Krugman and DeLong Are Right, Eurotimidity Must Be Defeated. Here Is How

Krugman and DeLong Are Right, Eurotimidity Must Be Defeated. Here Is How

photo: Images Money


Key takeaway – In Turkey, a coup attempt failed in less than 12 hours. President Erdoğan has declared that “the government is in control” and he is “not going to compromise”. What is next? Likely, Erdoğan’s popularity will increase, and constitutional changes will lead to a presidential system. Instability will continue, crackdowns on dissent will become the norm and further bloodshed is possible. In the short term, the international community will perceive Erdoğan as an autocrat holding chaos at bay, but in the long term it is likely to disagree on the direction – from democracy to authoritarianism – the country is taking. The economy will suffer, the ongoing decline in foreign direct investment (FDI) will accelerate and the Turkish Lira (TRY) will depreciate, putting additional pressure on inflation. Rating downgrades are likely. Market sentiment is negative (equities will suffer, bond yields rise) and oil prices are likely to increase. In the banking sector, as new loans growth will slow down and credit costs rise, profitability-enhancing reforms are now urgent. Going forward, stability is the key priority.


A. What happened?

In Turkey, an attempt of coup d’état … On July 15, 2016, a faction of the armed forces attempted to overthrow President Recep Tayyip Erdoğan. Clashes broke out in: a) Ankara at the military police command and in parliament; and b) in Istanbul, where the bridges on the Bosphorus were blocked and Atatürk airport was closed. The chief of military staff was taken hostage. The state broadcaster TRT and other privately owned TV channels were taken off air. World leaders called for “calm and democratic order”. President Erdoğan asked his supporters to take to the streets using a livestream video, stating: “I urge the Turkish people to convene at public squares and airports. There is no power higher than the power of the people”. All around the country, mosques called citizens to go out to the street and stand against the coup.

… has failed. On July 16 at 6.30am local time Mr Erdogan told a crowd of supporters in Istanbul: “The government is in control”. By late morning, the Turkish military headquarters were under the government control. By the evening, clashes in Ankara seemed to finally have ceased and Istanbul was under control. So far, five generals and twenty-nine colonels have been removed from their posts, and loyalists have arrested 2,839 army members and removed 2,745 judges from duty. In total, about 6,000 people have already been detained. At least 265 people have died in clashes, including 104 coup supporters, with the other 161 including civilians and police officers.

Erdoğan suggests he was target for murder and blames Gülenists for the coup, but Gülen denied any involvement. The president stated that an explosion in Marmaris proves he had been targeted for assassination. Fethullah Gülen, a cleric living in exile in Pennsylvania, leads a popular movement – Hizmet or “the service” – openly opposing Erdoğan. He has condemned the military uprising.


B. What is next?

B1. Politics: a stronger Erdoğan, but instability will rise

Erdoğan’s popularity will increase … Turkey has a long history of coups: in the 1960s, 1970s, in 1980 (possibly the most brutal) and most recently in 1997 – known as the “post-modern coup” (the military threatened the government with a coup to force its resignation).  There are insistent rumours that this coup was “staged” to pave the way for Erdoğan to consolidate his power.

… leading to constitutional changes. Turkey’s switch to a presidential system seems now more likely. Erdoğan chances of winning a referendum giving him enhanced presidential powers have increased, as MHP is likely to support his positions. Erdoğan might also ask the parliament to immediately revise the constitution. With the insurgency of Kurdish rebels in the south-east of the country and repeated Islamic State terror-attacks, Erdoğan will receive continued popular support. Crackdown on dissent will rise, and any opposition to Erdogan’s plans will be labelled as a betrayal to the country. There are also rumours that Erdoğan might simply declare a state of emergency, and assume greater powers.

