After Turkey’s official inflation rate surged above 70% in May, some global companies, including UK consumer goods giant Unilever, have begun applying hyperinflation accounting to their Turkish operations.
In recent years most European banks with operations in Turkey have been trying to reduce their exposure to Turkey’s cratering economy, with one big exception: Spain’s second largest lender, BBVA. In May, BBVA used some of the money it raised from selling its US operations to increase its stake in Turkey’s second largest private bank, Garanti BBVA, from just under 50% to 86%. Like its larger Spanish rival Santander, BBVA has spent the past couple of decades expanding in high-growth emerging economies as a means of boosting income. But as I’ve warned for a number of years, the strategy is not without its share of risks.
On Tuesday (June 28), one of those risks materialized. BBVA announced it had begun to apply hyperinflation accounting for its Turkish subsidiary Türkiye Garanti Bankası (also known as Garanti BBVA), which was its third largest source of group profits last year. The purpose of hyperinflation accounting, otherwise known as IAS (as in “International Accounting Standard”) 29, is to set specific standards for entities reporting in the currency of a hyper-inflationary economy, so that the financial information provided is meaningful. To that end, companies can opt to restate their financial statements, disclosing their results in real as opposed to nominal terms.
The accounting rules apply retroactively from Jan 1 of the year in question. The impact on BBVA’s first quarter results will be reflected in the bank’s second quarter income statement. In May, the official inflation rate in Turkey was above 70% and BBVA’s base-case scenario is that it will not fall below 60% at any point this year.
This is why BBVA has decided to apply hyperinflation accounting, which will wipe out €324 million from the bank’s P&L statement for the first quarter. Instead of providing €249 million in profits, BBVA Garanti will have generated €75 million in losses. Looking to the rest of the year, BBVA expects Garanti’s earnings in Turkey to be “non-material” to its overall performance, in light of the nation’s expected inflation. Despite taking a huge chunk out of BBVA’s profits, the adoption of IAS 29 does have a silver lining: it increases the bank’s Tier 1 capital ratio by 19bp to 12.89% in Q1 and raises its book value by €254 million.
Inflation Hits 23-Year High
In May, Turkey’s official year-on-year consumer price index (CPI) surged to 73%, a 23-year high. This has happened as the value of the lira against the dollar, which itself is more or less continually losing value, has plunged by almost 25% so far this year, after losing 44% of its value in 2021. The currency is currently trading at 16.68 units to the dollar, compared to 7.44 in January 2021 and 3.78 at the start of 2018.
The more the lira collapses, the higher the rate of inflation surges. In recent years Turkey’s President Recep Erdogan has held almost total sway over the country’s economic and monetary policy institutions, even going so far as to appoint his son-in-law, Berat Albayrak, as Minister of Finance in July 2018, a position he resigned from in 2020. Since 2019 Erdogan has fired three central bank governors for hiking interest rates over-zealously. In January 2022, he fired the director of TUIK for announcing an inflation rate that was deemed too high.
At that time, the official inflation rate was 36.1%. Today, it is over double that (73%) while producer prices have risen to an eye-watering 132%. Yet according to ENAG, an independent group of researchers in Turkey, the real rate of consumer price inflation is actually more than double the official rate, at around 160%. This has put ENAG on collision course with TUIK, which recently sued ENAG, accusing it of seeking to tarnish the national institute’s reputation.
Now, global companies are beginning to consider Turkey’s economy as hyper-inflationary. Like BBVA, the Spanish insurance firm Mapfre is also considering adopting IAS 29 for its Turkish accounts. It’s a step that global consumer goods giant Unilever has already taken, after announcing on June 28:
In Turkey, cumulative inflation rates over a three-year period exceeded 100% as at April 2022 and the accounting firms, based on IAS 29 criteria, have now classified Turkey as a hyperinflationary economy for reporting periods ending on or after 30 June 2022. Unilever concurs with, and has now decided to apply, the external guidance and as a result has completed a preliminary assessment of the expected financial statement impact for the quarter ending at 30 June 2022.
For Q2 2022 reporting, and until further notice, Unilever will follow its standard practice of capping the growth metrics UPG and USG, using the same methodology applied for other hyperinflationary countries (see practice described in detail in the link below). Growth will be the only metric in Q2 impacted by the classification of Turkey as hyperinflationary. All other aspects of Unilever’s first half financial statements will be reported as normal.
Hyperinflation denotes rapid and unrestrained price increases, typically measuring more than 50% per month. And Turkey has not reached that point — at least not yet. First established in 1989 as a universal standard for financial reporting in so-called “hyper-inflationary” economies, IAS 29 does not set an absolute rate at which hyperinflation is deemed to arise. It allows companies to judge for themselves as to when it might become necessary to reinstate their financial statements. The IAS Plus website lists some of the general economic conditions that may indicate whether a country is suffering from hyperinflation:
The cumulative inflation rate over three years approaches, or exceeds, 100% (in the case of Turkey, the cumulative inflation rate in April 2022 was 121%). This is a lot lower than 50% per month.
