Rebalancing at a Higher Level: No backstop risks a lead up to higher fx prices and higher interest rates alike.

Value of the Turkish Lira is a conundrum for most. Price expectations are all over the map but there is scarce reasoning behind. Neither Central Bank’s 625 bps hike nor the New Economic Program has provided enough clarity to form a consensus.

Let me propose a very simple test case to shed some light on what might happen next.

• All fx debt principal is rolled over at 1x.
• All fx debt interest is paid on time with around 300 bps increase in annual cost for the next year.
• No net change in short term inflows.
• Current Account Deficit, adjusted by adding net others, ends up around USD 20 billion for 2019.

Under this scenario, there will be an USD 20 billion demand by those who have to pay in fx and assuming the Central Bank does not provide this amount (from its USD 29 billion net reserve), the price at which locals sell their fx of this amount will determine the equilibrium USD price. Note that these locals have around USD 153 billion fx deposits.

I think that the high nominal cost of TL interest rates discourages speculative positions in absence of an external shock. Conversely, the conditions that require this high cost which can be summarized as lack of confidence leads to a stop in short term financial flows. The art of prediction will be to ascertain if the local, regional, global interplay of political and economical factors produce game changing positive / negative surprises.

A full rollover on the other hand is harder to achieve. Where short term inflows cease, longer term flows feeding on similar risk factors will be affected as well. Consequently, a less than 100% rollover is a risk to consider. 80% expectation might be more realistic and would imply a total local fx need of USD 50 billions or more.

On a pure pricing perspective, local sourcing for this amount is possible. However, the price impact could be severe if this year is an example. Even with full rollover, above inflation pricing is more likely without short term inflows.

If the current political landscape was different, a deep and rapid recession could have been expected. Resulting multi year correction coupled with both higher fx prices and higher real interest rates would act as stabilizers. Meanwhile structural economic reforms would promote a more globally competitive business model and inclusive political reforms would bolster legitimacy and widespread political participation. As the current balance of power is expected to prevail, the above series of events will not cumulatively take place and the resolution of the problems will happen under present political leadership’s policy preferences.

Since policy framework is not as comprehensive as suggested above, policymaker recession tolerance is low and global conditions are moderately unsupportive; even with a full rollover scenario, locals could demand significantly higher fx prices and consequently higher interest rates to cover the current account deficit plus the potential rollover gap. Without an external IMF-like backstop, rebalancing will eventualy take place but on a higher plateau for all the metrics.

September 2018