Like a prized fighter, Turkey and President Erdoğan fight on…
Back in 2010, the European Union (E.U.) selected Istanbul to be the European Capital of Culture (ECOC). The designation provided an opportunity for the city to display its cultural life and cultural development to the rest of the world. This nomination came on the 25-year anniversary of the program created in 1985 with the selection of Athens. To be clear, the E.U. made a final decision on Istanbul in November 2006.
A lot has changed since 2010 let alone 2006…Turkey is now the 19th largest economy in the world. The country took off during the 2000s, averaging 7.2% growth between 2002 and 2007. It slowed during the global financial crisis but still performed relatively well in 2008 and 2009 with 0.6% and -4.6% growth, respectively. Then the economy rebounded with 8.8% and 9.2% growth in 2010 and 2011.
The economic success story can be traced back to a series of reforms introduced at the start of the 2000s by then Minister of Economic Affairs Kemal Derviş, which were coupled with the IMF stabilization program initiated in 2000, in the midst of the economic challenges from 1999 to 2001. Later, after ascending to power, the Adalet ve Kalkinma Partisi (AKP) led by President Recep Tayyip Erdoğan continued implementing the previous regime’s reforms and began a privatization process which attracted significant foreign capital and investment. Erdoğan also introduced a floating exchange rate for the Turkish lira. Altogether, by 2017, the Turkish economy was growing at a quicker rate than China and India.
Jump three years forward and foreign investors are exiting the country at a staggering rate. Investors withdrew north of $7 billion from Turkey’s local currency bond market in the six months ending June 2020 which was the largest drawdown in the first half of a year on record, according to data from the Turkish central bank. Foreign ownership of Turkish government bonds is now around 5%, which is a massive drop from about one-third in 2013. The Turkish lira, in a similar period, is down about 69% against the U.S. dollar at end of July 2020 compared to end of December 2013. The roughly 14% drop for the Turkish lira since the start of 2020 does not compare to the rapid declines of 2018 but the government is doing more this time to prevent a 2018-like currency plummet against the U.S. dollar.
Still, despite all the government efforts, market and political analysts alike are left pondering the future of the Turkish economy. Today’s financial (and political) challenges resemble 2018 but investors’ increased exit from the market symbolizes greater fears. Yet market talk of higher risks or potential economic collapse, according to some market analysts, is overblown because the internal economy for the country remains moderately stable and there is enough outside support to stabilize the Turkish economy and stave off any contagion effect, if necessary, in the near term. Both sides on the Turkish debate are neither perfectly correct nor wrong.
Perspective…looking back at 2018 and 2019
Let us be clear…the Turkish currency and debt crisis in 2018 worried many investors. The currency crashed nearly 30% during 2018. Annual inflation rose above 25% which was a 15-year high. Market analysts and political pundits happily wrote the obituary for the country. Yet, after three quarters in a recession, the country bounced backed with quarterly growth in the third quarter of 2019.
The quick turnaround was underwritten by a significant amount of debt. Credit was cheap and Turkish officials were happy to use it to spur growth with the country’s budget deficit up north of 60% due to the government spending. Turkey’s central bank cut interest rates in 2019 below inflation by purchasing lira-denominated bonds. Their purchases amounted to approximately one-third of the purchases in 2019. The central bank also encouraged the expansion of loan books by reducing the reserve requirement of banks if their real loan growth (i.e., including inflation) was above 5%. This, coupled with the reduction on deposit interest rates below inflation, spurred private sector credit growth by 10% in 2019. A 15% minimum wage increase mixed with a decline in unemployment was also a sweetener to the economic pie.
Yet, despite all the financial stimulus, the Turkish economy remained relatively cool, growing less than 1% year-over-year by end of 2019. The effects of the stimulus, however, went beyond simple GDP growth numbers and introduced trends that continue today. First, the government introduced ‘indirect’ domestic capital controls by restricting most commercial transactions to being lira-denominated as a strategy to combat the growth of external debt obligations. Secondly, Turkish state banks increased their intervention in the market to manage lira volatility, spending tens of billions in 2018 and 2019 particularly through the aforementioned market purchases of debt. Thirdly, the Turkish state banks and entities became active in their support through equity and bond markets. For example, the Turkish sovereign wealth fund recently acquired a 26% stake in Turkcell, which is Turkey’s biggest mobile phone operator, for $530 million. Lastly, the first three tends points to the obvious reality of today’s market: foreign investors are becoming less involved in the Turkish market while the state becomes more active as the current economic circumstances remain the same.
