Turkish lira seen weakening further but no Russia-style rout

The lira may have 5 to 10% further to fall against the dollar if Turkey’s credit rating is cut to junk this month, though a downgrade should weigh less heavily on markets than on Brazil and Russia last year.The currency has already been under pressure, tumbling 7% against the dollar following the failed July 15 coup and the subsequent government crackdown on opponents, but has since recouped around 2.5%.Against trade partners’ currencies, it is now down 4.5% — among this year’s worst emerging currency performers.And adjusted for inflation — in real effective exchange rate (REER) terms, it stands 10% below its own 10-year average.But a slowing economy and political tensions, within Turkey as well as with the West, mean there are more stormclouds gathering.Finally, Moody’s and Fitch will review their Turkey ratings on Aug 5 and Aug 19 respectively — a cut to junk is expected from Moody’s, either this week or in coming months.The median forecast from a Reuters poll of 27 analysts was for the lira to fall to 3.12 in six months and 3.18 in a year, implying 5% depreciation by next July.But currency strategists have tended to underestimate lira weakness, suggesting the consensus view could prove too optimistic.Many banks are more pessimistic — the weakest six-month forecast was for 3.33 per dollar.Commerzbank which predicts a 3.25 rate by year-end, warned this may be reached sooner.UBS strategist Manik Narain says while the lira looks fairly valued on consumer inflation-based REER, it is relatively expensive when the REER is calculated on the basis of unit labour costs (ULC).Essentially the cost of labour used in generating output, ULC is a broad competitiveness gauge.Official data shows Turkish labour productivity lags the European average, rising 1.5% a year in the past five years while wage growth averaged 5%.Narain says the lira’s ULC-based REER is 10-15% above its five-year average, and indicates it should depreciate to near 3.25 per dollar.“You’ve seen very strong ULC rises in Turkey, with wages growing 14-15% in some sectors and close to zero productivity growth,” he said.“This helps to explain why the current account deficit has been so sticky and export performance hasn’t recovered.”Another reference point on where the lira could trade is CDS or credit default swaps, used by investors to insure against debt default or restructuring.A downgrade to the top junk rung roughly indicates five-year Turkish CDS at 300 basis points, says Koon Chow, emerging markets macro and FX strategist at UBP Asset Management.“If you put on some risk premium that’s another 50-100 bps so that’s 350 bps-plus,” Chow said.”When you look at the historical relationship between CDS and currency and extend Turkish CDS to 350, it implies dollar/lira at 3.2 (per dollar).”But most see a rout on the scale experienced by Russia and Brazil as unlikely — UBP’s Chow described Turkey’s situation “as 180 degrees different”.The rouble fell 60% in the six months before its first cut to junk and Russian dollar bond premia over Treasuries rocketed 500 basis points.Brazil’s real slumped 40% last year around S&P’s September downgrade and its premia over Treasuries doubled.But those moves coincided with a commodity slump that deepened stress for already struggling economies.Also, Russia had been slapped with Western sanctions for meddling in Ukraine, while Brazil was staggering under a 10% budget deficit and massive corruption scandals.Turkey meanwhile runs a budget surplus and its economy, while slowing is still expanding faster than 4%.Finally, emerging markets’ fortunes have turned since 2015, when the sector was pressured by US rate rise expectations.Now, they are enjoying robust investment inflows and posting double-digit returns.JPMorgan said past lira selloffs have typically coincided with a poor emerging markets backdrop.Turkey’s inflation, current account gap and banks’ external debt are undoubted risks, JPM said, but concluded: “Broader external pre-conditions for a crisis are not in place.”