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Categorized | Banks

A strong banking system alone cannot secure Turkey’s financial stability

Posted on November 29, 2016

Investors have good reason to be concerned about aspects of the Turkish economy these days.

The list of domestic challenges is long: political tensions are running high at home and internationally, while the current account deficit is widening again — despite a sharp slowdown in economic activity that may, in the third quarter of 2016, lead to the first negative GDP growth figures in seven years.

With a large external financing requirement and dollar-dominated external debt structure, Turkey is particularly vulnerable to the higher US yields and stronger dollar expected under a Trump presidency.

These global and domestic challenges have all taken their toll on the Turkish markets, with the currency bearing the brunt of the pressure. The lira has depreciated by around 15 per cent against the dollar since the beginning of the year making it the third worst-performing emerging market currency after the Mexican and Argentine pesos.

But the fact that Turkey is not performing even worse than it is right now is thanks to two factors.

First, the government’s fiscal stance has been conservative. As a result of continuing fiscal discipline, the public debt-to-GDP ratio has fallen almost continuously since Turkey’s 2001 economic crisis. It now stands at just 33 per cent, nearly half the 60 per cent upper limit mandated by the Maastricht treaty for EU member states. Even with the predicted loosening of fiscal policy in 2017, the budget deficit is expected to widen to only around 2 per cent of GDP, according to the government’s medium-term program projections.

The second factor has been the strength of the Turkish banking system. This was not always the case: during the 2001 crisis, the banks were the weak link that propagated shocks across the economy. But Turkish bankers have taken the lessons from that crisis to heart. Gone are the days of large short-FX positions and the business model of relying on wholesale funding from abroad to lend to the government. In fact, Turkish banks’ net FX exposure as of September this year is practically zero.

Instead, Turkish banks now engage in the very traditional practice of collecting deposits and lending to companies and households, staying away from fancy but risky products. They have been doing a good job of managing asset quality: the non-performing loans ratio of the banking system stands at 3.3 per cent — Italy’s ratio is 17.5 per cent, according to IMF financial soundness indicators.

Turkish banks also have ample protection against a deterioration in asset quality; the capital adequacy ratio is 16 per cent — double the minimum set by the Basel Accord — implying that the banks retain substantial buffers to absorb shocks.

But the strength of the banking system is not only about financial capital; human capital is a very important part of the story.

According to the Turkish banks’ association, 85 per cent of people working in banks have university or postgraduate degrees. Not only that, but, in a country where only 26 per cent of non-farm workers are women, the banking sector has a female employee ratio of 51 per cent.

This well-capitalised system is now an important pillar underpinning the stability of the wider economy. But banks do not operate in a vacuum and their access to foreign capital is very much affected by the rest of the world’s perception of Turkey.

They now face specific pressures: a government push to accelerate credit growth via lower loan rates could erode net interest margins. This could hinder capital generation and future loan growth — precisely the opposite of what Ankara is trying to achieve.

Although banks may not be running short foreign currency positions themselves, their clients are, and the banks are therefore indirectly exposed to the FX risk. The short foreign currency position that the corporate sector runs has so far not led to significant asset quality problems for the banks. But this is no guarantee that quality will remain unaffected if the depreciation continues.

Even though the banks’ capital cushions are strong, the stabilisation of the currency would be a welcome relief from future asset quality concerns. But that would require Mr Erdogan’s government to change its stance on interest rate hikes.

The Turkish banking system may be strong, but its strength is not sufficient to safeguard overall macroeconomic stability. Banks will do what they can to support economic activity, but they will also need all the support that they can get from the government to ensure their margins are not unduly eroded and the financial health of their clients is not compromised by the continuous depreciation of the currency.

If the banking system cannot get that support, this bright spot will fade too.

The writer is senior emerging markets economist covering Turkey at Nomura