Instability will continue. As accumulation of power takes place and authoritarianism rises, further bloodshed is possible. Turkey is a North Atlantic Treaty Organization (NATO) member and hosts a US air base (İncirlik), endowed with nuclear weapons and the main hub for US operations in Iraq and Syria. In the short term, the international community will perceive Erdoğan as an autocrat holding chaos at bay, but in the long term it is likely to disagree on the direction – from democracy to authoritarianism – Turkey is taking.


B2. Economy: volatility and overall weakness

The Turkish economy will suffer, downgrades are possible. Going forward, the number of foreign visitors – already undergoing the worst drop since 1999 – and FDI will significantly decline; consumption will be negatively affected. The Turkish economy will grow below 3.8 percent – its yearly growth average of over the past ten years – and inflation will rise due to higher oil prices and a weak currency. Turkey might see its credit ratings downgraded. The current ratings are: S&P – BB+ (stable); Moody’s – Baa3 (negative); Fitch BBB- (stable).

The TRY will depreciate against the US Dollar (USD). On Friday 15, USDTRY closed at 3.016, 4.8 percent lower than its previous closing (at 2.878), a six-month low and the steepest fall since 2008. Further depreciation is expected when markets re-open on Monday 18, with USD/TRY stabilising at around 3.10 in the short term.

Dependence on foreign finance will deepen … Low reserves[i], a rising external debt[ii] and low domestic savings[iii] are making the economy more dependent on foreign finance. Escalating geopolitical risks are also taking a toll. Sanctions due to political tensions with Russia have affected tourist inflows, construction firms and food exports. Internal instability – due to the collapse of the Kurdish peace process and Islamic State (IS) terrorist activities – is also impacting tourism[iv] and jeopardizing exports to Middle East [v]. The decline in oil and other commodity prices has negatively affecting Turkey’s exports (a loss of around USD 11.0bn in 2015)[vi], as the demand for Turkish products and services has dried up in the major oil exporters in the region. As a result, exports are decreasing: in 2015, total exports declined to USD 143.7bn, an 8.7 percent drop from 2014 levels.

… and FDI outflows will accelerate. Over 2007-2015, overall FDI into Turkey declined by 41 percent, mainly due to i) uncertainty about the economy[vii]; ii) high inflation[viii]; iii) a weakening TRY; and iv) regulatory unpredictability. TRY depreciation will keep eroding returns, and political uncertainty will further deter the flow of FDI at the pace of economic growth. Indebted in hard currencies, local investors will serve a growing debt (in USD terms) and reduce their investments, stifling growth.

Equity markets are at risk of negative performance in 2016. Year to date, the Borsa Istanbul was the second best performing in Eastern Europe (15.47 percent, only second to the Kazakhstan stock exchange at 19.80 percent). This performance was due to better-than-expected economic growth, at 4.8 percent in Q12016, lifted by private consumption. The Turkish equity market might now lose as much as 20 percent, and close 2016 in the red.

Bond markets will see rising yields. Yields will increase as capital will abandon Turkey, reducing the price of bonds available in the market. Higher yields will push market interest rates higher, putting pressure on the Central Bank of the Republic of Turkey (CBRT), precisely when lower rates and more liquidity are needed.

Oil prices might increase. Turkey holds a strategic position on energy trade routes, between the Middle East, Central Asia and Russia and the European markets. Further political instability and the possible cancellation of foreign investment in the energy sector might put upward pressure on oil prices.


B3. Banking: profitability-enhancing reforms are now urgent

Bank profitability is likely to further decline. Going forward, liquidity might become a challenge. Over the weekend, thousands of citizens rushed to withdraw money from ATMs. On Monday, when banks reopen, the CBRT is likely to pump liquidity into the system. Banks are already hindered by low profitability: over 2007-15, banking sector’s profitability – measured as ‘return on equity’ (ROE) – decreased by 54.4 percent, from 24.8 percent in December 2007 to 11.3[ix] in December 2015. As of December 2015, the differential between banks’ ROE and risk-free returns (at 9.8 percent)[x] was 1.5 percent, lower than both the average of Central and Eastern Europe (7.5) and the average of Europe’s developed markets (DMs) (7.8)[xi].

