Debt, credit growth and debt-equity swap

The “s” word is in the cards: stagflation. Slowdown is giving way to stagnation, and inflation hasn’t peaked yet. 20 percent CPI is in the cards now because the August currency shock hasn’t yet passed through and food prices were somehow low. We will see the full impact in September. Also, the scissors between domestic wholesale prices and the CPI are wide-open: 32 percent versus 18 percent. At this point, a substantial rate hike is warranted if only as an accommodative move because the benchmark Treasury bond carries 24.5 percent. If we measure the ex ante real interest rate with that metric, as it is sometimes done, the fully accommodative hike would carry 675 basis points. On the other hand, the contagion story in circulation still doesn’t look realistic to me. Argentina and Turkey have nothing to do with each other in terms of economic history or economic fundamentals; they are rather small economies not bearing much on the global financial system and so on. Yes, but panic and contagion could from time to time become ‘common factors, right? Just as EM capital inflows have provided the whole EM universe with a common driver, so can now contagion become a common cause for financial distress. However, “can” doesn’t mean “will”. Furthermore, Turkish economic woes are structural and fundamental rather than just being a nefarious consequence of the whimsiness of global financial markets or a sudden change of perceived risk premia for some EM assets. They run deeper.

Corporate debt and cred t growth

Redemptions are high. Short-term debt stock is also high at $179 billion (June data). The current account deficit could only fall to around $50 billion by the end of the year, and could stay there next year also even though there will possibly be stagnation – at least because oil prices are likely to go up than down. The corporate sector’s short position comes out on top. There is no turnover high enough to pay FX debt, cover the short position loss, incur the rising TRY interest rate debt, and transfer to the bottom line a profit to shore up equity capital in the presence of a currency shock of that magnitude. Admittedly, there can be no question of hedging or not because even if firms had wanted to hedge there was no options written for these levels. After all, we were talking about a shock wave even in July, and by the end of July the TRY/ USD exchange rate stood at 4.90.

Amortizations suggest $40-50 billion would be required in H1 2019 including the current account deficit, assuming reserves won’t help and nobody helps indebted firms in any way. Until January, there won’t be a balance of payments crisis but both financial and economic damages will extend further across sectors until then. There is obviously a close correlation with the currently negative private commercial banks corporate lending growth and this fact. Corporate lending disappeared not only because the supply and demand sides of the corporate bank loan market points to a downsizing, but because the risk management perspective doesn’t allow such growth either. If we put aside public banks, there is no market in the corporate lending business now.

Given this, the problem carries an inherent danger, that of a self-extracting threshold externality, which incidentally is negative in this case, because if lending dries up, firms can’t operate. And because their risk profile doesn’t encourage private banks to lend, well existing debt can’t be paid in the end, right? ‘Sudden stops’ aren’t good, not only for capital inflows but also in any market. If lending comes to a halt or even slows down to low single digit growth rates, neither firms nor households can secure a low but acceptable growth rate. This is a sure recipe for turning stagnation-cum-inflation into outright recession. Recapitalization is warranted on a large scale.

What can be done?

The problem is rather huge. It also has deep historical roots. Because FX debt accumulation took off back in 2004, the corporate debt cycle has largely run its course. At the same time, back in 2004, there were no mortgages, no car loans, no consumer credit comparable to today. In fact, right after the 2001 crisis, the banking sector looked like a large brokerage house, with only 25 percent of assets invested in lending, government securities crowding out most of the rest. Balance sheets were populated by non-core assets as well. It all started there when the local corporates realized that because the lira was appreciating even nominally, their FX assets were writing a loss and in return it could be a good idea to incur FX debt. In the begin-

ning there were FX assets (deposits) on the one side and FX debt on the other, sort of cancelling each other out except that assets belonged to individuals and debt to firms, even though they were the same person or household in many instances. Qua individuals, they were long FX; qua firms they owned, they were short FX. The ‘global savings glut’ had obviously encouraged them to choose that particular strategy. But bygones are bygones and we have come a long way since then.

