The Turkish Debt Dilemma

| About: iShares MSCI (TUR)

Over the past decade, Turkish GDP has been a star emerging market, with growth at 9% per year, and the Turkish stock market has boomed the past few years. On the surface, Turkey is a model emerging market, with an ostensibly successful Islamic government and an ostensibly independent central bank. I argue this is not the case, but rather Turkey is in danger of a collapse.

Turkish government debt to GDP is only 40%, which is a modest number for an emerging market country with explosive growth. But the problem with Turkey is not in the government's debt; it's the unstoppable private sector loan growth (32% per year since 2007) that isn't funding productive assets. Total loans now represent 60% of GDP. Since 2007, imports of capital goods have grown only 5% and in 2012, dropped by 9%. At the same time, Turkey is running a Greek-sized current account deficit of 9% of GDP and only appears to be stopped by moves in the Turkish Lira.

To fund this current account deficit, Turkey has increased short-term external debts to $110 billion (14% of GDP), and about half of this is in interbank borrowing, which could be withdrawn in days or weeks, not years. Investors (or foreign banks, typically European) with short-term money invested in Turkey are very sensitive to the value of the Turkish Lira, and its fluctuations over the past six months have been a going concern.

What is so scary about the private sector loan growth is that it is not correlated to GDP growth. In 2012, GDP growth was stagnant (2% yoy growth), while loans grew at 20% and imports remained flat. I liked an interpretation I read, "Turkey's eyes are too big for its stomach." Consumer spending increased by about $9 billion (6% yoy) in 2012 with loan growth of $70 billion -- where is the remaining $61 billion going? Not to productive assets as capacity utilization has remained relatively unchanged over the past year (down 1% in 2012).

The missing $61 billion is a mystery, but there's one theory that makes a lot of sense: investors are already beginning to capitalize interest. Interest rates have (until January) remained low, yet loan delinquencies have risen sharply - a very disturbing trend.

We can see a few trends here. First, Turkish corporations and citizens are borrowing money at record low rates, but they aren't funding productive assets. The Turkish economy is not using leverage to fuel growth - it is fueling private consumption. Second, the problem is quickly becoming systemic and, as foreign investors become increasingly sensitive to interest rates and the value of the Lira, there may be more problems to come for the Turkish economy.

Turkey is too dependent on foreign lending to "extend and pretend" as larger economies can do. Turkey has two main factors that it can control, its interest rates and its exchange rate. If Turkey devalues the currency, it will be able to temporarily move towards current account neutrality - but only temporarily, because relatively low-yielding short-term external debt is very sensitive to currency fluctuations. Furthermore, amidst an attack on the Turkish Lira in January 2014, the Turkish central bank spent close to $5 billion of its $40 billion of foreign exchange reserves after a corruption probe into the government sent the Turkish Lira plummeting. In a reactionary move, the Central bank announced an aggressive and immediate short-term interest rate hike to stop the bleeding. It has worked for now. But as rates increase, the cost of borrowing on the private loans has just become significantly more expensive. How long can the borrowers survive?

To expedite the social unrest which started this problem in September, Turkey will be holding elections in March, where the country's long-time Prime Minister Recep Erdogan will, it appears, do whatever it takes to win. He has taken an increasingly polarizing stance over the past year, and the elections appear a good catalyst for social unrest in Turkey. And even if the elections go off without a hitch, loan growth still has yet to slow. For the reasons listed above, I recommend reducing exposure to Turkey or shorting the MSCI Turkey ETF (NYSEARCA:TUR) or the Turkish Lira, or both.

Disclosure: I am short TUR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.