Turkish Lira Falls to Fresh Lows as Talks Break Down, Analysts Eye an Approach to the IMF

- Lira makes fresh historic low after failure of Washington delegation

- Finance Minister attempts to reassure markets with raft of measures

- Foreign investor outflows still surprising muted

The Turkish Lira crashed another 2.6% versus the US Dollar on Thursday, to 5.4217 at the time of writing after peaking at a new all-time high of 5.4479 earlier on the day.

The added weakness came as disappointment set in after talks between Turkish and US diplomats in Washington failed to result in a compromise that was likely to ease sanctions.

"A Turkish delegation met with the State Department's No. 2 official, John Sullivan, on Wednesday to address friction between the NATO allies. There were no signs of a breakthrough, however, after the hour-long talks," says Ali Kucukgocmen, a reporter for Thomson Reuters news.  

The Lira touched a record low of 5.44 against the Dollar, weakening some 2.5 percent from Wednesday's close. "There was widespread selling in the country's bond markets and Istanbul stocks dropped 1 percent too," adds Kucukgocmen.

Fears the country might have to turn to the IMF for support or introduce capital controls - measures that prevent outflows - became a distinct possibility.

"We think Turkey may need to approach the IMF or seek other external support. Otherwise, capital-control measures seem to be a distinct possibility," says Salman Ahmed, an investment strategist at Lombard Odier.

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Turkey Decides to Curb Growth Ambitions

There was some relief for the Turkish Lira later in the day, however, after Turkish Finance Minister, Berat Albayrak, announced a raft of measures aimed at reassuring markets about the country's financial resilience.

The measures included less ambitious growth targets which inferred president Erdogan may be more open to the possibility of the Central Bank of the Republic of Turkey (CBRT) raising interest rates, a measure he was stubbornly against previously due to its negative effect on growth.

"The government has set a growth target of less than 4 percent, down from 5.5 percent originally, Treasury and Finance Minister Berat Albayrak’s office said," in a report by Firat Kozok  and Onur Ant, correspondents for Bloomberg News.

Other measures included the follow list:

1. To reduce debt from 110% to 104% to be rolled over by end of 2018.

2. A reduction in government spending to generate a fiscal surplus of 5bn Lira (excluding payments on interest).

3. The budget shortfall (inc interest payments) to be less than 2.0% and no more than 1.5% in long-run.

4. The ratio of current-account deficit to gross domestic product to stabilise at 4% during the same period

5. 2019 GDP growth seen at 3% to 4%

6. Inflation lowered to single-digit levels as soon as possible

7. The reassurance that Turkey’s banks and non-financial companies face no foreign exchange or liquidity risk.

Investors responded tp the measures with a healthy dose of scepticism with one fund manager, Tim Ash, senior EM sovereign strategist at BlueBay Asset management, reportedly saying to Bloomberg, that, "It’s a case of seeing is believing in terms of delivery."

Foreign Investors Hang On

Yet all may not be lost for Turkey.

The commonly held view that foreign investors are fleeing the Turkish markets and this is behind the rout in the Lira and Turkish bonds may in fact be a misconception.

Analysis by Morgan Stanley shows foreign  investors are in fact holding onto their depreciating Turkish assets despite the bloodbath.

"The perception of foreign selling of Turkey government bonds ... is not happening," says Min Dai, strategist at Morgan Stanley.

"The Turkish lira's plunge this year has wiped out a third of the value of foreign investors' holdings of lira bonds but data shows there have not yet been net foreign portfolio sales," add Karin Strohecker and Claire Millhench, reporters for Thomson Reuters who have been covering the Morgan Stanley angle.

The lack of selling may reflect "inertia or a lack of liquidity," they go on.

Not only have Turkish bonds themselves fallen by 20% in value due to soaring inflation but the Lira has also devalued 28% further doubling down on the loss from the bond-price decline with a further loss from the FX depreciation.

Yet central bank statistics show foreign investors have been surprisingly tenacious.

The ratio of foreign holdings of government debt stood at just under 20 percent at the end of last month – largely unchanged from 22 percent in late February.

In addition, data from the Institute of International Finance which tracks weekly foreign portfolio flows shows that although Turkish local government debt have suffered outflows in the two weeks ending July 27, they are still $75m up on the year.

President Erdogan's famed reluctance to tolerate higher interest rates and the timidity of the CBRT in going against him has left bondholders with dwindling value due to persistent inflation hammering their expected 'real' returns.

Further Erdogan's decision to chose nepotism ahead of experience by putting his son-in-law in charge of the economy "has also unnerved some investors," says Strohecker and Millhench.

The poor response by the authorities to the worsening economic situation is reflected in the sobering statistic that Turkey is the second-worst performing market in the JP Morgan Government Bond Index (GBI) Emerging Markets (EM) behind Argentina.

"The big question now is whether these huge paper losses will be realised at some point if there is no resolution to the crisis, leading to some capitulation that could intensify the financial squeeze," say the Reuter's reporters.

But foreign investors are staying put for a number of reasons, says Morgan Stanley's Min.
The first may be 'liquidity' which has deteriorated significantly and is reflected in the high daily volatility of between 50-70 basis points (bps). This makes it difficult for sellers to find buyers at their desired price when they are unwinding their positions.

Another reason may be that investors are writing off their losses.

"There is always this kind of sunk cost feeling – the money is already lost," says Paul McNamara, investment director at asset manager GAM.

Another reason is that some gung-ho funds may actually be attempting to bottom-pick following the recent market turmoil.

The CBRT's massive 500bps hike in June may also have driven inflows.

Asset manager Aberdeen Standard Investments said in early June it had upped its exposure to domestic Turkish debt following a bigger-than-expected interest rate hike by the central bank.

But that stickiness may not persist as apart from holding around $20 billion of government debt, foreign investors also own around $33 billion of Turkish stocks which are more vulnerable.

There is a risk that if 'real' interest rates fall any further foreign investors could ditch their stock holdings and bail.

'Real' rates are the difference between the yield debt-holders get as compensation for inflation and inflation. With interest rates still judged too low in Turkey that difference is already quite narrow at about 2.0%. if it falls to zero or lower bondholders will be losing money.

"Portfolio investors need to believe the story in terms of the policy mix – real interest rates need to stay sufficiently high to provide enough carry for FX risk," says Tim Ash, a strategist at BlueBay Asset Management, in an interview with Reuters.

"That's a dangerous mix if the $50 billion plus portfolio funds begin to exit – suddenly your external financing gap gets that much bigger," says Ash adding that such an exit could also hasten further local dollarisation.

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