The general population prefers to keep its wealth in non-monetary assets or in a relatively stable foreign currency.
Amounts of local currency held are immediately invested to maintain purchasing power; the general population regards monetary amounts not in terms of the local currency but in terms of a relatively stable foreign currency.
Prices may be quoted in that currency; sales and purchases on credit take place at prices that compensate for the expected loss of purchasing power during the credit period, even if the period is short;
Interest rates, wages, and prices are linked to a price index;
The International Practices Task Force (IPTF), a task force of the SEC Regulations Committee focused on international emerging technical accounting and reporting issues relating to SEC rules and regulations, has compiled a list of 11 countries that currently have three-year cumulative inflation rates exceeding 100%: Argentina, Iran, Ethiopia, Lebanon, South Sudan, Sudan, Suriname, Turkey, Venezuela, Yemen and Zimbabwe. As IPTF acknowledges, the list is not exhaustive since the sources used to compile it do not include inflation data for all countries.
Rising Risks in Turkey
At the height of the last big wave of Turkey’s ongoing economic crisis, in August 2018, the European Central Bank issued a warning about the risks the plummeting lira could pose to Euro Area banks heavily exposed to Turkey’s economy via large amounts in loans — much of them in euros — through banks they acquired in Turkey. The central bank was worried that Turkish borrowers might not be hedged against the lira’s weakness and would begin to default on foreign currency loans, which accounted for 40% of the Turkish banking sector’s assets.
Since then, some European banks have reduced their exposure. For example, Italy’s Unicredit, which also has significant exposure to Russia, has sold its entire stake in the Turkish commercial bank Yapi Kredi. For other large European banks, such as BNP Paribas and ING, the exposure to Turkey is rather limited.
The same cannot be said for BBVA. In May, the Spanish bank paid Garanti shareholders €1.4 billion to acquire 36% of the Turkish lender’s remaining shares, taking its stake to 86%. As I wrote in early November, when BBVA first announced its intentions to take a majority stake in Garanti, the move amounts to a massive gamble on Turkey’s Erodgan-dominated economy and has found little favour among investors. Since that time, BBVA’s shares have fallen 30% while the shares of most other Spanish lenders, with the notable exception of Santander, have risen during that time.
Over the past 12 years BBVA has spent €8.3 billion to buy up 86% of a lender whose total market capitalization is currently €3.3 billion. Now, BBVA’s management has also had to write off an additional €325 million in Garanti’s profits due to the collapsing lira and the Turkish economy’s increasing flirtation with hyperinflation. While it is true that BBVA already has some experience of operating in hyper-inflationary environments, most recently in Venezuela and Argentina, neither of these markets are nearly as important to the banking group’s bottom line as Turkey, which accounted for 19% of total profits in the first quarter.
Like many banks in Turkey, Garanti has extended large amounts of foreign-denominated loans to Turkey’s real estate, construction, energy and tourism sectors, the first three of which are still recovering from the 2018 crisis while the fourth is reeling from the effects of the virus crisis as well as the fallout from the Ukraine conflict, as Russian tourists, normally a major presence and economic boon to Turkey’s coastal regions, stay away.
In another sign of the rising risk environment for Turkish banks, Garanti BBVA decided in May not to call its USD750 million Tier 2 debt. According to the ratings agency Fitch, the decision was probably guided primarily by economic considerations given higher refinancing costs amid market volatility:
The operating environment for banks in Turkey has deteriorated due to pressure on the lira, spiralling inflation and the negative implications of rising US interest rates on emerging markets. Sekerbank, a smaller bank, has also decided not to call its Tier 2 debt, instead extending the tenor.
Garanti’s decision is likely to have taken investors by surprise as the market norm for Turkish banks in recent years has been to call Tier 2 instruments. However, as well as saving Garanti the increased refinancing costs, the non-call will underpin the bank’s capital position by continuing to provide a hedge against lira depreciation (currently the greatest risk to Turkish banks’ capitalisation), and supporting its total capital ratio. The call will also preserve Garanti’s foreign-currency (FC) liquidity buffer amid ongoing lira depreciation. Lira weakness has been exacerbated by the additional market volatility triggered by the war in Ukraine, and creates heightened FC liquidity risks for Turkish banks given their exposure to international investor sentiment and their high deposit dollarisation.
It is not just banks that are feeling the pain. So too are insurance companies, whose premiums have increased in line with inflation while their profits have declined. As Reuters reported on Tuesday (June 29), data from the Insurance Association of Turkey (TSB) shows that the sector’s net profit was 264.1 million Turkish lira ($15.88 million) in the first quarter of this year, down some 85% from 1.75 billion lira in the same period of 2021. Conditions have become so dire that TSB is now in talks with Turkey’s Treasury about issuing an inflation-indexed bond as a means of protecting firms’ capital from soaring inflation.