Cold Turkey: Investor Exodus Tests Erdogan’s Economic Experiment

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A board showing foreign currency exchange rates against Turkish lira is on display at a currency exchange office in Istanbul, Turkey, July 25, 2019.
A board showing foreign currency exchange rates against Turkish lira is on display at a currency exchange office in Istanbul, Turkey, July 25, 2019. Credit: Murad Sezer/ REUTERS

A run on the lira proved a pivotal moment for Turkey’s financial markets in 2018, prompting action that has tilted the economy inward and frightened off foreign investors.

President Recep Tayyip Erdogan and his government have said the measures were needed to stabilize the economy and bolster trust in the lira, which has dropped 36% in two years.

But the impact on investment has been dramatic. The World Bank estimates that net foreign direct investment, which fell 30% last year, will not regain 2018 levels until after 2021.

Some analysts say the danger is that this outflow could over time starve the region’s top economy of funds and stall recovery plans.

Former Turkish Treasury research associate Ugras Ulku, who now heads the Institute of International Finance’s regional Emerging Markets research, said “tighter control on financial markets, risks including U.S. sanctions and Turkish borrowers’ inability to access foreign funding” mean the country may miss out on foreign cash.

Overseas investors have largely steered clear of Turkey’s sovereign bonds, while some players are reconsidering their strategies.

A Turkish flag flies at the HSBC headquarters in Istanbul, Turkey, June 9, 2015. Credit: Murad Sezer/ REUTERS

HSBC is considering selling its Turkish bank, sources told Reuters late last month. Citigroup transferred at least two foreign exchange and rates traders to London from Istanbul last year due to the uncertainty, a source said.

Citigroup and HSBC both declined to comment.

The fallout also led to losses for Goldman Sachs and other foreign firms that were burnt in 2019 when Turkey directed its banks to withhold liquidity from a key London swap market to defend the currency, two bankers familiar with trading activity said.

Goldman Sachs declined to comment.

Rate cuts, along with a surge in public spending and a push to get state-owned banks to lend more, have helped Turkey recover from recession. But a rapid uptick in lending in an already indebted economy and a widening budget deficit risk storing up trouble, ratings agencies and economists say. Turkey’s Treasury and its central bank declined to comment. Erdogan’s office was not available to comment.

An effort last year to boost lending by cutting savings interest rates prompted some to keep their spare cash in dollars or euros, according to bankers and central bank data.

State banks have since March tapped up to $32 billion of central bank reserves in buying up lira, a Reuters analysis of the central bank’s balance sheet shows.

The state banks then redeposit lira at the central bank, officials and bankers with knowledge of this loop told Reuters.

An official at one state lender said Turkey’s banks are now staffed by traders at all hours, part of what some call a “national team” ready to respond to any lira weakness.

A merchant counts Turkish lira banknotes at the Grand Bazaar in Istanbul, Turkey, March 29, 2019. Credit: Murad Sezer/ REUTERS

Despite this support, the lira skidded 11% last year, with the biggest slide between March and May, as interventions began.

Last year nonresidents sold a net total of $3.3 billion in Turkish bonds, compared to purchases of $7 billion in 2017, IIF data shows. That means local investors mostly profited as Turkey’s benchmark 10-year yield dropped below 10% from 21% in May.

The foreign flight is partly a response to the government’s approach to markets after a 2017 referendum handed Erdogan wide-ranging authority over the courts, military and economy.

The clearest signal of an intensification of this intervention came days before nationwide local elections in March 2019 that would deal a blow to Erdogan’s party, more than a dozen investors, bankers and Turkish officials told Reuters.

That was when Turkish state lenders cut short-term lira funding to the London swap market, sending rates rocketing to 1,200%.

The move reversed a volatile drop in the currency, but left big European and U.S. banks scrambling to cover positions and sell Turkish bonds, several sources have told Reuters. Goldman Sachs was among the hardest hit, two of them said.

A person familiar with Goldman’s operations said the Wall Street firm had not logged “material” losses. Reuters could not confirm positions in the market, where bilateral trades are made privately.

Since the March episode, foreigners have dumped Turkish debt even while most emerging markets benefited from a global hunt for yield. Data from Turkey’s bank regulator shows they owned only 8.3% of the debt in mid-January, down from nearly 17% in early 2018.

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