Explaining 2020…
Economy
The economy has struggled to regain its footing with covid-19. If anything, like many other countries, covid-19 came at the wrong time for the country. Global tourism and trade have nose-dived with many countries, including the United States, observing record GDP declines in the second quarter. Turkey, which depends heavily on tourism (as a European holiday haven), will not match last year’s 50+ million foreign visitors and approximate $35 billion in tourism revenue. Although attractive to visiting tourists, a weakened Turkish lira is not sufficient to overcome border closures, a deflated aviation industry, and a scared global public. Global trade and economies are equally slow with people at home on their couch and / or unemployed which hurts the country that is nicely situated as a commercial bridge between Europe, Asia, and the Middle East.
Furthermore, the remnants of 2018 and 2019 state response are ever-so present. Today, there is a significant amount of foreign debt in the private sector. Critics continue to blame the AKP for transferring a lot of government debt to the private sector through various privatization efforts wrapped in a strategy of freeing the government from foreign debt and dependency on international markets. Specifically, the government transferred large-scale projects financed by foreign-denominated debt to the private sector backed by a guarantee of high profits and favorable treatment from the Ministry of Treasury and Finance…today, the profits imagined have declined. As a result of these transfers, private sector debt peaked in February 2018 at more than $220 billion but recently fell to around $170 billion. Market analysts take two views on that decline…either the government can borrow more to fund growth (and get back to 2018 numbers) or the market is not willing to fund Turkish growth at similar levels to 2018. Lastly, let us not forget that there is a significant amount of debt due in the near term that someone must repay…the Turkish sovereign wealth fund being an example of a vehicle by which the state plans to help in these situations (i.e., the Turkcell acquisition and effectively the ‘rescue’ liquidity provided by way of it).
Secondly, local banks hold a high proportion of bad debt. The significant infusion of state cash into banks complicates the process for tracking the numbers. But the data suggests that bad debts may be approaching 2008/2009 levels with a high amount of the debt tied to infrastructure related sectors (i.e., construction and energy). Thirdly, as previously mentioned, the government has been actively intervening in the market to prop up the lira and stop the market from crashing under the sad global economic reality of covid-19. It is not clear, however, how much longer and with what cash the Turkish state can maintain such efforts. The government is currently borrowing on short-term loans to fund its budget’s deficit but will need a long-term solution. Lastly, the efforts to support the lira remains a long-term challenge as the system cannot control for the dollar leakage over time with the dollar auction transactions, especially as the difference between what investors receive for as an interest rate on Turkish lira versus the inflation rate is between 0.25% and 0.50%. In simpler terms, inflation basically wipes out roughly 96% to 98% of your interest rate earnings on a lira. As a result, the small percent that are not related to state entities who obtain dollars in the auction will send the money out of the country.
Populism and Politics
The politics of Turkey is a delicate conversation with critics coming from every corner. Ignoring the specifics of political policies is possible but skipping over the economics of populism is not. It is no secret that Erdoğan is fighting a political battle amid the economic calamities. The failed coup in July 2016 forced him to take harsh actions against parts of the armed forces while also seizing assets of various businesses.
Those realities, in turn, underwrote the political reality and fear (justified or not) of foreign investors who have been quicker to exit the country than return to it. This point cannot be understated…during the last decade, foreign capital flocked to emerging markets because of demand for increased risk and return. Turkey clearly benefited from such investor interest during the last two years. That said, the Turkish lira has taken the biggest dip against the dollar when compared against other emerging markets, such as South Africa, Brazil, or India. As U.S. ad U.K. investors sell out of Turkey, the currency situation becomes tied to situations in Italy, Argentina, and Hong Kong as the largest investors in Turkey. And, probably at an overstated level, the markets are also pricing in the increasing political risk in country associated with a potential call for early elections (next election is not until 2023) or an unexpected political uprising or challenge to Erdoğan’s presidential power. Tension with the U.S. and the E.U. will also be on the forefront of investors’ minds coupled with Turkey’s association with the wars in Syria and Libya.
Debating the Options Available to Turkey…
Worth a debate: Fixing the Turkish Lira to the dollar or euro?
It is hard to imagine this debate considering the weak alliance between Turkey and the U.S. today. But let us remember that Turkey is a NATO ally and that Erdoğan did carry forward an IMF program when he first entered office. Back then, he also helped to create greater press freedom and reduced the military role in politics such that discussions of Turkey joining the European Union had validity (again remember the E.U. love doled out to Istanbul in 2010). Yet today Turkey appears far away from the U.S. with no clear path to reconciliation between Erdoğan and U.S. President Trump. And it is not simply their relationship that appears weakened (i.e. a Biden November win will not automatically change the relationship)…Congress is also critical of Erdoğan and his political alignment with their efforts in the Middle East, relations with Russia, and so on. Skirmishes between the U.S. and Turkey over the arrest of U.S. pastor Andrew Brunson and Turkey’s purchase of the Russian S-400 surface-to-air defense system are manifestations of the gap in the current Turkish-American relationship. When you add it all up, it is easy to understand why Erdoğan does not want his future tied to good relations with the U.S. A similar argument goes against tying his future to the E.U. and the euro. At the end of day, he arguably has a good short-term solution through the dollar auctions at banks where state entities are the biggest purchasers of dollars, which largely guarantees a steady lira to dollar rate (again ignoring the dollar leakage in the process).
