There he is. Sat on the naughty stool. The economic wrecker Recep Tayyip Erdogan. He’s agreed to stay put, while the adults in the room, or the technocrats if you prefer, attempt to bring order to his basket case economy.

But will he stay put? Or rise and wreak more havoc with his “Erdoganomics”?

One by one, analysts are coming round to the idea that the stark policy U-turn permitted by Erdogan to his new economic team is the real deal and is here to stay. But the confidence is of a worryingly shaky sort. A very shaky sort.

Turkey’s meddlesome ruler could re-enter the economic fray at any time. As more and more Turks wince at the drastic bitter medicine administered by two ex-Wall Street bankers—finance minister Mehmet Simsek and Hafize Gaye Erkan (central bank chief until February 2, when she quit citing a “smear campaign”)—the authoritarian populist chameleon might decide that the treatment is not bearable after all.

In mid-January, bond giant Pimco gave Turkey a vote of confidence, saying it believed the country was on track for an investment-grade rating. The California-based fund manager has taken a bet on the abrupt economic reforms by buying some lira-denominated bonds.

“Interest rates have risen substantially, fiscal policy has tightened… policymakers continue to unwind unsustainable programmes, encouraging locals to invest back into the lira and away from US dollars… these efforts are working,” Pramol Dhawan, who heads Pimco’s emerging markets team, was reported as saying by the Financial Times.

But let’s not get carried away. Dhawan qualified the bubbling enthusiasm with the comment that such an upgrade could happen “within the next five years if everything goes to plan”.

That’s a very big if.

Turkey currently holds a single B rating across the major rating agencies, placing it five or six notches into junk status. Its investment grade designation was lost in the wake of the failed 2016 putsch against Erdogan.

Not in the mood to back Pimco’s rosy sentiments was Europe’s biggest asset manager Amundi on January 23.

Sergei Strigo, co-head of emerging market debt at Amundi, told Bloomberg in an interview that foreign investors would steer clear of lira bonds until inflation reverses course and decelerates. That, he said, is a distant prospect, implying that foreign inflows likely won’t materialise until at least mid-year at best.

“My sense is that for international investors to go into the domestic bond market, I would ideally like to see inflation really ticking down. And we are yet to see that. That for me would be the main trigger point.”

The now ex-governor Erkan was already by December stating that the time for foreigners to invest in lira-denominated government bonds “should be now”, given her quintupling of interest rates to 45% since her post-election appointment in June last year.  But with official inflation still sat at 65% and set to go higher before falling, her urging seems premature. Non-resident holdings in Turkey remain below $3bn—the most since early 2022 but just a fraction of their $70bn peak more than a decade ago.

So back to the crux. Is Turkey’s policy U-turn the real deal? Well, first a comment from veteran Turkey analyst Timothy Ash on the “Erdogan factor”. On January 15, he advised investors that the “sheer scale of the problems that faced Turkey, in the aftermath of the 2023 elections, because of the past decade of unorthodox policies, was such that there simply was no alternative but to move back onto an orthodox economic policy tack. If policy had not changed in the aftermath of the elections, Turkey would have faced a systemic economic crisis to rival that in 2001/2. I think that was crystal clear to all rational economic thinkers, and the message I think was overwhelmingly related to Erdogan. He listened, understood and accepted the need for change”.

Finally, let’s take an extensive look at an analysis released on January 25 by Capital Economics. It amounts to the most wide-ranging research on the topic that has lately dropped into this publication’s inbox.

In the “Focus” assessment, written by the firm’s emerging Europe economist Nicholas Farr, Capital outlines why it has become more positive on the Turkey outlook, finding reason for optimism, but nevertheless treads cautiously.

Farr advises: “It’s unclear what exactly caused President Erdogan to steer policymaking onto a new path. Perhaps he realised that the previous policy set-up was unsustainable and that a fundamental change was needed.

“A more pessimistic view is that the U-turn is simply a short-term strategy to attract foreign capital.

