Even though Türkiye's foreign currency short-term debt has increased only moderately overall in 2022, the foreign fund flow has reversed; funds are now leaving the economy. As global financial conditions tighten, a transformation is needed to break the negative correlation between growth and commodity-price cycles liquidity crisis
Some readers may remember the debt crisis of the 1980s. Since then, debt crises have become a regular cycle for emerging markets. For example, some emerging markets – such as Sri Lanka as a most recent example-require bailout packages from the IMF. What happened with Sri Lanka might end up being the case for some other emerging markets as well, particularly in low-income countries. This is what the World Bank also predicts.
Developing countries becoming high-risk debtors
The World Bank 60% of all developing economies have become high-risk debtors. As many as a dozen might default over the next 12 months. The probability of default for countries can be identified by following their CDS rates.
Most developing economies are unable to finance their deficit during a global downturn. Countries like Türkiye, which is currently tackling the challenges of returning to pre-pandemic economic and business conditions, must now cope with the Ukraine crisis.
The short-term debt-to-GDP ratio of Türkiye is around 20%. Still, Türkiye is not as heavily indebted as some other emerging markets. The burden is not short-term debt but the outflow of foreign capital. Foreign capital outflow has reached 5,9 billion dollars since the year’s start. In just four years, the share of domestic debt securities held by foreigners has decreased to 1.5% from 20%.
Can Türkiye possibly face a liquidity crisis?
As the country's credit rating downgrades, a development compounded by outflow of foreign capital, it is highly possible for Türkiye to face acute liquidity constraints that could turn into a solvency crisis. As mentioned earlier, higher CDS rates also raise the cost of borrowing. As one might infer from this, issuing a bond in order to refinance foreign currency debt in a high-CDS environment drives up bond yields. High CDS rates reduce the ability of countries to roll over foreign debt because of the higher probability of default.
Two other factors increasing the risk of a liquidity crisis
Turkish economic leaders attempted to grow the economy by expanding the financing conditions.
However, this movement resulted in the emergency of two factors, which are in turn increasing the risk of a liquidity crisis: the emergency of a complex lending structure and increased foreign currency deposits held by locals. In order to prevent locals from exchanging money borrowed in local currency into foreign currency, lending conditions have been tightened, a development which is making borrowing difficult for companies as well.
Central banks of most emerging economies are normalizing monetary policy by increasing the interest rate to fight inflation. However, Türkiye is testing another approach by cutting the interest rates, which is causing forex deposits held by locals to increase. As such, in addition foreign capital outflows, increased appetite of locals for foreign currency further shrinks forex deposits of the Central Bank of the Republic of Türkiye.
The classical theory asserts that reliance on foreign currency-denominated debt can reduce the risk of running out of FX reserves, but it can also increase the risk of sovereign default, especially in times of sharp depreciation of the national currency that suddenly raises the costs of servicing external debts. Moreover, this has usually been the case during heightened global volatility and tighter financing conditions, which are often associated with large-scale capital outflows. However, in the case of Türkiye, capital held by non-residents has already hit historical lows.
In general, one can argue that lowering output growth can be a useful tool in the short term. For countries that lack adequate FX reserves, high CDS rates may undermine macroeconomic stability and reduce the flow of foreign capital, unless the country in question can undergo the transformation needed to break the negative correlation between growth and commodity-price cycles.
Any information, comment or recommendation contained herein do not constitute investment advice or consultancy
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