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Article / 31 August 2015 at 10:00 GMT

CEE Explained: Turkey's rapidly changing landscape Team / Saxo Bank
  • Turkey's outlook clouded by weak lira, conflict on southern border
  • Central bank's defence of beleaguered lira compromised by dwindling reserves
  • Tension between Kurdish minority and Istanbul an ever-constant in relations
  • Fed rate hike move casts shadow over country's prospects
  • EU-accession hopes firmly on the back burner

Turkey offers a world of opportunity but the weakening lira and conflict
on its southern border are casting serious doubts over its direction. Photo: iStock

By Nİlüfer Sezgin

For an economist covering the Turkish economy and politics, there is never a dull moment. 

You could find yourself in the position of having to defend how much Turkey deserves an investment grade rating despite its huge external vulnerability (real sector’s open FX position corresponds to 24% of GDP), while the following year, you may have to discuss why rating agencies could cut the IG status because of the very same external vulnerability issue. 

Furthermore, one year Turkey could reap the benefits of a successful diversification of its export markets, but the very next, the headlines could focus on how these new markets have suddenly started weighing on GDP growth.

The tide may also quickly turn in politics. At one moment, Turkey may be only one step shy of solving a four-decade old Kurdish conflict via democratic means only to suddenly get cold feet and decide to resort to military options once again. 

Similar examples also abound on the international political front with the EU accession adventure probably being the most obvious. 

After having been accepted as an EU candidate in 2004, this seemed to be such a viable aspiration that FDI inflows surged to an average of $16 billion/year 2005-08, financing half of the country’s current account deficit. 

However, hopes of EU accession have been visibly fading since and Turkey is now far from being re-rated on the grounds of EU membership prospects. Turkey has only opened 14 chapters to date out of 35, yet has only been able to successfully close one chapter thus far.
To cut a long story short, it is often rather difficult to eliminate the distortions and to gauge the real prospects for Turkey. 

Absurdly, like the chicken and the egg problem, whatever is perceived as “prospects” for Turkey in return is actually playing a major role in determining the economic performance because of the very simple fact that Turkey is a savings gap country, relying on foreign countries’ excessive savings to keep its economy up and running.. 

Turkey’s growth story weakening

Turkey successfully sold its growth story between 2002 and 2011. 

Many favourable developments propped up the perceptions for Turkey during that period such as: there was a strong single party government which implemented structural reforms adhering to the IMF stand-by program (the IMF program ended in 2008), global growth was strongly helping Turkey’s export growth (except for the crisis years), Turkey’s EU candidacy helped attract FDI and became an anchor for the economy etc.

As a dividend of this political stability, Turkey managed to secure fiscal discipline as well as launch banking sector reforms. These achievements are still being appreciated as the building stones of Turkey’s more resilient economy. 

Although Turkey’s growth potential still remains high, the economic headwinds have been growing and the possibility that sub-trend growth will prevail in the near future is also high.

Turkey's ongoing Kurdish minority issue continues to plague political relations. photo: iStock
Looking to the Fed

In the absence of a story to capitalise on, the storm that is coming with the Fed rate hikes is a bigger concern, but what exactly does the Fed’s tightening mean for Turkey and how is Turkey preparing itself? 

Out of the private sector’s $211bn (29% of GDP) loans received from abroad, some 60% is USD-denominated, meaning that the Fed’s rate hikes would lead to a higher cost of borrowing for Turkish companies and the financial system as a whole. 

More importantly, a reversal of the global liquidity flux could pose challenges for smaller financial institutions whose access to foreign funding only becomes possible during abundant global liquidity conditions. 

Another impact would be through the portfolio channel. The normalisation of global monetary policies, starting with the Fed, is hindering interest in emerging-market assets and foreign savings start being more selective. 

Moreover, the anticipated uptrend in core yields is hitting high beta countries like Turkey the most. 

On the flip side, not the Fed’s rate hike itself, but the return of growth to more robust levels as a justification for rate hikes could be favourable for Turkey in the medium term. 

If growth rates in the US economy first and then in the global economy in broader terms normalise going forward, Turkey may eventually benefit from this trajectory by boosting its exports. 

This can help Turkey achieve faster GDP growth without leading to a larger external deficit.

The Turkish Monetary Policy Committee already disclosed a roadmap to manage the impact of the normalisation in global monetary policies on financial stability and liquidity. The most crucial goal in this roadmap is to simplify the monetary policy framework to a “single interest rate” policy. 

This would mark a return to a more predictable and understandable monetary policy framework and could be perceived among the favourable repercussions of the Fed’s rate hikes.

All in all, while on the one hand, the Fed’s approaching rate hike, which is going to kick start the normalisation of global monetary policies, poses challenges for Turkey, such as lifting interest rates and reducing capital inflows, there are also positive ramifications like a faster global growth trajectory and a healthier financing structure. 

Eventually, it is going to be Turkey’s performance of tidying up its own home that will determine its future prospects rather than the global headwinds. 

Nevertheless, less global liquidity would mean less tolerance for laziness and mistakes. In that sense, the current political instability is not helping Turkey at all. 

The Lira's plunge

The Turkish Lira (TRY) has so far borne the brunt of all the fuss about the Fed’s approaching tightening and the political instability. The decline in the Treasury’s borrowing needs, together with the strong demand from the growing pension system and the banking sector, have helped to keep the yields relatively more resilient.

The TRY lost 20% against the FX basket of half euro (EUR) and half USD since the beginning of the year and the TRY underperformed the emerging market average by some 11% during that term. 

The Central Bank of Turkey’s relatively low reserve possession and economic policy makers’ apparent choice for a weak currency against a high interest rate also played a role. 

At $33.5bn, Turkey’s net international reserves are hovering at the lowest level of the last decade. In the absence of an interest rate hike, these reserves are not likely to be enough to defend the TRY unless the reasons behind the TRY’s weakening, such as political instability, are resolved. 

The CBT has so far been reluctant to hike interest rates to sooth the pressure emanating from the political turmoil. However, the CBT made it clear that it is ready to hike interest rates as a response to the Fed’s tightening. 

In the short-term, the TRY could take a breather in its sharp weakening trend and could bounce back, as the expectations for the Fed’s first rate hike are being delayed again and the political outlook is unlikely to generate fresh news until November 1 elections. A 4-5% depreciation from the current spot levels could set the bar for now for the downside risk on the TRY.

Nevertheless, further depreciation should not be ruled out later in the year for two reasons. 

The markets have so far priced in the political uncertainty that would last until the new government is formed when there are repeat elections on November 1. 

However, the possibility of even more political instability is only partially within the valuations. 

In the event of further pressure from the political front, the CBT is unlikely to resort to its interest rate tool and would take only minor steps, such as increasing the FX sale auctions. Therefore, the TRY could remain prone to downside risks from that channel. 

The second reason that could lead to further depreciation would be the realisation of the Fed’s first rate hike. If the Fed surprises with an earlier hike, this could put EM currencies under pressure and the TRY could be among the hardest hit. 

However, in that case, the CBT is expected to react by hiking the policy rate and that might help the TRY to some extent.

 A Fed rate hike could eventually work in Turkey's favour but the plunge in the lira in
recent weeks means it might not be everyone's cup of tea in the short term. Photo: iStock

— Edited by Martin O'Rourke

Nilüfer Sezgin is chief economist at Erste Securities İstanbul


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