Notes from BlueBay Asset Management economist Timothy Ash on his latest visit to Turkey.

I visited Istanbul and Ankara this week and met various officials from the Treasury, CBRT [Central Bank of Republic of Turkey], international financial institutions, banks, politicians, journalists, diplomats, analysts—the usual suspects, you know who you are! Here are my Turkey trip notes.

Political setting

The ruling AKP administration is still smarting/coming to terms with their losses earlier in the year in the municipal elections—Istanbul, Ankara, Izmir, et al. These elections seem to have energised the opposition both inside and outside the ruling AKP. Indeed, within, or now without the AKP, encouraging high profile departures from the AKP, including former PM Ahmet Davutoglu and former first deputy prime minister Ali Babacan. Both are now trying to forge political parties/forces to challenge the ruling AKP. Many spoke about the mood within the ruling AKP towards greater criticism of the leadership—open dissent against the party line.

The repeat Istanbul elections were perhaps most significant though as they proved to many that the AKP, and particularly President Recep Tayyip Erdogan, is beatable in a political campaign. I think they also proved to many that democracy is alive and kicking in Turkey, given widespread prior concern about the over-concentration of power around Erdogan and his executive presidency. The elections were free, albeit given state control of much of the media, not necessarily that fair. And in my view, while there might be concern around rising populist policies and autocracy globally, the political mood in Turkey seems to have now turned against that, and the next political iteration is most likely to be a reversal of this—an iteration to the likes of [opposition party Mayor of Istanbul Ekrem] Imamoglu or even Babacan. The longer term trend seems to be positive in terms of politics. The population have seen the vision of centralised leadership and have come to the conclusion that they don’t really want that—they actually prefer the concept of Western liberal democracy and came out in their millions to vote for candidates representing that in the municipal elections.

The ruling AKP seemed to be rocked initially by the municipal elections, and opinion polls showed a decline in popularity which some suggested might be terminal—and the AKP alliance with the nationalist MHP showed the vulnerability of the ruling party and its fear of failing to secure outright majorities in its own right.

Some of the swagger of the ruling party has been restored by Turkey’s successful intervention in northern Syria, and by Erdogan’s apparent out-witting of President Trump therein. Recent opinion polls have suggested a modest bounce in support for the AKP—up 2-3% but still sub-40%. But whether this bounce will prove enduring will depend still on how the ceasefire in northern Syria plays out. I fear that the ceasefire deal will prove short-lived, and as is, Turkey does not have control over the 400km-plus buffer zone it initially targeted. It hence was only a partial and perhaps temporary win.

Peace on Turkey’s border with Syria, and indeed in its own southeast region might only come with a broader settlement with the Kurds both within and outside its borders. Erdogan proved in the past he can deliver this, but after a bitter upsurge in conflict over the past four years or so, the mood in the country does not yet seem right for such an iteration for Erdogan—albeit it could bring big political wins for Erdogan both at home and abroad, particularly with the US and the West.

The biggest near-term challenge to Erdogan likely will come from his coalition with Devlet Bahceli and the MHP. Bahceli has recently suffered ill health, and questions surround the durability of the AKP-MHP coalition in a scenario where Bahceli is no longer able to remain as leader of the MHP. Could Erdogan forge a lasting coalition with a future leader of the MHP, would he seek new coalition partners, for example with Meral Aksener and the Iyi Party (Good Party), or even go for early elections? All are possible.

But in terms of economic policy I think what is important is that Erdogan is facing a challenging domestic political outlook—early elections are possible in a scenario where the coalition with the MHP breaks, and at this stage AKP popularity is flagging. Thus even though formal elections are not slated to take place until 2023, Erdogan is likely to be very mindful of his poll ratings; the temptation still will be to run more populist and pro-growth policies. Indeed, I think this is already evident from the CBRT’s breakneck and front-loading pace of policy rate cuts. 

Geopolitics—binary outcomes dependent on the Supreme Leader (Trump, that is)

Turkey’s relations with the West are strained, and remain at a low point. With the US, issues are outstanding around the S400 Russian missiles/US F-35 fighter planes, Halkbank and Iran sanctions compliance, detained US state department employees, [self-exiled cleric and Erdogan adversary Fethullah] Gulen, Turkey’s pivot to Russia, Syria and US support for the Kurdish YPG [militia]. With the    EU, there are outstanding issues around Turkey’s energy exploration in the Eastern Med, Syria, migrants, and Turkey’s stalled EU accession bid. Both the US and EU are concerned about trends in Turkey in democracy, human rights, rule of law, media freedoms, et al. The “to be worked on” list is very long from both sides.

But in the case of US-Turkey relations, there is this extraordinary relationship between Presidents Trump and Erdogan. A personal chemistry which seems capable of punching through established and entrenched views in both countries. This was amply seen with the Syrian ceasefire deal agreed, out of the blue and against expectations, during the recent visit of VP Mike Pence to Turkey. Trump has shown the ability to give Erdogan a hall pass when it comes to potential US sanctions whether CAATSA [Countering America’s Adversaries Through Sanctions Act] or for Syria. And therein Trump’s willingness to use political capital in support of Erdogan, against the D.C. establishment, and for seemingly very little reciprocity, is extraordinary. Therein I don’t think the Turks could believe their luck with the deal signed by VP Pence—they got literally all their demands from the US for next to nothing in return.

