Turkey’s banks in very different place to few years ago but weak spots remain says Capital Economics

Turkey’s banks in very different place to few years ago but weak spots remain says Capital Economics
Turkish banks’ holdings of FX as cash or at Turkish central bank & short-term external eebt ($bn). / Refinitiv, CBRT, CEIC, Capital Economics
By bne IntelIiNews March 23, 2023

Amid the global banking crisis, Turkey’s banking sector can be seen as “in a very different place to where it was just a few years ago as the credit boom of the 2010s is deflating, banks are deleveraging their external debts and FX cash buffers are now much healthier”, according to Capital Economics. “All of this has helped to reduce some banking vulnerabilities. So long as there is no marked deterioration in global risk appetite and a major external financing squeeze is avoided, Turkish banks could muddle through further [Turkish lira] currency falls and a period of tighter external financing conditions without severe problems,” Capital’s Liam Peach said in a March 22 note to investors.

He added: “But risks are not completely eliminated as there are some weak spots that could be exposed if concerns about the global banking system were to escalate. For one, banks could face more severe external funding strains. Turkey’s banks still need to roll over a large amount of external debt this year ($80bn of principal and interest). They could burn through their FX assets but this would cause credit conditions to tighten.

“What’s more, Turkey’s current account deficit (5.7% of GDP on a 12m basis in January) is financed in large part by ‘other investment’, including banking sector flows. We’ve been concerned about the overvaluation of the lira for some time and it could come under more pressure. If capital inflows were to dry up, Turkey would need a period of much weaker domestic demand to narrow the deficit.”

Left: Turkish banks' total external debt rollover rate (6m Sum %).
Right: Banks' total external loans (% of GDP).
(Credit: Capital Economics).

While Turkey’s banking sector has been one of the weak links in the EM world in recent years due to its very high external debt burden, analysts are encouraged that its banks have paid down external debts and built up their FX liquidity buffers since 2018, a year in which the country’s fortunes took a severe turn for the worse with a balance of payments crisis. The lower external debts have reduced some banking vulnerabilities, but the economy remains highly reliant on external financing, leaving it exposed to souring global risk appetite.

Said Peach: “Turkey is one country that has consistently flagged up as the most exposed to a deterioration in external financing conditions. Turkey’s banks have one of the highest external debt burdens in EMs, a large share of which has historically consisted of cross border bank loans issued at short maturities.

“This has been a key source of vulnerability in the past, particularly during the 2018 lira crisis when the currency plunged, risk appetite soured, borrowing costs spiked and banks faced difficulty rolling over their external debts. But the situation looks different today. Crucially, there has been a change in the structure of Turkey’s banking sector since 2018, reflecting very harsh external deleveraging.”

Turkish banks’ total external loans (i.e. cross-border bank funding) peaked at $101bn (12% of GDP) at the end of 2017 and declined to $60bn (7% of GDP) as of 3Q22, noted Capital. This has brought the external debt burden of Turkish banks closer into line with EM peers, even though it is still high by comparison. 

“More broadly, the stock of Turkish banks’ total external liabilities (which includes currency and deposits, debt securities, loans and equity) declined from $200bn to $125bn over this period (a 9% of GDP fall) and banks’ total external assets rose by $15bn to $55bn. The result has been a marked improvement in banks’ net foreign asset position to levels not seen since 2010,” observed Peach.

The fall in external liabilities has driven a reduction in banks’ total liabilities and the size of their balance sheets relative to GDP has declined. “On the asset side, banks have significantly pulled back lending activity,” added Peach. “We estimate that bank loans to the private sector have declined by 15-20% of GDP since 2018 and that the loan-to-deposit ratio has fallen to a ten-year low of 0.9. All of this follows one of the largest private credit booms seen anywhere in EMs in the 2010s, which came to an abrupt end in 2018.”

The retrenchment, concluded Peach, hasn’t come without cost, with the decline in lending activity, for example, coinciding with a slump in construction investment. “But,” said Peach, “it has meant that Turkey’s banking system is now in one of the strongest positions it has been in for many years. The decline in external liabilities has helped to reduce banks’ vulnerability to sharp falls in the lira and tighter external financing conditions. “Banks also have much better FX liquidity buffers than in the past – Turkish banks rebuilt their FX cash holdings in 2021 and these now exceed their short-term external debts for the first time in at least a decade.”