How the lira selloff compares to Turkey’s previous crises

Although Turkey’s lira rebounded somewhat on Tuesday, investors say the crisis is far from over, leading them to look to some of the country’s previous crises to assess the outlook for both the economy and the currency.

And the conclusion is grim.

The lira USDTRY, -5.5210%  has dropped more than 40% against the U.S. dollar so far this year, according to FactSet data. Over the past 12 months, it has plunged more than 45% versus the greenback.

That’s not dissimilar to the selloffs seen during Turkey’s 1994 crisis, when the lira plunged 60%, or its 2001 tumult, which triggered a 70% drop in the currency, said Win Thin, global head of EM currency strategy at Brown Brothers Harriman.

Two other Turkish crises in 25 years

The 1994 crisis came on the coattails of heavy borrowing abroad by commercial banks, a budget deficit of 10% of GDP, a central bank that printed money to fund the government’s red ink, high inflation, an overvalued exchange rate and a growing current-account deficit. Currency-market interventions and interest-rate hikes in 1993 didn’t squelch the flight of capital. The lira sold off some 60% against the dollar in 1994, Thin said, while inflation hit 100% and the economy contracted by 5%.

With the help of a program set up by the International Monetary Fund that included government spending cuts, higher administered prices, tax hikes and privatizations of state-owned businesses, the economy bounced back quickly in the mid- to late-1990s.

Ahead of 2001, Turkey was getting assistance from the IMF, and Ankara had opted to use a crawling peg for the lira that was tied to a combination of the dollar and the euro. Turkey’s banking system had been deregulated without much oversight, leading to systemic weakness as banks were highly reliant on foreign funds and therefore more exposed to currency risk, which ultimately led to a system-wide liquidity crisis.

The crawling peg broke in 2001 and the lira plunged some 70%, as inflation spiked and banks failed, Thin said. Turkey’s financial regulatory body improved regulations, restructured state banks and strengthened private banks in response. The government entered into a voluntary debt swap in 2001, and Turkish corporate borrowers did the same a year later.

In 2002, current President Recep Tayyip Erdogan’s AKP party came to power.

Looking ahead

So what has changed since those crises? Has Turkey learned valuable lessons, and are the crises comparable so investors may have a better idea of what may comes next this time?

“The biggest difference is the lira is no longer pegged,” said Thin. “We have always felt that a floating exchange rate acts like a shock absorber.”

That is, a fast and large market-driven devaluation like the one the lira has experienced of late is painful, but a broken peg is worse. “Even if the lira goes on to weaken further, the stepwise nature does give domestic agents some time to adjust.”

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That’s where the good news seem to end.

“With regards to the bad news, the economy is in danger of a hard landing,” said Thin, pointing at the 5% GDP contraction after the 1994 crisis and the 5.9% reversal after 2001.

“As such, we see rising risks of a deep recession in 2019. Bank loans are likely to contact and nonperforming loans are likely to spike,” he added.

Given this, there are plenty of reasons for the lira to remain weak, making it harder for those who borrowed in foreign currency to pay their debts.

That could be a concern for lenders outside the country. In particular, European Central Bank regulators were said to be concerned about the exposure of Spain’s BBVA, Italy’s UniCredit and France’s BNP Paribas to lira weakness.

Turkey’s inflation stood at 15.8% on the year in July, its highest level since October 2003 and above its central bank’s target range of 3%-7%. This could get worse, if the past crises are an indication. Consumer prices skyrocketed 106% in 1994, and surged 54.4% in 2001.

On the plus side, both recent crises saw a subsequent improvement in external accounts.

But here’s what’s different since its last troubles: “Turkey’s external debt metrics are much worse now than they were in either 1994 or 2001,” Thin said.

“External debt as a share of both GDP and exports is higher now, as is the ratio of short-term external debt to foreign reserves,” Thin said. “By any metric, Turkey’s external vulnerability is at an all-time high.”

And while the Turkish government still has access to foreign currency to deal with its external debt burden, it is getting more and more expensive for Turkish companies to do the same.

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