Understanding a corporate debt crisis

Here we are, in a debt crisis again, this time with the real sector indebted and levered as never before. Turkey, as a whole, has never been as indebted as we are in this episode. It has to be clear that the loss due to the lira depreciation is a real loss that will have to be shouldered by somebody.

Turkey is, yet again, undergoing a debt crisis. On that front, in a shallow sense, this time is not different. The details are different, and those details matter. We have always been a crisis-prone economy due to government profligacy, and we were a run-of-the-mill emerging market that had large current account deficits, driven by large budget deficits, which blew up regularly. Those were our crises. This time the driver of current account deficits is private debt, in particular debt of non-financial corporations. 

Getting government accounts under control was a main pillar of the post-2001 crisis stabilization program and it was achieved, but with much pain. The second pillar was recapitalizing and regulating the banking sector. (The third was creating a credible monetary policy carried out by an independent central bank.) Since all our crises were triggered by colossal public debt intermediated and partly held by a weak banking system, getting those under control gave a false sense of security. When the government is borrowing at all costs, as much as it can, no one else can borrow much and get into trouble. Hence, we never learned about the private sector's debt problems. We are learning now. 

One of the smartest ingredients of the post-2001 regulatory environment was not only barring banks from borrowing in foreign currency and lending in liras, but also not allowing them to convert currency risk into credit risk: banks were not allowed to lend in foreign currency to firms that did not have foreign currency receivables. The former part of this regulation was obvious: currency mismatches had burned the Turkish banking system one too many times. But the latter was ingenious as it was a precaution against a problem that had never been an issue in Turkey before. With the government appetite to borrow at all costs, Turkish firms were never able to borrow much, in any currency. That prudent regulatory stance served us well for some years, but the latter part of the regulation was rescinded in 2009, in the thick of the global financial crisis. 

At a time when the Turkish economy was shrinking at a rapid pace, the government encouraged banks to lend and firms to borrow, whichever way they did it. That may have made some sense, perhaps, in 2009, but keeping that lax regulatory stance on foreign currency debt was a key ingredient of the mess we are in now. Firms, faced with much lower interest rates in foreign currency and an appreciating lira, began to borrow massively in foreign currency. That foreign currency borrowing simultaneously made Turkey vulnerable to an exchange rate shock, and made that shock more likely. 

The rest is a well understood story of macroeconomic mismanagement. The government, due to an unending series of elections and referenda, needed growth out of an economy that could not grow quickly for structural reasons. Bolstering demand with both low interest rates achieved by pressure on the Central Bank, and increased primary spending—not leading to higher budget deficits due to lower interest rates—led to a boom in borrowing, as reflected in unheard of current account deficits, and to unanchored inflation levels. 

Here we are, in a debt crisis again, this time with the real sector indebted and levered as never before. Turkey, as a whole, has never been as indebted as we are in this current episode. The country is not its government, it is not the state. Looking at the country as a whole, the private sector has done the borrowing and the government not only abetted but also actively aided that. With the sharp lira depreciation in summer 2018, many firms now have understandable solvency problems. That is the current ailment of the Turkish economy.

It has to be clear that the loss due to the lira depreciation is a real loss that will have to be shouldered by somebody. What the government clearly has not understood is that that "somebody" cannot be the firms or owners of firms alone. The government, personified for these matters by the son-in-law-minister-of-finance, is still talking about fiscal austerity and helping banks if need be. These are the cookie cutter policies that were meaningful in the previous Turkish crises, which were due to government budget deficits and unhealthy banks. As an aside, the government is saying these things because they apparently think that is what financial markets want to hear, but is not acting on that policy rhetoric. Budget deficits are increasing sharply due to unproductive government spending and banks have not seen any help. But carrying out these policies would not have helped anyway. This is the strategy to fight the last war. 

The government, a government, will have to see that there are two choices, both leading to socialization of some of the non-financial corporate debt. We will either do a real sector bailout before these firms go bankrupt, and then will have to think about how to deal with the government debt, or we will not do that, let the firms fail, then will have to recapitalize banks whose nonperforming loans—i.e., the defaulted debt of these firms—will balloon, and then will have to think about how to deal with the same government debt. Either way, in the end we will be dealing with the problem we are used to, government debt. But in one case we will have a beating heart in the real sector, in the other we will be left with healthy banks that cannot find firms to lend to. 

Clearly, a real sector bail out is preferable and incentive compatible mechanisms can be designed so that this does not turn into picking winners who are politically connected. Firm owners may be required to inject capital, banks may be given incentive contracts on firm production or employment in a few years’ time to be made whole for the debt write downs they do, and so on. The key is to see that letting firms go bankrupt does not solve the problem, but rather makes it a banking problem that still needs resolution. It's better not to go that way. 

The current government has not given any signals that they understand this is the problem and these are the choices. Talking only about the government budget balance and banking sector health is an unmistakable way of saying one does not understand what the current problem is. Kicking the can down the road does not postpone the need to make a decision: it is the decision. Not dealing with corporate debt now is a death sentence for the indebted firms.

The number of unemployed people in Turkey is at a historical record by a wide margin and making firms go bankrupt or undertake fire sales of assets to delever will only make the problem worse. This is a very painful but solvable problem, but solving it requires understanding the problem and policymakers who are capable of and interested in that understanding, as well as in doing the right thing.   

April 12, 2020 This place is different