Turkey has calmed its economic crisis for now. Here’s what could restart it.

A new policy aimed at easing Turkey’s currency crisis highlights a historically robust sector of the economy: the banks.

Confidence in the local banking system has remained strong despite repeated currency depreciations, sackings of central bank chiefs and boom-bust cycles. The country’s lenders are at the center of the government’s bailout for the pound unveiled this week. The plan pays Turks to keep their bank deposits in lire and not withdraw money from the banking system no matter what happens in the forex markets.

For now, the pound’s selloff has calmed down as the currency recovers some of the massive losses it has suffered against the dollar this year. But some are skeptical of the long-term outlook. Galloping inflation and the strong dollarization of the banking system make this large emerging market vulnerable.

Turkish President Recep Tayyip Erdogan addresses the media in Ankara, Turkey on Monday.


Photo:

MURAT CET NMUHURDAR / PPO / REUTERS

What could make the situation worse? A depositor running on dollars held in the Turkish banking system or Turkish banks losing access to international dollar markets would freeze the financial system. This could prompt the government to take even more drastic measures, including capital controls.

“In a few years, I think we will come back to this situation when Turkey really started to turn,” said Jason Tuvey, senior emerging markets economist at Capital Economics.

Risks of dollarization

Part of the reason Turks trust banks is that they use them to hold not only their savings in lire, but their largest stash of dollars and euros. Almost two thirds of deposits in the banking system are held in foreign currencies.

The Turks have stored their savings in dollars, gold and other durable goods for generations. But the accumulation of dollars has accelerated since the monetary crisis of 2018.

Turkish President Recep Tayyip Erdogan ousted a series of central bank chiefs and insisted on a campaign to cut interest rates despite soaring inflation. This undermined confidence in the read.

“The root cause of all of this is inflation. If inflation weren’t high, the pressure to dollarize wouldn’t be a problem, ”said Edward Al-Hussainy, senior analyst at Columbia Threadneedle Investments.

In addition to deposits, Turkish banks get dollars by borrowing them abroad. While the amount is lower than it was before 2018, it remains substantial, with around $ 83 billion owed over the next 12 months in September, equivalent to around 11% of the country’s gross domestic product, according to Capital Economics.

Banks owe dollars

Banks maintained access to dollar markets despite fluctuations in the pound. Bank Yapi Kredi said this week it has secured around $ 560 million in long-term funding in dollars and euros.

“There are still signs that banks are able to enter the market at this time,” said Lindsey Liddell, Turkish bank rating manager at Fitch.

There are worrying signs, however. The rate at which banks are able to replace maturing dollar debt has fallen below 100%, meaning they borrow less in new loans than they owe.

Dollar loans to government

Another source of risk is who Turkish banks lend their dollars to. More and more, they are loaning them to the government. Some will buy Turkish government bonds issued in dollars.

Banks also lend their dollars to the central bank through more than $ 60 billion in currency swaps, a type of derivative contract. Part of bank dollars is also held by the central bank as reserve requirements.

The central bank used the dollars borrowed from these swaps to intervene in the forex markets to support the lira. He left the central bank with a negative net foreign exchange reserve.

A doomsday scenario, economists say, is for Turkish depositors to withdraw their dollars from banks. The banks would ask the central bank to recover their dollar reserves and could try to unwind the swaps. If the central bank was unable to comply, the banks would be unable to pay depositors. This is similar to what happened during the Lebanese financial crisis of 2020.

So far, there are few signs of a dollar shortage in the banks. The rate Turkish banks have to pay on dollar deposits is around 0.5%, according to Goldman Sachs.

It’s better than what savers get in the United States for their dollars, but not much more. This rate skyrocketed during the 2018 crisis, but remains calm for the time being.

More loans and more inflation

Mr. Erdogan’s effort to save the lire risks devaluing it in the long run. As part of the savings plan, the government will guarantee returns on lira deposits at a rate similar to what they would earn by holding foreign currency, thus offsetting any further depreciation against the dollar. In return, Turks have to keep their lire locked in the bank for 3, 6, 9 or 12 months, like a certificate of deposit.

With inflation above 20%, the pound should naturally continue to depreciate against the dollar because it loses its purchasing power. The government will have to borrow, or the central bank will have to print money, to support Turkish savers under the deposit plan, fueling inflationary pressures.

The plan also comes into play when the growth of lira loans is already increasing.

But there is a mystery as to where these loans go, as this money is not returned to the banking system in the form of deposits. This could be a sign that the money is being invested in brokerage firms, which place their lire in short-term debt funds outside the banking system, or that it is used to purchase items or services from companies. non-residents.

“Since the outlook for inflation looks quite difficult, some of the clients of the banks may take lira loans and then buy currencies or other assets like stocks or maybe even cryptocurrencies,” he said. Ugras Ulku, Head of European Emerging Markets Research at IIR. .

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com

As the Federal Reserve and other central banks around the world face rising inflation amid the economic recovery from the pandemic, Turkey – where the rate is currently above 20% – is issuing a warning. Soaring inflation has caused economic turmoil after years of strong growth. Photo: Sedat Suna / Shutterstock

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