Turkey Gets a Temporary Reprieve

turkeyThe Turkish lira has stabilized but we do not think the worst is over yet.  External conditions have deteriorated ahead of the June elections, leading to a perfect storm.  Whatever further measures are taken, Turkey is likely to remain under pressure within the context of a broad-based EM sell-off.

POLITICAL OUTLOOK

President Erdogan is widely expected to win the presidential election on June 24.  Likewise, his AKP party is expected to win another parliamentary majority.  Elections were moved up from the scheduled date in November 2019, as Erdogan tries to take advantage of his current high popularity.

President Erdogan remains firmly in control.  Under the recently approved constitutional amendments for presidential reform, Erdogan can run for two more 5-year terms, which could theoretically see him rule the country until 2028.   After these elections, the post of Prime Minister will be eliminated and most of its powers will be shifted to the presidency.

The opposition remains divided, and yet Erdogan is taking no chances.  His ruling Justice and Development Party (AKP) entered into an electoral alliance earlier this year with the Nationalist Movement Party (MHP).  Whilst the MHP has opposed Erdogan in the past, it is facing the prospect of failing to win 10% of the vote in the election.  As such, it has entered this alliance in order to avoid extinction.

The other main opposition parties are the Republican People’s Party (CHP) and the People’s Democratic Party (HDP).  These four were the only parties to surpass the 10% threshold in the 2015 elections that is needed for parliamentary representation.  The CHP remains the largest opposition party.  Like the MHP, the HDP saw its vote share fall from the prior election to barely over 10%.

The rise of the centrist Good (Iyi) party is worth watching.  Founded in October by its leader Meral Aksener, Iyi is made up of many former members of MHP and CHP.  Iyi is quickly gaining traction with its anti-establishment message.  In the most recent Mediar poll, its presidential candidate Aksener is polling nearly 20% vs. 44% for Erdogan.  Aksener’s recent surge came largely at the expense of Erdogan.  Likewise, his Iyi party is polling nearly 20% and could be the third largest party in Parliament behind AKP and CHP.

Turkey scores well in the World Bank’s Ease of Doing Business rankings (60 out of 190).  The best components are protecting minority investors and enforcing contracts, while the worst are dealing with construction permits and resolving insolvency.  Turkey does slightly worse in Transparency International’s Corruption Perceptions Index (81 out of 180) and tied with Ghana, India, and Morocco.      

ANOTHER BRIEF HISTORY LESSON

Necmettin Erbakan served as Prime Minister from 1996-1997.  He was considered to be mildly Islamic, but was forced from office by the military for violating the secularist tradition established under Kemal Ataturk.  Erbakan was barred from politics, as was his Welfare Party.  However, Erbakan helped his colleagues from the Welfare Party, including then-Istanbul Mayor Recep Tayyip Erdogan, establish themselves as the next generation of Islamic leaders in Turkey.  More on this below.

Turkey experienced a severe financial crisis from 2000-2001.  The seeds were planted by the 1997-1998 Asian crisis.  Even though that had largely ended by 1999, Turkey continued to have trouble attracting foreign capital flows as it moved into 2000.  The IMF approved a supplemental $7.5 bln package in December 2000 on top of the $4 bln standby that had been approved in December 1999.

As with so many EM crises, Turkey’s crisis had banking and currency aspects to it.  After the new government came into power in December 1999, policymakers introduced a crawling peg regime for the lira in an effort to anchor inflation and inflation expectations.  Crawling pegs were in vogue at the time for many of the CEE countries as they transitioned to market economies after the fall of the Iron Curtain.

Ahead of the crisis, Turkey’s banking system had systemic weaknesses.  It had been deregulated without introducing sufficient regulatory oversight or supervision.  Furthermore, the banking system was highly dependent on foreign funding, and faced a largest structural maturity mismatch.  Thus, one major bank facing a cut-off in interbank funding quickly turned into a system-wide liquidity crisis.  This in turn morphed into a currency crisis.

After the peg broke in February 2001, the lira weakened nearly 60%.  Inflation spiked and the recession deepened and led to a series of bank failures.  To put things into perspective, the lira has weakened less than 20% during this current bout of weakness.  We have always felt that a floating exchange rate acts like a shock absorber.  While the 20% loss is causing stresses in Turkey, it is much less disruptive than a broken peg.  Even if the lira goes on to weaken further, the stepwise nature does give domestic agents some time to adjust.

The economic chaos of 2000-2001 paved the way for the landslide election victory by Erdogan’s Justice and Development Party (AKP) in November 2002.  At that point, Erdogan was still banned from politics for reciting a religion poem and so Abdullah Gul became Prime Minister.  Erdogan then took over in March 2003 after his ban was overturned.  He’s never looked back.

Yet once upon a time, Erdogan followed orthodox economic policies and stuck to a well-trodden secular path.  When the AKP took over, it introduced significant structural reforms that included a new law on Foreign Direct Investment, privatization of State-owned Enterprises, and corporate tax cuts.  These measures helped the Turkish economy take off, with growth averaging nearly 7.5% from 2003-2007.

The IMF had approved a $16 bln standby program for Turkey in February 2002, before the AKP came into power.  Turkey stuck with that program, and a new $10 bln standby was reached in May 2005 with the Erdogan government.  This one was successfully completed in 2008, and Turkey has not needed IMF since then.

