Turkey’s coming default will shake the world

MoneyWeek magazine cover illustration – Erdogan

The emerging market may not seem like a significant player in the global economy, but if it reneges on its debt, that could have huge repercussions. John Stepek reports.

This time last year, MoneyWeek contributor and former fund manager Jonathan Compton warned in these pages that Turkey would be ground zero for the next big wave of sovereign defaults. A year on, that’s looking pretty prescient.

At the time of writing, the Turkish lira had lost around 40% of its value against the US dollar in the year-to-date alone, with the majority of that fall happening in the past week. You can read Jonathan’s view on what happens next at the bottom of this article. Here, I want to look at what’s gone wrong, what the impact could be on your money, and what the threats and potential opportunities are.

What do Turkey’s woes mean for the rest of us?

With an overheating economy and fast-rising inflation, Turkey was an accident waiting to happen, for all the reasons Jonathan outlines below. As Ambrose Evans-Pritchard says in The Daily Telegraph, the catalyst came when President Recep Tayyip Erdogan stopped the central bank raising interest rates; higher rates were needed to stabilise the lira.

This was followed by a spat with the US over Andrew Brunson, an imprisoned American evangelist, which has resulted in sanctions being placed on two Turkish politicians. For a less vulnerable economy, this would not have mattered. But for Turkey, it appears to have been the last straw. With investors fretting over Erdogan’s unwillingness to let the central bank take action to stem inflation, plus the threat of an escalating battle with a Trump-led US, the lira lost all support.

The question is: what does it mean for the rest of the world? If we look at Turkey alone, the answer is “not very much”. We should all certainly sympathise with the Turkish people (they’re facing recession, inflation and probably worsening political repression too), but in economic and investment terms, their country is tiny.

As Andrew Kenningham of Capital Economics points out, Turkey accounts for about 1% of the global economy, and it doesn’t do a huge amount of trade except with its neighbours. The Turkish stockmarket is also internationally insignificant – the UK stockmarket alone is 50 times as big, and only a fifth of Turkish stocks are owned by non-residents, as Kenningham notes.

As for the banking system, some eurozone banks have exposure to Turkey: Spain’s BBVA has a big stake in Turkey’s second-biggest private bank, and the French and Italian banks are next, but they don’t have huge exposure (and the UK has very little). So assuming a normal course of events, any spillover in terms of rising bad debts shouldn’t cripple the financial system (although we’ll revisit that assumption in a moment).

The real problem is the Federal Reserve

One problem is that what’s happening in Turkey is just a symptom of a wider malaise. Turkey is being hit hardest because it’s vulnerable (which in turn is due to bad and deteriorating governance), but it may just be the canary in the coalmine. As John Authers points out in the Financial Times, we’ve seen this panic before. In May 2013 the Federal Reserve in the US signalled that it would begin the process of “tapering” quantitative easing (QE), buying fewer and fewer bonds as the months went by, until the Fed had stopped injecting new money into markets altogether.

The market panicked, understandably given the impact QE had on the way up. The first markets to feel the pain were those emerging-market countries with high current-account deficits. The main problem with a high current-account deficit is that it means you are reliant on foreign money to prop up your economy. This foreign money is often “hot” – that is, fickle. So if you are an investor in one of these countries, it makes sense to panic first and ask questions later.

As a result, Turkey, Brazil, Indonesia, India and South Africa (the “fragile five”, as they were nicknamed) all saw their currencies slide against the US dollar. The same is happening today – fears about Turkey have infected the same group of countries. We’ve also seen jitters elsewhere. Italian government debt is showing mild signs of stress – it’s become more expensive for Italy’s government to borrow money, particularly relative to a “safe” country such as Germany. In short, investors are becoming more risk-averse as global monetary policy tightens.

The worst-case scenario

So it’s a worry, but containable? Maybe. However, there is a much bigger risk, notes Russell Napier – one of MoneyWeek’s favourite analysts and one of the very few to see this coming. Turkey might be able to repay its debts (at the price of bearing some economic pain) – but will it choose to do so?

Writing on his research platform Eric, he notes: “In a world of discount rates and cash flows, the ability to pay and the willingness to pay are the same thing… Yet history is littered with numerous examples of those who could pay but have chosen not to”, simply because the political and social cost is too high. And Turkey might well fall into the latter category, particularly given Erdogan’s attitude towards foreign investors (he has referred to them as “like the loan sharks who enslaved the Ottoman Empire”, notes Napier).

