As Turkey prepares for its general election on June 24th, its economy and free-falling currency is what global investors have their eyes on.
The lira, Turkeys official currency, hit a record low against the US dollar in May, effectively forcing the country’s monetary authorities to hike rates by a significant 300 basis points.
“The hike will be enough to prevent the Turkish lira from weakening more than other emerging markets currencies versus the dollar in the coming days and weeks,” Per Hammarlund, chief emerging market strategist at SEB, the Nordic corporate bank, said in a note to clients on May 24th. “However, the hike came late, and even including the 75 basis point hike on April, it was smaller than the 550 basis point hike of the one week repo rate that the bank delivered in January 2014.”
A combination of factors led to the lira’s sharp decline–mainly the appreciation of the US dollar and rise in US rates, which has caused investors to look more closely at what countries might be vulnerable to rising costs of capital. Turkey, with a wide and widening current account deficit, sizeable short-term external debt, weakening (though still strong fiscal position) and double-digit inflation, looked particularly vulnerable, especially once the central bank remained reluctant to hike interest rates, a move it regularly has done in the past.
“Questions about post-election policy and rising oil prices exacerbated the trend, especially as the government’s proposed solutions, more credit to the local private sector, might only increase the external imbalances,” Rachel Ziemba, adjunct senior fellow at the Center for New American Security (CNAS) told Emerging Market Views in an interview. “Unorthodox views of the central bank and President Erdogan exacerbated this decline, and locals and foreigners reduced their exposure. While little of these unorthodox policies were new, the obvious lack of response from the central bank have sent the currency into free fall.”
Looking ahead, several factors might be necessary for a reversal. Defensive rate hikes, clarity on government support measures for banks and a shift in global risk sentiment towards yield seeking, for example. This would necessitate a shift in US monetary policy stance, which is unlikely given the local growth and inflation path, while sizeable US treasury debt issuance is likely to keep interest rates moving up to absorb these new bonds, likely challenging global spreads. Oil price trends and evaluation of the sanctions regime on Iran are also quite important – but are unlikely to move in Turkey’s favor.
EU Membership “Effectively On Hold”
Amid all this, Turkey’s aspirations of formally joining the European Union are effectively a non-starter. Membership talks are on hold, though occasional discussions take place intermittently on less contentious chapters. “EU membership is not really a key goal of the current Turkish leadership or population, or Europe,” Ziemba explains. “Given its market access, Turkey has to comply with many European Union regulations, but political and institutional issues tend to diverge. Refugees are a key issue, as Turkey is hosting many Syrian refugees reducing pressure on EU and other developed economies.”
Turkey has been tilting towards centralization with a reduction in freedom of speech and political diversity, as well as extreme pressures on selected businesses. The crackdowns and purges after the Gezi protests and then again after the attempted coup in 2016, contributed to adding political risk to businesses, increasing costs, the risk of arbitrary decisions and increased the incentive to invest in areas privileged by the government including construction. The purges may have contributed to loss of human capital and a willingness to share diverging opinions.
“Regardless, growth in these government linked sectors including construction contributed to high levels of growth and some wage increases, but it came with the cost of lower quality of growth. It hurts the EU prospects and is a major source of concern, though note that EU integration would be a long shot even with policy changes.”
“Investors will be expecting more measures to be taken to lower vulnerabilities in the Turkish economy, such as the expanding current account deficit and double-digit inflation,” Hammerlund noted. For example, reducing fiscal stimulus programs will be important to restore confidence in the lira. In addition, Hammerlund adds, president Erdogan in May said that he would take on more responsibility for monetary policy if he were to win the presidential elections on June 24 (and July 8 if no candidate gets more than 50% in the first round). “Those comments are still fresh in investors’ minds and political leaders will need to ease concerns that monetary policy will be determined by politicians.”
Photo Credit: AFP/Ozan Kose