Weak Fundamentals and Political Tensions To Weigh on Turkish Lira

new turkeyThe Turkish economy is finally picking up.  However, we believe weak fundamentals and ongoing political tensions will continue to put downward pressure on the lira.

POLITICAL OUTLOOK

President Erdogan remains firmly in control.  Dissent has been quashed with purges of the military, police, academia, and the civil service.  Opposition leaders and lawmakers have also been imprisoned.  The state of emergency has been extended several times already, and shows no sign of ending anytime soon.

The next parliamentary and presidential elections are scheduled for 2019.  Under the recently approved constitutional amendments for presidential reform, Erdogan can now run for two more 5-year terms, which could theoretically see him rule the country until 2029.

The opposition remains weak and divided.  The Republican People’s Party (CHP) held a peaceful protest march back in June.  It was responding to one of its lawmakers being sentenced to 25 years in prison for revealing state secrets.  This was time a lawmaker was jailed after parliamentary immunity was stripped last year.  The pro-Kurdish Peoples’ Democratic Party (HDP) has a dozen of its lawmakers imprisoned.

Iraqi Kurds just voted overwhelmingly for independence.  Results of the poll show 93% were in favor of seceding from Iraq.  This should keep regional tensions high, with Iraqi Prime Minister al-Abadi authorized by parliament to send government troops to the flashpoint city of Kirkuk.  Iraqi Kurds have basically been semi-autonomous since 1991, but the referendum upset the delicate balance that had been established.

For its part in raising tensions, Turkey has threatened to shut off the flow of oil from Iraqi Kurds that must go through its port of Ceyhan.  Erdogan is concerned that the quest for independence will spread to Turkey.  Why?

The concept of a Greater Kurdistan encompasses the mountainous regions of southeastern Turkey, northeastern Syria, northern Iraq, and western Iran.  There are large Kurdish minorities in all four nations that share a common culture and heritage.  The majority of Kurds are Sunni Muslims.

The goal of establishing an independent Kurdistan took hold in the early 20th century.  After World War I ended with the defeat of the Ottoman Empire, the Western nations made provisions for the establishment of a Kurdish state.  Yet when the Treaty of Lausanne was signed in 1923 to set the boundaries of modern Turkey, the idea of a Kurdish state was eliminated from the agreement.

Turkey scores OK in the World Bank’s Ease of Doing Business rankings (69 out of 190 but up from 63 in 2016).  The best components are protecting minority investors and enforcing contracts, while the worst are paying taxes and resolving insolvency.  Turkey also does OK in Transparency International’s Corruption Perceptions Index (75 out of 176 and tied with Bulgaria, Kuwait, and Tunisia).

 

ECONOMIC OUTLOOK

The economy is finally picking up.  The government’s forecast of 5.5% this year (initially considered to be too optimistic) is looking more and more realistic, as GDP rose 5.1% y/y in Q2 vs. 5.2% in Q1.  GDP growth is forecast by the IMF to decelerate modestly to 2.5% in 2017 from 2.9% in 2016, before picking up to 3.3% in 2018.  Monthly data so far in Q3 suggest some modest improvement, and so we highlight clear upside risks to the growth forecasts.

Price pressures bear watching, with CPI accelerating to 10.22% y/y in August from 9.6% in July.  September CPI data is due out next Tuesday.  Given the lira weakness seen this month, we see risks of some further acceleration of inflation.  If so, this would move it further above the 3-7% target range.

While this supports the case for higher rates, we believe the central bank will be under pressure to loosen policy.  Indeed, Economy Minister Zeybekci noted that there’s room (2-3 percentage points) to lower commercial bank loan rates.  This is just the latest in a long string of efforts to influence monetary policy.  Next policy meeting is October 26, and no change is expected then.

Fiscal policy has remained surprisingly prudent.  The budget deficit came in at an estimated -1.1% of GDP in 2016, close to the -1% posted in 2015.  It is expected to widen to around -2.7% of GDP in 2017 and -2.4% in 2018.  The government is drafting tax reforms that would reportedly increase the tax on the finance industry from 20% to 22%.  The plan would also hike taxes on gambling, soft drinks, and motor vehicles.

The external accounts should worsen.  The current account deficit was about -3.8% of GDP in 2016, and is expected by the IMF to widen to -4.7% in 2017 and -4.6% in 2018.  This wider gap will likely have to be covered largely by so-called “hot money” as FDI inflows remain weak.

Foreign reserves have steadied after falling over the course of 2015 and 2016.  At $90.4 bln in August, they cover nearly 4 ½ months of import but account for only half of the stock of short-term external debt.  This is the amongst the worst in EM.  Indeed, there are only a handful in EM whose reserves are smaller than short-term external debt.  Besides Turkey, these include Malaysia, Ukraine, and South Africa.  Furthermore, so-called usable reserves (which net out commercial bank FX deposits at the central bank) stand at only $27 bln currently.

 

INVESTMENT OUTLOOK

The lira continues to underperform, as it did in 2016.  In 2016, TRY fell -17% vs. USD and was ahead of only the worst performer ARS (-18%).  So far in 2017, TRY is -1.2% YTD and is ahead of only the worst EM performers PHP (-2.5%) and ARS (-9.4%).  Our EM FX model shows the lira to have VERY WEAK fundamentals, so this year’s underperformance is likely to continue.

USD/TRY couldn’t sustain a break below 3.40 and has turned higher.  The low for this move was recorded on September 11.  Break of the 3.5485 area sets up a test of the July 7 high near 3.6470.  After that is the April 7 high near 3.75.  The 200-day MA comes in near 3.5925.  We think the high carry currencies that were so popular earlier this year will continue to fall out of favor now that the Fed will start shrinking its balance sheet and continue hiking rates.

Turkish equities are outperforming EM after underperforming in 2016.  In 2016, MSCI Turkey rose 4% vs. 7% for MSCI EM.  So far this year, MSCI Turkey is up 29% YTD and compares to 25.5% YTD for MSCI EM.  This outperformance should continue, as our EM Equity model has Turkey at an OVERWEIGHT position.

Turkish bonds have performed OK recently.  The yield on 10-year local currency government bonds is about -30 bp YTD.  This is in the middle of the EM pack.  The worst performers are Czech Republic (+83 bp), China (+61 bp), Korea (+29 bp), and India (+16 bp), while the best are Brazil (-159 bp), Indonesia (-143 bp), Peru (-113 bp), and Russia (-69 bp).  With inflation likely to continue rising and the central bank likely to fall further behind the curve, we think Turkish bonds will start underperforming more.

Our own sovereign ratings model showed Turkey’s implied rating worsening a notch for the second straight quarter to B+/B1/B+.  We think Turkey continues to face strong downgrade risks to its BB/Ba1/BB+ ratings.