(I last wrote about Turkey last month, which can be found here.)Last week, Turkey’s policymakers cut the amount of swaps domestic banks are permitted to hold to 25% of regulatory capital, down from 50%. By limiting the supply of swaps, this constrains how much lira-based lending Turkish banks can offer and has sent the annual cost of borrowing in lira from 17% to more than 35%. Shorting the lira no longer looks that attractive. However, banks and their clients use swaps as a way to protect against currency fluctuations. Regulatory limits against these products are therefore a negative given the various fiscal and monetary imbalances in the country spilling over into its economy and currency (covered in more detail below). Regulators are also allowing Turkish banks to calculate their capital ratios using the lira’s exchange rate retroactive to June 30. This will help to prop up capital ratios in the banking sector. Every 1% decline in the lira creates about a 0.05% decline in capital ratios. It will be artificial but helps with meeting regulatory requirements. Turkish banks will need to raise capital due to the depreciation in the currency, but continuing to borrow externally exacerbates the problem, and recent issues will curtail the availability of foreign lending. Consumer loan default rates will begin to pick up. Its central bank, the CBRT, is having trouble doing its job because of political interference. Its one-week repo rate is set at 17.75%, though the CBRT uses a corridor at +/-150 bps above and below that mark, and has effectively pushed the rate to the upper edge of that range to 19.25%. Given inflation is high and increasing, that leaves the real (inflation-adjusted) interest rate right around zero. Turkey’s main problems are the following: 1. Too much dollar-denominated debt that gets hurt by rising US rates (makes USD assets more attractive and raises the price of the dollar) and drop in the lira because it makes it harder to service. 2. Large current account deficit and status as a debtor country makes it vulnerable to capital flight and weakness in its domestic currency. 3. Currency weakness and inflation can make even government short-term credit undesirable because it means a potentially negative return for investors, leading to the purchase of inflation-hedge assets and capital withdrawals instead of the credit creation necessary to grow the economy. 4. Turkey has a large external financing need to the point where this requirement is 80% of FX reserves. However, Turkish banks have a wholesale funding need that’s largely in lira. But this assumes depositors don’t make a run on this capital by shifting from lira to dollars or taking these deposits out of the commercial banking system entirely. Historically, governments (not limited to any country in particular) have tried to counteract these measures by establishing foreign exchange controls and abolishing public gold ownership (an inflation hedge). Sometimes price and wage controls are instituted, but rarely do these solve problems because they create market distortions that, on aggregate, make the situation worse. 5. The Turkish banking system has an unusual set of vulnerabilities because the banks need to rely on FX swaps to exchange the dollar funding (foreigners want to lend to Turkey in dollars and to a lesser extent euros) into lira in order to preserve their ability to lend to households. As part of macroprudential regulation, Turkish banks are barred from lending to households in foreign currencies, though households want to borrow in lira anyway. These problems haven’t manifested in the past because its external funding and domestic deposit base have been historically resilient. 6. This combination – foreign entities wanting to lend to Turkey in dollars and Turks wanting to borrow in lira, has led to a surfeit of dollar funding and shortfall in lira funding – is easy to find in the data through the loan-to-deposit ratios:Loan-to-deposit ratio in USD or EUR: 0.8 Loan-to-deposit ratio in TRY: 1.4 7. Historically, Turkey’s central bank has used prudential regulatory measures to fight inflation rather than interest rate hikes, which isn’t necessarily effective. 8. Unlike Argentina, whose vulnerabilities are seated in the government’s excess external foreign debt borrowing, in Turkey they are predominantly in the private sector. (Interest rate manipulation to control the credit creating capacity of the economy isn’t ideal either, but that’s a different topic.) The government’s gross external debt is some $100 billion and public banks are around $40 billion. On the other hand, private banks are around $160 billion and private non-banks and state-owned enterprises have some $160 billion. 9. Turkey’s big problem is that it doesn’t have enough reserves to cover its external financing needs, or the sum of its current account (6.5% of GDP) and maturing short-term debt (21% of GDP). They also don’t cover its short-term external debt, 60% of which is in its banking sector. So when you take into account a rising US dollar from rising US rates relative to other developed economies (increases the burden of servicing foreign debt) and rising oil in conjunction (Turkey has to import it, worsening the trade deficit), this makes for a bad combination. When you don’t have enough foreign currency reserves, you can lose control of the currency. Turkey’s central objective should be to build up its asset reserves. The IMF broadly identifies Turkey’s problem in their reserve metric, but not the extent stated, making the issues in Turkey understated for anyone who relies on the IMF for research, because they use M2 in their calculation. M2 is a misleading and non-robust monetary metric that conflates money (what payments are settled with) with credit (promises to pay). Conclusion Turkey is in a bind because it can’t use its reserves to defend its currency because if you try to cover a protracted current account deficit you’re inviting a loss of access to bank funding through a run on foreign currency liquidity (i.e., creditors withdraw it). Since Turkey’s corporations are indebted in dollars, a drop in the lira causes distress because this debt load becomes harder to pay off. If you try to fight this by raising rates, this diminishes credit creation and thus slows the economy, though it helps to diminish the current account deficit.