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Turkey’s wings clipped – what next?

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Summary

With the Turkish lira falling fast, we examine the pros and cons of capital controls and ask the question, could it ever happen here?

3 min read

As the Turkish government makes efforts to stabilise the lira, we consider whether President Erdogan will turn to capital controls to halt the falls.

Turkish delight turns bitter

Although considered one of the fastest growing emerging economies, Turkey has run in to problems over the course of 2018 thanks to rising inflation and concerns about external debt. Additionally, sanctions imposed by the US earlier in August have exacerbated the situation and accelerated the decline in value of the Turkish lira. The Turkish finance minister Berat Albayak has announced various measures to ease the pressure and calm markets.

Alan Higgins, Managing Director at Coutts said, “The measures don’t address the structural issues that are worrying investors – chiefly a high balance of payments deficit and what investors see as the unconventional policies and undue influence of government on the central bank.”
 

Could Turkey impose capital controls?

Mr Albayak explicitly rejected the possibility of capital controls last week, but markets remain anxious that the lira’s plunge makes some form of control on foreign exchange inevitable.

Capital controls are put in place by governments to restrict the ability of locals to buy foreign assets, or foreigners from buying local assets. They generally come about when governments fear that trade in local assets could have a destabilising effect on the economy.

The Greek government imposed capital controls in 2015, for example, after the European Central Bank froze its support of the Greek economy by refusing to offer further emergency funding. As well as closing banks completely for a period of 20 days and limiting cash withdrawals (to prevent a bank run), the Greek government limited transfers from Greek banks to foreign banks which could have seen local banks emptied of cash reserves.

Banking crises in Cyprus (2013) and Iceland (2008) also saw controls imposed to prevent a complete collapse of the banking system. Controls in Iceland remained in place in one form or another until 2017 as the country recovered from the effects of the global financial crisis.

“The UK ranks highly as one of the easiest countries for doing business, attracting large levels of international business. No government would want to threaten this standing by putting up extreme barriers to trade like capital controls.”

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And closer to home?

Alan Higgins explained, “It’s a measure that we typically don’t see in large developed economies. For example, the recent fall in sterling has certainly had an impact on the UK economy – inflation in particular – but a catastrophic run on the pound seems highly unlikely given the UK’s position in the global economy.

“Capital controls are usually associated with a crisis in the banking sector – as in Cyprus and Iceland – or debt – as in Greece. In the event of a hard Brexit, it would be unlikely to see capital controls imposed. The UK benefits enormously from free foreign exchange as a centre for international business.”

As we recently pointed out, the UK ranks as one of the easiest countries for doing business, attracting large levels of international business. No government would realistically want to threaten this standing by putting up extreme barriers to trade like capital controls.

In the meantime, analysis from the Bank of England (BoE) suggests a banking crisis in the UK is highly unlikely. UK banks have improved leverage ratios and substantially increased capital ratios, which measure a bank’s exposure to debt and other risks, putting them on a firmer footing than before the financial crisis. They’ve also passed all BoE stress tests across a number of scenarios – for example, world GDP hypothetically falling 2.4%, UK house prices hypothetically falling 33%, hypothetical BoE rate rises to 4%, and numerous others.

The question of whether Turkey will impose further capital controls depends on what other action it takes. The government has already put measures in place that have the same effect, by lowering the threshold of foreign currency swaps for lenders. This makes it harder for offshore investors to short the lira, and has provided some support for the currency.

As Alan Higgins points out, “More conventional remedies exist. Raising interest rates would be among the more obvious ways to support the currency, but President Erdogan has stated that he believes rate rises encourage inflation, in contradiction of the generally accepted wisdom. While the government has said ‘no’ to capital controls, events may force their hand.”
 

Coutts emerging markets exposure

Coutts portfolios have no direct exposure to Turkey, although some of our emerging markets fund managers will have modest holdings in Turkish assets in their portfolios. Earlier this year, we reduced emerging markets in favour of developed markets, where we see a stronger economic outlook led by the US. This will limit the impact on our clients’ investments of any Turkish contagion that may spread to other emerging markets.

We have also modestly increased our holdings in cash and gilts in response to what we see as a rising risk environment, although we maintain an overall preference for equities over more defensive asset types.

We are, of course, monitoring the situation and are ready to make further adjustments should they become necessary, as we aim to preserve our clients’ wealth over the long term.

Past performance should not be taken as a guide to future performance. The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment.

The crisis for the Turkish lira has raised the spectre of capital controls. Capital controls impose limits on foreign exchange and are a way to staunch a sharp devaluation and protect banks and other institutions. It’s very rare to see these measures enacted, especially in developed markets. While Turkish officials ruled them out last week, it remains a source of market anxiety.

About Coutts Investments

With unstinting focus on client objectives and capital preservation, Coutts Investments provide high-touch investment expertise that centres on diversified solutions and a service-led approach to portfolio management. Our investment process is as disciplined as it is creative – ensuring tailored solutions with robust results.

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