“In any case, investors will be approaching this policy shift with their eyes wide open. After all, there have been several false dawns for policymaking under Erdogan in the past. In 2020, for instance, a new CBRT [Central Bank of the Republic of Turkey] governor [Naci Agbal] was appointed and interest rates were hiked. But Erdogan reversed course four months later by installing a replacement governor obedient to his desire for low interest rates.

“This time around there are clearer signs to suggest that Erdogan is committed to sticking with the new policymaking approach. Erdogan has publicly given up his unconventional view that high interest rates cause high inflation, and has fully endorsed the central bank’s monetary tightening. Even the prospect of a close race for his AK party in upcoming local elections this March has yet to sway him to fall back on stimulus to garner support.

“While we would not want to play down the risk of Erdogan shifting back to his old ways, it seems more likely this time that the policymaking shift will prove lasting.”

Farr poses the question, “Is Turkey’s economy adjusting to the policy shift?”

Tackling the question, he writes that “at face value, the early signs are that the policy shift is already helping to alleviate the macroeconomic imbalances that have built up over previous years. For one, interest rate hikes and changes to banking regulations appear to have taken heat out of credit growth; while nominal bank lending is still running at a very elevated level, real bank lending growth turned negative at the end of last year (see Chart 2)”.

Farr notes a sharp slowing of the economy, with GDP growth weakening from 3.3% q/q in 2Q23 to 0.3% q/q in 3Q23, driven by a fall in household consumption. Based on the latest activity data, Capital, he adds, thinks that the economy probably contracted outright in 4Q23.

“Encouragingly,” says Farr, “inflation pressures are also cooling. While headline inflation has risen further in recent months (and hit 64.8% y/y in December), seasonally adjusted m/m increases in core consumer prices – which provide a better gauge of the latest underlying price pressures – have eased.”

Taking the baseline view that the new orthodox approach to macroeconomic policymaking is here to stay and Turkey’s imbalances will improve over time, Capital forecasts headline inflation will average 48.5% this year and 24.3% in 2025, noting the predictions are below consensus.

High inflation differentials will continue to weigh on the lira over the coming years, says Farr, “but we think that the scale of nominal depreciation will be less than is discounted in the forward market and by less than most analysts currently forecast. Our forecast is for a ~25% fall to 40/$ [from the present 30/$] by end-2025.”

He continues: “In this scenario, high interest rates are likely to offer attractive returns in Turkey’s bond market. We think that Turkey’s 10-year local currency bond yield will remain close to 25% this year, and fall to around 20% in 2025. Nominal lira depreciation will weigh on returns in dollar terms, but Turkish local currency bonds still stand out as having the potential to deliver among the highest returns among EMs if the policy shift stays on track (see Chart 17).”

Given the wild ride taken by Turkey’s economy in the last several years, no analyst will take two steps forward on assessing the outlook, without pausing to check on the whereabouts of the emergency exit, and as his analysis gathers momentum Farr halts and advises: “Notwithstanding the relatively positive signs so far, it is important to stress that the policy shift is very much in its infancy, and a lot more needs to be done before policymakers can declare any sort of success.”

The most important objective, he reiterates, is to bring down inflation substantially. “Despite the recent softening, the latest monthly gains in core prices are still consistent with an annualised inflation rate of around 35%. While that’s a lot lower than current inflation and suggests to us that a lot of disinflation is in the pipeline this year, it is far from the single-digit rates [looking achievable only by 2030 in Capital’s assessment] that policymakers are trying to reach,” says Farr.

“An important step,” adds Farr, “to achieving low inflation on a sustainable basis will be for policymakers to reduce inflation expectations, which are still extremely high. Five-year market breakeven inflation rates and surveys of analysts’ expected inflation in two years’ time are both still above 20%. This suggests that investors and analysts are not yet convinced that the central bank will do enough to get inflation under control in the coming years.”

As Capital notes, low and stable inflation is also needed to rebuild confidence in the lira as a store of value.

