Turkish assets have been one of the worst performers since the U.S. elections along with Mexico. This is hardly a surprise. Under our base case of higher core rates, a stronger dollar, and higher commodity prices, we expected Turkey to suffer dearly. Turkey has low domestic savings; is highly dependent on external funding; runs large external imbalances; and lacks real yield support behind the Lira. Besides, domestic and geopolitical problems and the strong push from President Erdoğan for the presidential system have been adding extra layers of uncertainty.
Following significant underperformance, the relevant question becomes whether Turkish assets have cheapened enough or is there more pain to come?
From a very top down view, Turkey gives the impression that it keeps diverging from its successful reformist past, rather than converging back to it. The commonly shared concern is that this path would lead to a strong one-man-rule with weakened institutions and checks and balances. If this is the case, there is little reason to expect asset prices to start mean reverting to long-term averages given the unfolding structural break. There will be more pain to come.
However, the Turkish private sector and many investors still hope that this time is no different and this is just another round of brinkmanship in the run up to elections. They hope that things will normalise soon after the forthcoming referendum in late March/early April, and Turkey will open a new page with the approval of the presidential system. If that is the case, we should be close to the bottom.
Peer countries’ experience can offer some guidance on Turkey’s recent struggle. The below chart looks at the sovereign spreads of Russia, Brazil, and Turkey relative to the J.P. Morgan EMBI Global Diversified Index.
When faced with multiple shocks of adverse terms of trade, geopolitics and international sanctions, Russia’s large reserves and orthodox policy responses of floating RUB, tightening monetary policy to contain second round effects on inflation, and managing a significant deleveraging created a strong backstop. Together with higher commodity prices, spreads tightened considerably.
The Brazilian political crisis was a slow burning one initially, and picked up pace on the way, somewhat similar to Turkey. While Central Bank of Brazil’s tight monetary policy alone was not enough to stop the bleeding, it created a strong tailwind once backed up by the political change triggered by the impeachment of President Dilma. Higher commodity prices also helped.
Following these examples, the missing key ingredient in the Turkish case during these turbulent times is a prudent set of macro policies to create a backstop. This needs to change. President Erdoğan and his economic advisers are still vocal on their populist/unorthodox proposals and keep the risk premium high. Central Bank of Turkey (CBT), on the other hand, once again resorts to unorthodox measures to put more yield support behind the Lira, rather than simply hiking the policy rates sharply, which had worked every single time in the past.
We can easily make a strong medium-term macro case for Turkey with its strong demographics, established private sector, geopolitical advantage, large domestic market, good infrastructure and relatively strong public finances. However, it’s kept back by bad policies and we need to see some genuine reform appetite at the top level to start discounting a better medium-term outlook.
We have four main macro/political concerns:
1) Domestic politics in the driver’s seat. The shift to the presidential system has been a number one priority for President Erdoğan. The draft suggests that it will be a strong one-man rule without adequate checks and balances. This may push Turkey closer to an illiberal democracy with weaker institutions.
2) Turkey’s growth model is out of date. The days of high productivity growth are long gone. The consumption driven growth, supported by construction, and funded by external borrowing creates macro imbalances. In the days of cheap dollar liquidity, this was manageable. But a global dollar squeeze is likely to cause a forced deleveraging in the private sector and a contraction in economic activity. Corporate distress is likely to increase with a weaker Lira.
3) Turkey’s external imbalances are large. The gross external funding need is around USD 200bn in 2017 (c.25% of GDP). They have one of the weakest reserve coverage among peers. CBT’s gross and net FX reserves are around USD 95bn and USD 30bn respectively. This is almost two months of gross external funding need. Besides, there are significant dollar liabilities to domestic banks and dollarisation has been on the rise (c.40% of deposits).
4) Policy mix is wrong. President Erdoğan’s insistence on low interest rates and his preference for more state intervention in the economy creates significant complications. On the one hand, Turkey is moving in the footsteps of Brazil with its expanding Treasury contingent liabilities and politically driven credit expansion through state banks to sustain growth. On the other hand, it lacks an independent central bank to anchor expectations and the exchange rate. The President’s Chief Economic Adviser suggests that the tight jacket of inflation targeting should be abandoned, although inflation averaged above 8% over the last 5 and 10 years vs. the target of 5%.
All in, Turkey is at cross-roads. Cheap valuations are attractive, but we need to see which way they will choose to go before turning more constructive fundamentally. Going back to orthodoxy in macro and resuming stability in domestic politics is likely to make Turkish assets one of the top performers this year. We have gone through those cycles back in 2012 and 2014. If they opt for more unorthodoxy in macro policies and populism in domestic politics, their current balance of payment problems, which are relatively easier to address, can easily evolve into a credit problem.