The latest news on Türkiye

An op-ed by Ronald Schneider, head of Bonds, CEE & Global Emerging Markets at Raiffeisen Capital Management, published in the Börsen-Zeitung.

Investors are once again looking anxiously towards Türkiye. On the one hand due to the terrible earthquake and on the other due to the parliamentary and presidential elections that will likely be held in May and are being anxiously awaited primarily by those who would like to see a change in the political system after nine years of autocratic rule by Recep Tayyip Erdogan. In addition, the NATO country of Türkiye plays an important role as a mediator between Ukraine and Russia. In light of this mix of circumstances and the current economic policy, the stability of the lira is astounding.

The catastrophic earthquake that devastated the region of Türkiye near the border with Syria in early February is also having a tremendous economic impact on the country. The latest cost estimates project that the damage could be as high as 4.5 to 5% of the country’s GDP. These figures are having a rather moderate effect on economic growth according to initial estimates. The latest forecasts indicate that the negative growth effect will amount to roughly 1%, because although around 16% of the population lives in the affected region, their contribution to the country’s value creation amounts to less than 10%.

However, the negative effects will be reflected in the country’s budget, because the reconstruction costs alone will be staggering. There may be tax hikes following the elections, but this will not be nearly enough to pay for the rebuilding efforts. These developments will also have negative effects on inflation, which is currently at 55%, and the decline in inflation will be less pronounced than orginally expected. In terms of foreign trade, a high level of imports will be required in the areas of construction materials, chemicals, and a multitude of other goods, which will have a negative impact on the trade balance.

Lira relatively stable

Türkiye has already been in a precarious economic situation for quite some time due to its unorthodox monetary policy, and this has not improved recently. At the same time, it is benefiting from positive effects arising from the war due to its role as a mediator between Russia and Ukraine and the fact that it is not supporting the economic sanctions imposed by the West. As such, Türkiye has profited from the capital flight from Russia as well as from the support for its foreign currency reserves provided by the Gulf states.

Thanks to their provision of FX swaps along with creative rules on the part of the central bank and the introduction of currency hedged savings deposits, Türkiye has managed to keep the lira relatively stable. However, this balancing act between NATO membership, acting as a mediator in the war, and not supporting the sanctions also has political risks. These risks are not yet being discussed on the capital markets at the moment, but are a latent issue that could quickly bring the lira under pressure.

The earthquake has brought difficulties for Erdogan and the AKP party, primarily in connection with the accelerated construction activity along with the failure to comply with regulations related to earthquake-resistant construction. Although Erdogan has promised a rapid rebuilding effort, among other things, his crisis management is under heavy criticism and serves as ammunition for his political opponents. They believe their chances of achieving a system change in the elections and ousting the AKP and especially Erdogan from power are growing.

However, it will be no easy task, and some market participants are already anticipating another term of office for Erdogan, as he is currently taking advantage of his opportunities to hand out pre-election gifts. The good news in any case is that the institutions in Türkiye are strong enough that no party or individual can defy a clear election result. Whether a clear result can be achieved is uncertain, however, and this is naturally also a source of concern. One thing that is clear at any rate is that both sides have very different approaches with regard to economic and interest rate policy. Naturally, this is highly relevant for the development of the currency and interest rates.

In the case of a victory by Erdogan, the unorthodox economic and monetary policy will presumably be continued. The local market performed very well in 2022 despite negative real interest rates, which can be attributed in part to the fact that the central bank cut interest rates and purchased government bonds itself. In this way, it simultaneously insulated the market from foreign capital and shifted the risk within Türkiye from one side to the other – without making it disappear, however. Because if interest rates are now increased significantly, it would have a negative impact on the bondholders. Thus, a risk transfer was completed – away from companies with foreign debt and into the public sector.

No default risk

Fundamentally speaking, the public sector is in good shape, with relatively low government debt and a budget deficit that has increased considerably due to the pandemic and the earthquake, but is still relatively moderate. This means that there is exchange rate risk and interest rate risk in local currency, but no default risk. However, the trend is worsening, which is reflected by the fact that Türkiye was downgraded to B by rating agencies in recent years. If Erdogan is re-elected, a continuation of this system is likely and foreign investors will tend to avoid the market based on the excessive risks. Sooner or later, this system will reach its limits and thrust the country into another crisis situation.

Should the opposition win, it would result in a change in the interest rate policy and likely also in the monetary policy, and the lira is not really overvalued. Although the country has a high current account deficit, this is because of significant gold imports and expensive energy imports. But the underlying balance is not dramatic and competition is intact. At 8.5%, however, interest rates are much too low in relation to inflation of 55%. In the event of a considerable interest rate hike, negative effects would be expected that would dampen growth substantially. On the other hand, a credible programme for changing the economic policy could make the country attractive for foreign capital again, which would likely help stabilise things in a potentially volatile initial phase.

At the moment, however, the mix of circumstances in Türkiye is still too risky and the outlook too uncertain to put the market back on the buy list from a local currency standpoint. All the more so based on the fact that other Emerging Markets offer more attractive yields with less risk. Türkiye is paying quite a high risk premium on the hard currency side. An issue denominated in dollars with an interest rate of just under 9% came onto the market at the beginning of the year.

Source: Börsen-Zeitung