Observes Farr: “Turkey’s inflation problem is a key reason why the lira has been under significant downward pressure for many years – and has continued to fall since the policy shift. (The nominal exchange has needed to weaken to offset upward pressure on the real exchange rate, which adjusts for price differentials between Turkey and its trading partners.)”

Relatedly, Turkey’s external vulnerabilities remain a dark cloud hanging over the economy. “The legacy of persistent current account deficits over past years,” says Farr, “has been significant foreign borrowing and an accumulation of large external debts. Total external debts currently stand at around $482bn (45% of GDP), of which a third is short-term (maturing within the next twelve months) (see Chart 10).

“These external debts need to be rolled over, which leaves Turkey vulnerable to shifts in risk appetite and tighter external financing conditions. And a weak currency only makes it more costly (in lira terms) to repay these debts.

“To achieve a more significant reduction in Turkey’s external vulnerabilities, current account surpluses will ideally be needed for several years. This would lower the economy’s dependence on capital inflows and allow the CBRT to further build its FX reserves.”

To encourage investors, Turkey will need to cement the shift towards policy orthodoxy and work to sustainably its macroeconomic imbalances.

Capital sees a need for high real interest rates to prevail for a sustained period. Says Farr: “This would keep credit growth subdued, encourage savings and reduce demand.

“In previous analysis, we looked at 18 EMs since 1980 that experienced inflation problems on a similar scale to Turkey’s and that subsequently lowered inflation to single digits. The key lesson from these experiences was that real interest rates in most cases increased to 5-10% (or higher), and it typically took more than five years for inflation to fall from a peak to below 10%. The tight policy stance was usually maintained for some time, even as inflation reached single digits.

“Similar to these experiences, we think that a positive real interest rate of around 10% in Turkey will be needed for at least the next few years to bring single-digit inflation into sight at end of this decade. While the CBRT seems to have ended its monetary tightening cycle this month with the policy rate at 45.00%, we think that inflation will fall below this level in the second half of this year.”

Capital expects the policy rate to be maintained at 45.00% throughout 2024 and above 30.00% out to end-2025. “In our view, policymakers are clearly wanting to send a hawkish message, which is why we think rate cuts will probably only materialise in early 2025 once inflation is at a much lower level,” adds Farr.

High real rates are also crucial to Turkey’s tackling of other imbalances such as the lack of lira deposits and related dollarisation in the banking sector, Farr says, adding: “High real interest rates would also help to improve the balance of payments by attracting capital inflows and improving the current account.

“In this regard, it’s worth noting that the adjustment in the current account balance is far from complete. The recent reduction in the current account deficit has largely been driven by a narrowing in the energy trade deficit back to more normal levels. That has a lot to do with falls in global energy prices, rather than a fundamental policy-induced adjustment in demand. A period of higher savings and weaker demand is likely to be required to weigh on imports and improve the current account further.”

Turkey since its economic U-turn has supported higher interest rates with tighter policy in other areas such as through fiscal consolidation, with various tax hikes brought in after the election, but, says Farr, a lot more work still needs to be done in this area, with Turkey’s budget deficit having come in above 5% of GDP last year, its highest level in more than a decade. High expenditures to support re-construction after the earthquake disaster that hit southeastern Turkey a year ago are set to keep the deficit wide this year as well.

“Any fiscal giveaways could easily be interpreted as a sign that commitment to the new policymaking approach is slipping,” says Farr, also advising that the government will need to scale back its indexation policies. Officials recently announced a 49% minimum wage hike for this year, adding to near-term inflation pressures.

“Of course, policymakers cannot cut back indexation too far and risk public discontent – this itself threatens a collapse in the policy shift. Accordingly, the government will need to find a balance; future minimum wage, pension and public sector salary hikes will need to become less generous over time to avoid offsetting policy tightening in other areas, whilst also keeping the public on board with the new policymaking approach,” adds the economist.

Analysts are also watching for work from policymakers on phasing out the use of unorthodox tools in the financial sector.

