Better not look down,

Better not look down,

If you want to keep on flying.

Put the hammer down,

Keep it full speed ahead.

Better not look back

Or you might just wind up cryin’.

You can keep it moving,

If you don’t look down

“Better Not Look Down”, Sample & Jennings, BB King, 1979

Perhaps your analyst has a cultural proclivity to look down too often. Certainly there have been no rewards in financial markets, at least since Q1 2016, for those not prepared to put the hammer down. Whether gauged by low cash levels in pension funds and mutual funds, high margin levels, low short interest levels or extinct volatility, all the evidence is that the hammer is down. Meanwhile, far below – so far it seems that even those occasionally glimpsing down cannot see it – a liquidity crisis is developing that is likely to become an emerging market debt crisis.

Since Q1 2013 this analyst has been pointing out that the debtors of Turkey are likely to default. They may indeed be forced to do so if their government were to impose capital controls. Mass defaults have not occurred, though Turkey’s largest ever private sector default was finally formally recognised by the commercial banks in September. Ojer Telekomunikasyon AS is unable to service its US$4.5bn loan – an issue that had been known about for over a year but is now under resolution. Well, it has still not been a series of defaults since 2013. So while a full-blown credit crisis in Turkey has not developed, it is worth remembering just what has happened on the road to default since 2013:

  • The yield on the Lira-denominated 10-year Turkish Government Bond has risen from a low of 6% in 2013 to 11.9% today.
  •  In 2013 the Lira/USD exchange rate was 1.75 in and it is now 3.89. This has an important impact on solvency in a country that has US$151bn in cross-border loans from BIS reporting banks, and US$125bn in outstanding international debt securities. Servicing this debt has become significantly more expensive.
  • The three-month Lira interbank rate has risen from 6% at the start of 2013 to 13.5% today.
  • The yield on the Government of Turkey USD bond (maturing April 2043) has risen from 4.5% in 2013 to 6.3% today.
  • In local currency terms, the stock market has risen by 38% since the beginning of 2013, but in USD terms it has declined by 34%.

Ask anyone what has happened in the post-GFC world and they will tell you that interest rates have collapsed and liquidity has soared, but not if you live in Turkey. Ask anyone and they will tell you that we live in a world where central bank policy can mean that unsustainable debt burdens can always be sustained. Well, perhaps, but is that true in a country where the total debt owed to foreigners is US$405bn, and US$276bn of that is denominated in foreign currency? (The remainder primarily being Lira-denominated loans by foreign-owned local banks or Lira-denominated debt instruments owned by foreigners.) So interest rates are up, liquidity is down and the Turkish Central Bank cannot directly provide the foreign currency liquidity needed to sustain interest and principal payments on foreign currency debt. What happens next?

Many investors believe that Turkey is just too politically important to go bust. The reasoning goes that the unsustainable will be sustained by foreign powers, given Turkey’s geopolitical importance. This assertion will remind grizzled veterans of emerging market investment of the very expensive mantra chanted by bulls of Russian debt in early 1998 – ‘countries with nuclear weapons won’t be allowed to go bust’.

Well, there’s a first time for everything, as we discovered on 17th August 1998, when Russia devalued and defaulted on its local currency and foreign currency debt. If you want to bet on foreign government support for an unsustainable debt position, you’d better be sure that the country in question has a lot of foreign friends. Turkey’s friends get fewer by the day.

A large, mystery capital flow into Turkey, usually assumed to be coming from the governments of Saudi Arabia and Qatar, may now cease to flow. Saudi Arabia has accused Qatar of siding with Iran in backing terrorist groups and, amongst other things, has demanded that Turkey close its military base in Qatar. Turkey is now providing aid to Qatar as it responds to the blockade by Saudi Arabia and its allies.

Capital inflows to Turkey from Saudi Arabia seem unlikely given this shift in alliances. The blockade of Qatar has given it other priorities than supporting Turkey. The increasingly assertive leader of Saudi Arabia is not likely to look kindly on further financial support for Turkey, particularly as he seems to be significantly more assertive against Iran and those he considers to be supporting Iran. A key capital flow into Turkey is now likely to abate.

Meanwhile, the Chancellor of Germany has said that the EU will begin to withdraw the pre-accession funding it has been sending to President Erdogan’s government (EUR 4.5bn from 2014-2020). This may not be the crucial flow that has been keeping Turkey solvent, but it is sending clear signals to the European bankers with US$94bn in Turkish credit risk. Those foreign creditors, who had viewed Turkey’s closer alignment with the EU as reducing their credit risk, are increasingly rethinking this position.

This all comes at a time when Turkey has fallen foul of the US for detaining US nationals, detaining consular staff, negotiating to buy a Russian missile system and increasingly turning on the US-supported Kurds as the war with ISIL draws to a close. With President Trump clearly aligning himself with the leader of Saudi Arabia, favours for Turkey are not likely to be forthcoming from this quarter.

