira’s exchange rate fall, $12 billion of dollar deposits left the Turkish banking system.13 If this flight were to happen again, Turkey could simply run out of dollars. Turkey’s FX reserves are small by international standards and, therefore, do not provide much of a buffer against a bank run.14
Finally, swaps the banks use to exchange dollars for lira typically have much shorter maturity dates than the lira loans they make to households, which means they must be rolled over or refinanced more frequently. When interest rates rise, therefore, banks’ funding costs can increase faster than the interest rates on loans to households, squeezing bank profits.15
The ratings agency Fitch has downgraded the credit ratings of 20 Turkish banks because lira exchange rate depreciation, high interest rates, and a slowing Turkish economy weaken their asset base and raise the risk of insolvency. Fitch’s outlook for the Turkish banking sector is “negative,” reflecting its view that the risk of local financial crisis is rising.16 Few analysts think that a financial crisis in Turkey would spill over to other developing countries, but some warn that there could be difficulties for banks in Europe that are exposed to Turkish bank debt.17
Turkey’s FX reserves shrank considerably in August 2018 due to the foreign currency deposit run triggered by the lira’s exchange rate collapse.18 Shrinking FX reserves are themselves a risk factor for a currency crisis, because the lower the FX reserves, the more likely it is that the country will run out of dollars. So in September 2018, the central bank acted to stabilize the lira. Citing rising inflation, it raised interest rates to 24 percent.19
This was a risky strategy. Such high interest rates may cause liquidity problems for banks because short-term lira funding will be much more expensive. High interest rates may also make lira credit scarcer and more expensive, which could reduce domestic demand, leading to slower growth and possibly even a recession. Some analysts argued that raising interest rates was the wrong medicine for Turkey.20 However, after the interest rate rise, the foreign currency deposit run stopped and the lira’s exchange rate stabilized.21
Although the lira’s precipitous exchange rate fall in August 2018 was triggered by a strong dollar exchange rate, the root cause was the imbalance in Turkey’s own economy. High corporate debt in foreign currencies raises the risk of private sector defaults when the exchange rate falls, while FX risk in the banking sector due to funding in dollars and lending in lira creates the possibility of a foreign currency bank run. Raising interest rates to stabilize the exchange rate helped to ward off an FX crisis and restore international business confidence – at least temporarily. But Turkey could still face a banking crisis and economic recession.
With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. “TRYUSD,” Bloomberg; https://www.bloomberg.com/quote/TRYUSD:CUR
2. “Turkey tantrum? Investors fret over contagion from lira plunge,” Reuters; https://www.reuters.com/article/us-turkey-markets-contagion/turkey-tantrum-investors-fret-over-contagion-from-lira-plunge-idUSKBN1L00YJ
3. “2018 performance of emerging-market currencies versus US Dollar,” The Atlas; https://www.theatlas.com/charts/HJmnMweJQ
4. “Turkey: 2018 Article IV Consultation,” International Monetary Fund: https://www.imf.org/en/Publications/CR/Issues/2018/04/30/Turkey-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-45822
6. “Framing Turkey’s Financial Vulnerabilities: Some Rhymes With The Asian Crisis, But Not A Repeat,” Council on Foreign Relations; https://www.cfr.org/blog/framing-turkeys-financial-vulnerabilites-some-rhymes-asian-crisis-not-repeat
7. “Turkey: 2018 Article IV Consultation,” IMF; https://www.imf.org/en/Publications/CR/Issues/2018/04/30/Turkey-2018-Article-IV-Consultation-Press-Release-Staff-Report-and-Statement-by-the-45822
8. “Balance of Payments Statistics,” TCMB; http://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Statistics/Balance+of+Payments+and+Related+Statistics/Balance+of+Payments+Statisticss/
9. “Framing Turkey’s Financial Vulnerabilities: Some Rhymes With The Asian Crisis, But Not A Repeat,” CFR; https://www.cfr.org/blog/framing-turkeys-financial-vulnerabilites-some-rhymes-asian-crisis-not-repeat
12. “Short selling Turkey no longer a money-spinner,” Financial Times; https://www.ft.com/content/f223e784-b4c0-11e8-bbc3-ccd7de085ffe
13. “International Reserves/Foreign Currency Liquidity,” TCMB; http://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Statistics/Balance+of+Payments+and+Related+Statistics/International+Reserves-Foreign+Currency+Liquidity/
14. “Assessing Reserve Adequacy – ARA (May 2018) – Ratio of Reserve/ARA Metric,” IMF; https://www.imf.org/external/datamapper/Reserves_ARA@ARA/CHN/IND/BRA/RUS/ZAF
15. “Framing Turkey’s Financial Vulnerabilities: Some Rhymes With The Asian Crisis, But Not A Repeat,” CFR; https://www.cfr.org/blog/framing-turkeys-financial-vulnerabilites-some-rhymes-asian-crisis-not-repeat
16. “Fitch Downgrades 20 Turkish Banks, Outlook Negative,” Fitch Ratings; https://www.fitchratings.com/site/re/10046735
17. “ECB Concerns Grow Over EU Banks’ Turkey Exposure as Lira Slides,” Financial Times; https://www.ft.com/content/51311230-9be7-11e8-9702-5946bae86e6d
18. “International Reserves/Foreign Currency Liquidity,” TCMB; http://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Statistics/Balance+of+Payments+and+Related+Statistics/International+Reserves-Foreign+Currency+Liquidity/
19. “Press Release on Summary of the Monetary Policy Committee Meeting (2018-41),” TCMB; http://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Announcements/Press+Releases/2018/ANO2018-41
20. “Turkey’s economy doesn’t need higher interest rates,” FT Alphaville; https://ftalphaville.ft.com/2018/09/10/1536568138000/Turkey-s-economy-doesn-t-need-higher-interest-rates-/
21. “TRYUSD,” Bloomberg; https://www.bloomberg.com/quote/TRYUSD:CUR