“The distortions in Turkey’s financial sector run deep and many have their roots in the unorthodox policies that have been adopted over past years,” Farr also notes in his report.

“Among the most pressing is the need to carefully dismantle the lira-protected deposit scheme. Under this scheme, holders of lira deposits since late 2021 have been able to receive a return equal to the higher of the interest rate offered by commercial banks or the rate of depreciation of the lira against the dollar. In other words, policymakers have insured depositors against currency depreciation.

“This tool played a part, along with other forced ‘lira-isation’ measures, in encouraging a shift away from holding deposits in foreign currencies in 2022. But it shifted a lot of exchange rate risk from the private to the public sector,” adds Farr.

The government has made steps towards abandoning the lira-protected deposits scheme, known as KKM, including banning conversion of regular lira deposits into the scheme from the start of this year (it is now only allowing FX to be transferred into the scheme). But this tool will need to be fully phased out to reduce debt risks further down the line and restore confidence in the exchange rate regime, Farr says.

Another distortion that has raised a lot of eyebrows is the central bank’s use of off-balance sheet FX swap contracts to support the lira. They have ramped up over the past year. Once these liabilities are taken into account, the central bank’s net FX reserve position is still deeply negative (despite the increase in gross FX reserves) (see Chart 15).The lira has been allowed to depreciate at a faster pace since the election. It is more than 30% weaker against the dollar than it was at the beginning of the policy shift at 30.5/$.

“That said,” notes Farr, “following a sharp adjustment initially, the lira has depreciated at a slower pace and traded in a tight range in recent months. This suggests to us that authorities are still intervening to manage the extent of depreciation.”

Policymakers are faced by the need to perform a delicate balancing act of permitting market forces to take over in governing the exchange rate level over the coming years and managing the pace of depreciation.

Says Farr: “If policymakers allow the lira to depreciate too quickly, it will only feed into inflation and inflation expectations, which could have a self-defeating impact on the policy shift. It would also make it difficult to avoid a rush of deposits into foreign currency without further interest rate hikes—a smooth transition out of the KKM scheme will require lira deposit rates to be sufficiently attractive relative to the rate of inflation and lira depreciation.

“Similarly, letting the currency depreciate too slowly could undermine Turkey’s external competitiveness, weigh on foreign capital inflows and potentially store up pressure for a larger depreciation in the future.

“We expect policymakers to slowly release their grip on the lira and forecast the currency fall by ~15% by the end of 2024, from 30.3/$ now to 35/$. While that’s a large fall, it is less depreciation than what is discounted in the forward market over the coming year (a ~30% fall to 43/$) and lower than the consensus expectation among analysts (a ~20% fall to 37.5/$). We expect the lira to depreciate by a further 10-15% in 2025, to 40/$.”

Looking at the risk of the Erdogan administration abandoning the new policy settings, Farr concludes: “A sharp slowdown in growth, a material hit to the labour market, and/or a sharp decline in households’ real incomes could discourage President Erdogan from sticking with his new approach. Similarly, the local elections in March remain a potential trip hazard. While we think the policy shift will survive the election, a loss of support for the AK party or growing discontent has the potential to be a trigger for another policy U-turn.

“There are other risks to the policymaking shift too. Turkey’s large external debts leave the economy vulnerable to swings in global risk appetite. Global factors could lead to destabilising capital outflows, but also any sign that policymakers are not fully committed to the new approach could also discourage foreign investors, and cause strains in the external position to emerge. A rise in geopolitical tensions – including those related to Erdogan’s sympathetic views towards Hamas in its war with Israel – has the potential to dry up capital inflows too.   

“Another (albeit less dramatic) risk is that the policymaking shift takes longer to deliver results than many are anticipating. As evidenced by the de-anchoring of inflation expectations, high inflation has become ingrained in Turkey over the past decade. This means policymakers may need to keep policy tighter for longer than we expect, and a more extended period of weak growth may be needed to get inflation down.”