We think Turkey will only go to the IMF as a last resort as long as Erdogan is in control.  Despite first embracing economic liberalization, he has since turned away from orthodoxy.  The IMF would prescribe greater central bank independence and fiscal austerity, which we consider deal-breakers for Erdogan.  Yet market turmoil may eventually force his hand.  We believe the current EM sell-off is still in its early stages, with greater stress to come for Turkey.  It is simply not prepared (or able) to go it alone.

ECONOMIC OUTLOOK

The economy is in danger of overheating, though those risks are ebbing.  GDP growth is forecast by the IMF at 4.2% in 2018 and 4% in 2019 vs. 7.4% in 2017.  GDP rose 7.3% y/y in Q4, down from 11.3% rate in Q3 but still quite strong.  However, monthly data suggest Q1 has slowed significantly.  The longer rates stay high, the greater the economic costs.  As such, we see downside risks to the growth forecasts going forward.

Price pressures remain high and likely to rise further due to the weak lira.  CPI rose 10.85% y/y in April, the highest since December and well above the 3-7% target range.  Core inflation has also accelerated to 12.2% y/y, just below the cycle high from December.  PPI rose 16.4% y/y in April, also a cycle high and portending further acceleration in CPI inflation.

The central bank started the tightening cycle with a larger than expected 75 bp hike in the de facto policy rate at the Late Liquidity Window to 13.5% at its April meeting.  The bank was then forced by the lira free-fall to move intra-meeting, hiking that rate another 300 bp to 16.5% last week.  Next policy meeting will be held June 7.  Officials have pledged to hike rates further if May inflation rises.  CPI will be reported on June 4 and is widely expected to accelerate.  If the bank doesn’t hike then, then credibility will be lost.

The central bank just simplified its interest rate regime.  The official policy rate is now back to the one-week repo after that role was usurped by the Late Liquidity Window (LLW) rate back in January 2017.  Yet the switch did not involve any further tightening, as the repo rate was set at the old level of the LLW rate of 16.5%.  The LLW rate will be set at 19.5% going forward.

For now, the central bank’s moves have helped stabilize the lira.  However, we think more needs to be done.  Note that many investors like to focus on real rates rather than nominal.  Argentina has a 40% nominal policy rate and 25.5% inflation, which gives a real rate of 14.5%.  Compare this to Turkey, where the 16.5% nominal rate doesn’t look so high when adjusted for inflation.  CPI rose 10.85% y/y in April, which gives a real rate of 5.65%.  If May inflation accelerates as expected, then the real rate would fall further.

The fiscal outlook bears watching.  The budget deficit was equal to -3.2% of GDP in 2017, and the IMF expects it to narrow to -2.4% in 2018.  We see upside risks to this forecast due to increased spending ahead of the elections.

The external accounts remain worrisome. The current account deficit was -4.6% of GDP in 2017, and the IMF expects the deficit to widen to -5.4% of GDP in 2018.  Due to the so-called J-curve effect, we expect recent lira weakness to pose risks of an even wider current account deficit ahead.  Higher energy prices are also boosting imports.

Foreign reserves have dropped steadily over the course of the year.  In January, reserves peaked at $91.4 bln but have fallen to $84.7 bln in mid-May.  They cover less than 4 months of imports and are equivalent to about a third of the stock of short-term external debt.  However, usable reserves (which net out commercial bank FX deposits at the central bank) are only about $30.3 bln, and shows even greater external vulnerability.

INVESTMENT OUTLOOK

The lira continues to underperform.  In 2017, TRY fell -7% vs. USD and was ahead of only the worst EM performer ARS (-14.5%).  So far in 2018, TRY is -17% and again is ahead of only the worst performer ARS (-25% YTD).  Our EM FX model shows the lira to have VERY WEAK fundamentals, and so we expect underperformance to continue.

Using the January-May rise in USD/TRY, we could see the pair retrace up to 50% of the move which would put it near 4.32.  However, that would be largely driven by short-covering and positioning.  Most investors remain wary of EM in general and Turkey specifically, and we cannot see a sustainable rally in Turkish assets given current market conditions.

Turkish equities are underperforming after a stellar 2017.  In 2017, MSCI Turkey was up 44% vs. 34% for MSCI EM.  So far this year, MSCI Turkey is -9.5% YTD and compares to -2.5% YTD for MSCI EM.  With tight monetary policy posing downside risks to growth, we expect Turkish equities to continue underperforming.

Turkish bonds have underperformed.  The yield on 10-year local currency government bonds is +216 bp YTD and is the second worst EM performer, behind only Argentina at +272 bp.  Shorter-dated paper has fared even worse as a result of the 16.5% policy rate.  With inflation likely to move higher and the central bank likely to tighten policy further we think Turkish bonds will continue to underperform.

Our own sovereign ratings model showed Turkey’s implied rating rose a notch to B+/B1/B+, reversing last quarter’s drop.  However, we still think Turkey faces strong downgrade risks to its BB-/Ba2/BB+ ratings.  Fitch has already warned that unhedged external debt obligations will weaken the nation’s credit metrics.