A country with a current account deficit that is 4.1% of GDP which is also attempting to service a high foreign currency debt burden needs foreign friends. Turkey may be gaining a new friend in Vladimir Putin. Perhaps President Erdogan will wish to now punish the old friends who are deserting him? As The Solid Ground has reminded investors in the past, President Erdogan has strong opinions on foreign creditors, stating that the Republic of Turkey will not be enslaved by foreign creditors as they once enslaved the Ottoman Empire.

The ex-friends of President Erdogan have lent Turkey a lot of money, but it seems very unlikely they will be lending him much more. His incentive to support the high interest rate policy aimed at stabilising an exchange rate, while ensuring companies and people can continue to repay their foreign currency debt, is waning rapidly.

The deterioration in financial conditions in Turkey since 2013 has been accompanied by deterioration in the rule of law. The President has accused many wealthy people of conspiring against him. Their wealth is no longer secure given these accusations and, to the extent that they can, they are seeking to get their money out of the country. The actions which compel this capital outflow clearly come at a bad time for a country struggling to support its exchange rate, keep domestic interest rates low and service its large foreign currency debt burden. When domestic investors fear sequestration of their assets, a capital outflow is likely and, who knows, even foreign investors might come to consider that a breakdown in the rule of law is ultimately not even in their interests.

A slow motion car crash has been under way in Turkey since 2013. It has involved a doubling in domestic interest rates and a collapse in the exchange rate. The decline in the exchange rate and the rise in interest rates have accelerated since September. That acceleration began just as Turkish banks took recovery action on Turkey’s largest ever default – a US$4.5bn loan to Ojer Telekomunikasyon AS.

You may see the future as one with higher growth and higher inflation and thus there is little reason to look down until we see material rises in interest rates. The Solid Ground continues to look down to a series of imperilled cash flows across the planet that is increasingly insufficient to service record high debt levels (the forthcoming Q4 report will look at this series of vulnerable cash flows in more detail). This report singles out Turkey due to the recent move in the Lira and interest rates, following the country’s largest ever default, which suggest that the time for a credit crisis in Turkey is now very near. Total foreign credit exposure to Turkey is US$410bn and there will be further equity exposure, whether in the form of direct investment or equity holdings.

What investors must remember is that the imposition of capital controls would produce a de facto default on all of those obligations. This is not a question of corporations and individuals choosing to not repay their obligations to foreigners, but of such repayments being made illegal. Capital controls, in their strongest form, represent a de facto debt moratorium. For this analyst, the risk in Turkey has always been more about the potential move to capital controls by a President who has constantly disparaged foreign creditors and the high interest rates that he sees as flowing from their demands. Should the President lash out at his ‘loan sharks’, then the whole of emerging market risk will be reassessed as it was in 1982, when Mexico defaulted, and in 1997 when Thailand defaulted. A credit crisis in Turkey will have a negative enough impact on capital inflows to EMs as low risk premiums on EM debt are reassessed and interest rates rise. However, if the credit crisis is accompanied by capital controls, then the world changes, as your analyst witnessed when PM Mahathir imposed capital controls on Malaysia in 1998. There are clear forces of political change sweeping the world as voters demand or acquiesce to more power for their local politicians. Investors must expect that some of that return of power will come at the expense of capital and not just at the expense of the EU or the Government of Spain. Those seeking a return of control will lash out at the proximate cause and this can just as easily be capital, labelled to be driving interest rates up and creating bankruptcy as European politicians are unable to control immigration. The President of Turkey has made it very clear who he believes to be the proximate cause of his lack of control – you

!As a young man your analyst studied the law of animals as part of the syllabus on tort law. I learned only one thing from that book – every dog is allowed one bite. It is so because it was assumed that an owner would need knowledge that his dog was dangerous before he could have liability for his dog biting anyone. In the case of capital controls, this dog has had more than one bite. Even in the developed world recently, politicians in Iceland, Greece and Cyprus have all thought such de facto moratoriums necessary. There have been numerous impositions of capital controls in the emerging world post-GFC. This is more than a snarl.

Listen to the President of Turkey when he tells you that you are the enemy and that you are responsible for the high interest rates triggering bankruptcy in Turkey. I do realise that listening to Presidents is something they don’t ascribe much weight to in a traditional economic/financial education. Of course, they didn’t ascribe much weight to money or credit either in the run up to the GFC. The words of the Turkish President, combined with prior imposition of capital controls elsewhere, provide sufficient grounds for any lawyer to make a decent case for negligence against any investors who find their clients’ funds trapped in Turkey when the President finally punishes those he believes responsible for the growing chaos. The implications are thus rather personal for some fund managers but they are huge for the future for emerging markets. Ho-hum, who cares. ‘You better not look down if you want to keep on flying.’

This is a guest journal written by Russell Napier, member of the Cerno Capital Investment Committee.

Russell is a stock market historian and global equity strategist, and co-founder of ERIC (Electronic Research Interchange), an online platform for the sale of high-quality individually priced investment research. He is the author of The Solid Ground, a global macro report originally published by CLSA.

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