Worth a debate: Dance with the IMF?
Again, it worked in the early 2000s. But accepting the IMF today looks like a political trap for the savvy Erdoğan. Accepting IMF assistance, in political parlance, appears weak in Turkey. His son-in-law and Minister of Finance and Treasury Berat Albayrak accordingly has told international investors that the country will not seek an IMF bailout. To be fair, the conditions attached to IMF funding today will not look like the terms from the early 2000s. The economic story and (lack of) trust associated with Turkey today, at least from the ‘West’, will sadly play against Turkey.
Politics aside, what can the IMF do? The previously discussed transfer of debt from government balance sheets to the private sector constrains the potential work of the IMF. The IMF is not exactly setup to assist the private sector thus it cannot truly tackle the debt problem in Turkey. Although also not politically palatable, a bilateral agreement with a ‘partner’ country on support sounds more reasonable than going to the IMF with ‘cap in hand’ and asking for help.
Worth a debate: Global partners coming to offer assistance?
If not the IMF, will Turkey turn to another ally? It was Qatar doling out cash in 2018 and again earlier this year with a $15 billion currency swap to help Turkey. But more support will likely be required by the end of the year. The simple scenario assumes Qatar is a willing partner until Turkey turns the corner. If not, then it is not clear-cut who would come to the assistance of Turkey. That said, it is hard to imagine a world where Turkey gets shun by everyone. The country plays such a vital role in regional politics. Specifically, irrespective of one’s view on ‘how’ Turkey plays it role, it plays a role in Syria, Libya, and Iraq. For example, it still controls part of the Syrian border (and continues to confront the Kurds both there and in Iraq) while also spending significant cash in Libya with many critics arguing that Turkey is only doing so for the contracts and money to be gained in the post-war reconstruction period. Also, as discussed, Turkey is a big part of the U.S.-Russian relationship which looks to be increasingly more contentious, especially in Turkey’s regional backyard.
There is opportunity for an E.U. deal. But that deal would also have strings attached…and one must ask if the U.S. would not interject its views and power into those discussions anyways. Maybe a deal with China, Russia and another country are palatable, underwritten by a contrived anti-American theme. Still, it is not clear how sustainable such an alliance would be through the up and downs of the current Turkish situation. Furthermore, the true gauge of any alliance depends on how the public will respond and how it plays politically at home…it is not clear how financial ties to Russia and China would play with the Turkish public.
Same ole story…with same ole conclusion
The story line to the Turkish economy has a few different chapters this time around but a lot remains the same. Inflation is high…there is a lot of debt…lira is weak…and so on. That said, the global political backdrop has changed. The U.S.-Turkey relationship requires more work to return to its former goodwill engagement. The Syrian and Libyan wars are less clear cut today with Turkey partially becoming the common villain for many international players (who themselves fail to assume full responsibility for their actions or inactions)…again the view of Turkey as villain #1 short sells the country’s importance in global politics. It is this reality that makes most market and political analysts assume there will be a willing partner to support Turkey. Also, the contagion risk of a failing Turkey on both external economies and regional politics is enough to make resistant parties come to the negotiation table.
But, again, let us assume there is no international partner for Turkey. The short-term solution may be to print money and get more lira in circulation. This will create a risk of higher inflation in the short-term, but the Turkish government can employ measures to combat it. This would also allow the country to manage external debt levels in the short-term. That said, this strategy would be very dependent on a post covid-19 recovery and the government’s ability to revive the Turkish economy and generate revenue for its coffers. The reality, however, is that covid-19 may slow the globe through the end of the year and, at least, the first half of 2021.
Erdoğan nevertheless is a chameleon…better put, he can easily remake himself and is a very skilled politician. To write Erdoğan and Turkey off today ignores the proven survival nature of the country and its leader. If anything, 2018 teaches us that Turkey will survive 2020 and 2021…although, it may do it with less support from foreign investors. Still Turkey has friends and Erdoğan is quick on his feet. That has given Turkey a fighter’s chance for a long time…though critics will question how many more rounds Turkey and its gifted political fighter can go in these economic times.