Asset quality will decline amid an imperfect legal framework for bankruptcies and personal guarantees. ‘Non-performing-loans’ (NPLs) will go up. As of December 2015, the banking sector’s NPL[xii] ratio stood at 3.1 percent (up 0.3pps in 2015), a comparatively[xiii] low level, but NPL rates might be artificially low: at the moment, Turkey has no personal bankruptcy law, which results in keeping in the books loans that would otherwise be classified as non-performing. The legal framework for bankruptcies and personal guarantees needs an urgent improvement[xiv]: in absence of a uniform legal framework, insolvencies cannot be resolved by the calling of personal guarantees[xv].

New loans growth will slow down. In the banking sector, the loan portfolio will remain stable but new loans growth will decline, hampered by lower deposits and liquidity shortages. Over 2007-15, deposits grew by 12 percent (if measured in USD) or 25 percent (in TRY), but growth will decline in 2016. The USD component of the loan portfolio will perform well – and will be more profitable in Euro terms if the USD were to appreciate as a consequence of the shock.

The critical area will be credit costs. Strategically relevant sectors – such as hotels and tourism – need a preferential discount. Yet, if banks become dependent on CBRT short term liquidity, a significant contraction in lending and lower profitability are likely.

Raising capital will be even more of a challenge. In 2016, Turkish banks will have to meet additional Basel III capital buffers, to satisfy i) higher minimum capital requirements[xvi], ii) increased risk-weights[xvii], and iii) further TRY depreciation that will erode Capital Adequacy Ratios (CARs). Raising funds at the local level is expensive: as of July 16, 2016, in Turkey the benchmark interest rate was 7.50 percent compared with zero percent in the Eurozone (EZ) and 0.25-0.50 percent in the US; raising capital from foreign sources will be further hampered by TRY depreciation. Hedging is expensive due to the large interest rate differentials, and the low profitability impedes capital accumulation through organic growth.

The Turkish banking sector needs profitability-enhancing reforms. If improvements are enacted, banks could attract foreign direct investment (FDI). Investors need exchange rate stability, capital protection and a clear, uniform legal environment for bankruptcies and personal guarantees.

Going forward, stability is the key priority. In Turkey, the government needs to guarantee stability as soon as possible, in order to restore inflows of foreign capital and tourists. In the past, despite political headwinds, Turkey has proven resilient, but the economy needs resources from abroad[xviii] and foreign investors and visitors need to be reassured; otherwise they might withdraw, with very heavy consequences on economic growth.


[i] In January 2016, FX reserves fell to USD 127.1bn, down 4.3 percent month-on-month (m-o-m), and 15.5 percent from an all-time high of USD 150.4bn in July 2014.

[ii] In December 2015, the gross external debt stock reached USD 398bn or 55.3 percent of GDP, against a Q3-2010-Q3-2015 average of 45.0 percent: most of this debt is private (71.3 percent), making Turkey vulnerable to a rise in US interest rates.

[iii] In 2014[iii], the ‘savings to gross domestic product’ (GDP) ratio declined to 15 percent, the lowest – together with South Africa – of all emerging markets (EMs). As a result, the country needs to make use of foreign savings. The resulting current account (c/a) deficit increases dependence on global liquidity conditions.

[iv] In 2016, according to Hürriyet daily, citing sector representatives, the revenue loss in the foreign tourism sector may reach USD 12bn. The economic think-thank TEPAV had previously estimated the cost of the Russian travel ban on Turkey at around USD 8bn this year, including direct and secondary impacts. In 2015, Turkey’s gross income from foreign tourism services reached USD 31.5bn.

[v] Exports to the Middle East dropped by 10.4 percent in 2015 compared to 2014 due to sharp losses in the Iraqi market.