Hence, we might be tempted to think of the whole process (of borrowing in dollars) as a probability limit that in the end almost fully converges to its limit. In a sense, the story of the 1990s was similar. Back in mid-1980s, the ANAP-Özal government had decided to issue domestic debt in order to finance rising public expenditures, and then it decided to open up the financial account so overseas investors could jump in. The roller-coaster of the 1990s was marked by the vicissitudes of portfolio capital inflows (and outflows), the so-called “hot money”, that was instrumental in financing public debt without resorting to money printing much. Well, there wasn’t hyperinflation as a result, but the public sector borrowing requirement grew by leaps and bounds, both inflation and interest rates rose, and eventually the process caused an ‘explosion’. The ‘thing ’ – or model - worked for about 15 years at most, and the outcomes followed the textbook wisdom closely. Because most macroeconomic variables explode even under rational expectations if you set up a relatively ‘non-money printing’ scheme that heavily relies on government debt issuance, in the end what you get is hitting the wall. The wall was almost hit by mid-1999, so Turkey signed a stand-by with the IMF, i.e. the infamous – and latest of its genre - Tablita that went bankrupt in February 2001. In the same vein, shifting grounds and resorting to FX-denominated overseas funding quite heavily in order to close the savings gap rather than exuberant public spending led to a probability limit in about 15 years. True, the net public debt fell, but it was replaced by the rising current account deficit. True, the public savings went up especially in the early 2000s, but the private sector borrowed instead. Trading one gap with another is no panacea for the set of structural problems the Turkish economy faces, however. Now it is the private sector that is the locus of not only a marked slowdown – stagnation perhaps, or even worse - because the FX-denominated debt stock it has piled up over the last 12-15 years is large and its open position is significant. Should we bail out at least some of the private enterprises? Should we let them go bankrupt, hoping that on the basis of cheapness they will be bought by (foreign) capital and expect that the new owners will act more rationally? Should we design a scheme whereby banks participate in their equities? Although the real estate and construction and energy sectors come to the forefront, the impact of a fast depreciating currency isn’t confined to them. The impact is widespread across sectors.

Liquidity is key in such situations. Issuing bonds can provide us with a starting point. It may be a workable idea. Two rounds of superbonds, 6 months each, can translate the locus from liquidity to the P&L. In case some firms pass on to banks as collateral because they couldn’t pay their debt at all, it could be better to lock them in an SPV – possibly run by the TMSF (SDIF – Savings Deposit Insurance Fund of Turkey) - and let them be taken over by a team of real sector experts. As such, the capital adequacy of banks can be shored up against the incoming storm – if there is one of course, but this is likely. Genuine NPLs could be transferred to the P&L instead of being retained in the balance sheet, with a discount or haircut of course. Or else they can be offset against SDIF premia. A further real economy benefit would show itself in unemployment figures because experts would decide to what extent lay-offs are required because such decisions are better made not by the current owners. FX debt should be consolidated under one center thereof. If everything goes well, owners can always reclaim their firms after they are cleaned and everything is netted off.

Another approach could be the establishment of a ‘bad bank’ and/ or a REIT. Bankrupt firms’ credit collaterals would be transferred to the ‘bad bank’, other banks would accept a haircut, and the rest of the shares could be re-issued to the public. Banks need be financed via long-term bonds until the IPO or SPO is completed. Banks could also be allowed to participate directly to equity through debt-equity swaps. If they so choose, banks will have to inject capital before the swap. The extent of the haircut can be rendered dependent on the amount of capital injection; the more recapitalized a bank is the milder is the haircut. Hence, with a tripartite scheme, risk can be redistributed and the maturity can be re-extended. Of course, to be able to do any of this, a major macro programme has to be designed and markets, both domestic and overseas, should accept it. That would, or should, bring in a large chunk of front-loaded FX loans. When the problem is a garden-variety balance of payments crisis or a standard fiscal deficit issue, what is to be done is almost clear. When the locus of the problem is the private sector itself, however, one needs a little bit more of a financial prowess. Can it be done? Yes, I believe. Will it be done? Probably not in the very short-run. We may see more of a muddling through in the short-run, but eventually the malaise will have to be fundamentally addressed. By eventually, I mean a few months or, incidentally, after the municipal elections due in March 2019 at the latest.