22 February 2019

Last year’s Turkish financial market crisis emanated from the confluence of several domestic and international factors. To be sure, Turkey is no stranger to boom-bust economic cycles.  And, fueled by overly expansive macroeconomic policies, the Turkish economy was overheating and inflation rising sharply by mid-2018.  Against this already challenging backdrop, the Erdogan government introduced additional fiscal stimulus and pressured Turkey’s central bank (CBRT) to maintain an inappropriately accommodative monetary stance in the runup to last year’s election. The perception that political interference prevented the CBRT from independently pursuing its inflation target severely damaged the central bank’s credibility. Furthermore, the composition of Turkey’s economic activity was highly imbalanced, with excessive domestic demand leading to a sharp deterioration in the current account deficit. Rising inflation also led to an overvaluation of the Turkish lira.

If that was not enough, Turkey’s dramatic buildup of short-term foreign debt following the Global Financial Crisis (along with its burgeoning current account deficit) produced a huge  external financing requirement. Under normal circumstances, Turkey could readily roll over these liabilities. However, rising US interest rates, a strengthening US dollar, and greater risk aversion amongst investors made it impossible for Turkey to attract the required foreign capital; thereby, sowing the seeds of the lira’s collapse.

Eventually, the CBRT’s belated decision to hike rates from 8% to 24% ended the crisis, and has helped stabilise the currency in recent months (after partially recovering some of its earlier losses). However, with Turkey again heading to the polls at the end of March 2019 for local elections, will renewed government interference into CBRT decisions provoke another financial crisis? Alternatively, has enough changed in Turkey’s domestic economic performance and the global market environment for investors to reconsider Turkey?

Rebalancing and External Adjustment

Imbalanced economic activity, especially excessive domestic demand growth, contributed to the swollen current account deficit. However, sharply higher interest rates and the weaker exchange rate aims to curb local spending and boost exports; thereby, reducing the external imbalance. The Chart above illustrates that these policies now have eliminated the current account imbalance following a deficit approaching 6% of GDP during each of the past two years.

To be sure, this outcome is welcome. However, it is worth bearing in mind the adjustment results largely from a collapse in domestic spending — note the 10% decline in retail sales in the Chart above.  As a result, imports were reduced by 24% in Q4 2018. On the other hand, the 8% rise in exports (Q4 2018) is a bit underwhelming. The export performance may reflect supply-side defficiencies, such as Turkey’s tepid (volatile) growth in manufacturing productivity (Chart below).

Inflation and Restoring CBRT Credibility

The Erdogan government’s intrusion into CBRT decision-making last year was a crushing blow to CBRT credibility. However, trust in Turkey’s central bank had been damaged already by its failure to meet its inflation targets for many years. During 2016 and 2017, for example, the CBRT set an inflation target of 7.5-8%, but the actual results were 12% and 10.5% respectively. Even worse, 2018’s 20.3% outcome compared unfavourably with the 7.9% goal! In all three years, the CBRT established a long-term objective of 5%!

So, as a starting point for boosting its credibility, the CBRT must demonstrate it can achieve its 14.6% goal this year (recently reduced from 15.2%). Both history and the January 2019’s 20.4% CPI increase certainly cast doubt on their ability to achieve the aim. Remarkably, however, I believe there’s a reasonable chance the objective can be met this year!

First of all, headline inflation has already declined from October’s peak of 25.2%, and the composition of the improvement is revealing. For example, the Chart above indicates that core goods price gains are well off last Autumn’s peak levels. Crucially, however, the following Chart illustrates that core goods quotes have declined sharply during the past three months, reflecting both the weak economy and the lira’s stabilisation. Strong disinflationary pressures exist in this sector.

Core service sector inflation has proven to be stickier, and several subsectors are still experiencing large price gains. Even in this sector, I believe the worst is over. The Chart above shows that core service sector inflation has cooled to 15% in recent months compared to 21% last Autumn. And prior to the last year’s crisis, both headline and service sector inflation was near 10%. Thus, given continued severe weakness in the domestic economy, service sector price gains should cool below 15% this year.

With goods prices collapsing and service quotes below 15%, core inflation may well achieve the CBRT’s target. Headline results will face additional cross currents. On the one hand, adverse weather has continued to produce sharp gains in food prices, up 31% in January. On the other had, lower oil prices should produce more modest energy prices hikes, which rose 13% in January and will continue to decline sharply in coming months.

External Financing: Still the Achilles Heel

A country’s external financing requirement is defined as the sum of the current account, short-term debt obligations, and amortization of long-term debt. Vulnerability is often assessed by comparing the funding need with a nation’s international reserves. How has Turkey evolved since last year’s turmoil? On the bright side, the elimination of the current account deficit will meaningfully lower its need for foreign capital inflows. On the other had, the Chart above illustrates that despite minor reductions, Turkey’s short-term debt burden remains enormous, and poses risks to financial stability.

The Chart above illustrates that while Turkey’s vulnerability is considerably reduced compared to last year, it remains amongst the most fragile in the Emerging Market universe. Likewise, an analysis of the recent pattern of capital inflows into Turkey underscores its vulnerability.  In 2017, for example, Turkey enjoyed $24 billion of foreign portfolio inflows (equities and bonds). While the large-scale sale of securities which took place last summer has now ceased (24% interest rates help!), inflows have not resumed yet. Likewise, while the banking system often records foreign capital inflows (e.g. $5 billion in 2017), this sector accounted for $10 billion of outflows last year, and capital flight of a similar scale occurred in Q4 2018 in this sector.

Strategic Implications

• I believe the CBRT should be able to come close to meeting its 2019 inflation target of 14.6%, although the 8.2% goal for 2020 is very highly doubtful.
• An improved international environment should allow Turkey to meet more readily its external borrowing need, especially compared to last year.  In particular, delayed interest rate hikes in the USA and Europe combined with a weaker US dollar eventually should be helpful.
• Consequently, the CBRT should be able to reduce the repo rate by 500bp during the next 12 months.
• The March 6 CBRT meeting will provide useful clues regarding whether the electoral cycle will again influence monetary decisions this year, especially prior to the March local elections. Despite the current account reduction, Turkey’s external position remains fragile. Political interference would again pose serious financial risks.
• Unlike prior to last year’s crisis, the Turkish lira is now deeply undervalued (see Chart).  If the CBRT rebuilds it credibility (e.g. if President Erdogan refrains from central banking), the real exchange rate should appreciate by 10% or more (mostly through higher Turkish inflation). Under these conditions, TRY should remain in a USD 5.0 to 5.5 range (in nominal terms) — perhaps weaker prior to the March elections, but potentially breaking out of  the bottom of the range if the Fed remains on hold into 2020.