[vi] As of March 30, 2016, oil prices are at USD 39.26 per barrel (USD/bbl), 69 percent below the post-crisis peak level of April 8th, 2011 (126.65).

[vii] In March 2016, the Economic Confidence Index – a composite index based on several surveys of business and consumer confidence published by the Turkish Statistical Institute (Turkstat) – increased to 78.3 points, up 9.5 percent from February 2016 level (71.5, the lowest value on record), but still down 22.3 percent from December 2015 level (100.8).

[viii] In February 2016, inflation reached 8.8 percent y-o-y. In March 2016, inflation declined to 7.5 percent, 250 basis points (bps) above CBT’s target (5.0 percent since 2012). The target has been consistently missed since 2011, with actuals on average 310bps above target.

[ix] In 2015, the ‘return on equity’ (ROE) – net income divided by average shareholders’ equity – stood at its lowest post-crisis level, below both the pre-crisis (2003 – 2008) average (18.4 percent) and the post-crisis peak of 2009 (22.9). Forecast for 2017-2020 shows an average ROE level at 15.0 percent (Source: Bloomberg Consensus, 2016).

[x] Source: TBB, 2016. Risk Free return is measured as 10-year sovereign bond returns. Further average differentials: Middle East, 10.4 percent; Latin America, 10.0; North America, 9.7.

[xi] Over 2007-2015, profitability measured as ‘net interest margin’ (NIM) decreased by 22.2 percent, from 4.5 percent in 2007[xi] to 3.5 in 2015. Over 2007-2015, the ‘return on assets’ (ROA) decreased from 2.8 percent in 2007 to 1.2 in 2015 – its lowest level since 2002.

[xii] In 2015, NPLs stood at 3.1 percent, below both the pre-crisis (2004 – 2008, excluding outliers for 2002 & 2003) NPL average (4.3) and the post-crisis peak of 2009 (5.2) but above the post-crisis trough of 2011 (2.7). As of April 2016, Moody’s forecasts a 0.4-0.6 percentage points (pps) rise in the NPLs of the Turkey’s banking sector in 2016: the increase in bad loans would stem largely from the consumer and small-and-medium enterprises (SMEs) loan segments, whose stocks of problem loans have already grown significantly over 2015. Corporate loans have proven resilient so far, but they remain vulnerable to TRY depreciation and a likely increase in their borrowing costs.

[xiii] Bank NPL to gross loans ratio for emerging markets – Brazil (3.1 percent); Russia (7.4); India (4.2); China (1.7).

[xiv] In 2015-2016, Turkey dropped 22 positions in ‘Resolving Insolvency’ category of the World Bank’s Doing Business 2016 ranking – and it is now classified 124th out of 189 economies. The average duration of insolvency procedures is 4.5 years, higher than the average of Europe and Central Asia (ECA – 2.3 years). At the end of insolvency proceedings, secured creditors recover from insolvent firms 18.7 cents on each USD (ECA average: 38.3 cents).

[xv] In practice, personal guarantees are not always enforced, in particular those on deposits held abroad, and execution mechanisms remain unclear.

[xvi] The minimum CET1 for larger institutions will rise from 4.5 to 5.625 percent, and up to 9 percent by 2019 Under the latest Basel III capital requirements to be implemented in Turkey from 2016, by 2019 banks will have to build up a common equity Tier 1 (CET1) capital conservation buffer equal to 2.5 percent of RWAs. They will also have to hold a buffer, with size dependent on systemic importance. This buffer will range from 1.0 percent to 3.0 percent of RWAs, but capped at 2.0 percent for the larger banks.

[xvii] Other changes to RWAs applicable to Turkish banks from March 2016: residential mortgage loans will attract a minimum 35 percent risk weight (currently 50 percent) and unsecured consumer portfolios will be weighted at 75 percent (currently 75 percent-250 percent).

[xviii] In 2015, the current account deficit stood at 4.4 percent of GDP, above its pre-crisis (1998- 2008) average of 2.7 percent.