“For a country with large foreign-currency debt,” continues Napier, “in particular, a mass sale of local assets to foreigners or a crushing recession delivering a major current-account surplus are the only ways to repay excessive levels of such debt. These two options are rarely compatible with re-election for politicians and are seen by the populace as sacrificing local livelihoods for the benefit of foreign financial predators.”

As a result, Napier reckons that Turkey will impose capital controls, which in turn could result in an effective default on around “$500bn of credit assets held by the global financial system”. This would “almost certainly be the largest emerging-market default of all time”.

In turn, this would force investors to price in a major new risk to emerging markets across the globe, particularly those with large levels of foreign-denominated debt. “A major and rapid re-evaluation of emerging-market risk is now on the cards with negative impacts for… exchange rates and asset prices and, ultimately, through a higher cost of capital, global growth.” Can this be avoided? It’s now in the realm of politics. As Eoin Treacy points out on FullerTreacyMoney.com, a move to release Brunson “would at least signal Erdogan is willing to make concessions which could aid the currency.” Right now, that doesn’t seem very likely.

How I got it right – and what will happen next

The key to any forecast is never to provide a date so as to improve the odds of being right – perhaps years ahead, writes Jonathan Compton. In June 2017 (see below), I flouted this rule and was unequivocal that Turkey would default on its international debt obligations by the end of 2018, a forecast that looks increasingly probable. Luck, or a stopped clock being right twice a day? A bit of both for sure. Yet there were, and remain, four clear reasons why this had to happen, and why it is likely to end in Turkey’s economic collapse.

MoneyWeek magazine cover 850First, then prime minister, now president, Erdogan had made many speeches in which he attacked foreign lenders and their interest rates as immoral and evil and he threatened not to repay Turkey’s debts. The only observer to note the importance of this was Russell Napier – see above.

Next, as Erdogan accumulated power, so he morphed from elected populist into vote-fixing despot. He removed any competent official who questioned his policies from the central bank, Treasury, army and judiciary, replacing them with incompetent placemen. With a court of “yes-men”, it was inevitable that he would try to hold back economic tides – such as interest-rate shifts – that did not suit him.

Early in 2017 it became clear that the economy was overheating badly – but with elections looming, he poured petrol onto the economic fire to provide an illusion of prosperity. This exacerbated the fourth and key problem, mismatched debt. The boom was built on a borrowing binge in dollars by local companies rather than Turkish lira because domestic interest rates were much higher. This can work for a while, provided the exchange rate remains stable and the budget and current-account deficits modest. But both exploded, ensuring the lira had to fall, making foreign debt hugely costly. This was a disaster waiting to happen.

There are strong clues as to what happens next. Erdogan has near absolute power, is xenophobic, paranoid and essentially anti-capitalist. He also hero worships the strong leaders of the once-impressive Ottoman Empire. So my guess is he decrees either a moratorium on repaying foreign debts; or a “haircut” (say 50 cents in the dollar); or even the repayment of dollar loans in Turkish lira at the current exchange rate.

He cannot be seen to back down nor be at fault, so the anti-foreigner speeches ratchet up. Alleged alternatives such as help from Russia (which would love to have control over the Bosphorus) can only work for a short period. Turkey therefore has to default, again. Almost all advanced countries (save Switzerland) have done this in the past, many more than once (although it may not be called a default because of a legal quirk that means default can often only be declared by lenders, not by the borrower).

The economy will shrink dramatically; thereafter who knows? But internationally, three results are probable. First, markets panic and dump bonds from countries whose corporate sectors are over-borrowed in foreign currencies – China, Hungary and South Korea, for example. Secondly, there is a scramble to buy US dollars, to reduce foreign borrowing or merely out of fear, putting even more stress on mismatched borrowers.

Lastly, the banks. As Turkish repayments cease, the global financial system suddenly discovers a giant financial black hole: as Napier notes above, between $450bn and $550bn of seemingly safe, liquid assets vanish, shredding the equity bases of several Italian, French, Spanish and other banks. The entire high-yield/junk-bond market ratchets lower, creating further stresses.

So Turkey may be the trigger that makes markets realise the days of easy borrowing and cheap money are coming to an end. That’s my prediction – but this time I’m not giving a date.