So herein the slated November 13 meeting between Trump and Erdogan in D.C., has the potential again to move the relationship forward in a positive way. Likely Erdogan will want assurance of no further sanctions from the US on Turkey, and the dropping of the Halkbank case, which is a huge political embarrassment to the Erdogan administration. Erdogan will likely mention Gulen [who is living in exile in the US] albeit given all the high-level exposure therein with respect to the Rudy Giuliani/Mike Flynn axis, it’s hard to see any wiggle room from Trump. Both sides will focus on easy wins, for example, plans for a USD100bn trade deal. But I am not sure what Erdogan can deliver to Trump—big new orders for Patriots [missile defence systems], and recommitment to the F-35 programme, albeit the latter would still require mothballing the S-400 programme.

On the S-400 issue I think the Turkish side thinks they have called the US bluff, again, and will try and play for time with both the US and Russia. Obviously going back on commitments to Russia, would risk escalation and big refugee flows from Idlib in Syria, which would risk further undermining domestic political support for Erdogan given the rising sensitivity of the Syrian refugee problem in Turkey. Maybe placing a big order for Patriots, while stalling the activation of S-400s will be enough to secure Erdogan a happy photo shot with Trump.

Congress though still remains unpredictable in all this. Mitch McConnell still seems set on trying to guard Trump from having to make difficult decisions on Turkey relations, by stalling a Senate sanctions bill on Turkey. But Trump’s problems around impeachment could yet generate surprises, and McConnell might be unable to hold the line. A US Senate sanctions bill could still make the floor in early December, and this might just dovetail with EU sanctions related to Turkey’s exploration for energy in the Eastern Med.

The Halkbank issue is a further complication and Trump now seems unable to stall the judicial process which has now begun. Indeed, with the recent SDNY [Southern District of New York] indictment against Halkbank, Trump signalled that this was now beyond his control. The Turkish side does not appear to be helping its own case by seemingly refusing to accept US jurisdiction—the appointment of the indicted felon, Atilla Hakan, as Borsa Istanbul CEO also does not help the mood music around this case.

Continuation on this path looks set to risk fines for contempt of court, which could well escalate, even before any formal judgement is made, or even eventual penalty from OFAC [Office of Foreign Assets Control]. Now while Halkbank might have no assets in the US, Halkbank’s failure to accept US jurisdiction might have broader implications for other Turkish state-owned banks, and also the Turkish banking sector in general. Turkish state ownership of Halkbank suggests any decisions being made as to how to defend against the SDNY court case very likely are being made by the bank’s political masters. And this would raise the broader question as to whether the Halkbank owners, in this case the state, accept US regulatory oversight on Turkish financial institutions in general.

Can Turkish financial institutions be expected now to accept US jurisdiction? How will international banks view their Turkish counterparts and the veracity of contracts which might be eventually contested in the US courts?
These are huge issues for Turkey, potentially. I would also expect issues around the Halkbank case to be detailed in the looming FATF [Financial Action Task Force on money laundering] annual report in Turkey. Concerns are likely to be highlighted which could well have broader resonance across the markets. Continuation on the current path, would eventually risk warnings around FATF grey listing.

Surely the Halkbank case could have been settled some months ago in a conciliatory manner from both sides. Some liability could have been accepted, a modest fine paid, behaviour changed and both sides could have moved on. But at present we seem locked in escalation mode, which seems unlikely to end well—not for Turkey at least.

It’s the economy stupid!

True, the secret of Erdogan’s electoral success over the past 17 years has been the economy—delivering real GDP growth and jobs, significantly helped along the way by foreign credit-fuelled investment.

The Erdogan model has appeared seriously under threat over the past 12-18 months, as economic mismanagement, primarily reflected in overly loose monetary policy and Erdogan’s total erosion of central bank independence, left the lira brutally exposed last year. Currency collapse, followed by belated and consequently then extreme interest rates hikes, resulted in the brakes being slammed on, and a massive deflation ensuing. Domestic demand collapsed, unemployed soared and non-performing loans increased markedly. 

Anti-crisis measures eventually stabilised the ship—but at the price of elevated inflation, eroded living standards and lost output. AKP popularity declined and to some extent this was reflected in the party’s poor showing in municipal elections early in the year.

There are now some signs of stability, even recovery. Output has bottomed out, and higher frequency indicators are suggesting a return to growth. The collapse in domestic demand, a huge nominal and real depreciation of the lira has helped turn around the external accounts—a USD54bn current account deficit has turned into a USD4-5bn surplus.

High policy rates, the maintenance of a current account surplus, and aggressive micro management of the FX regime—closing, in effect the offshore TRY swap market—stabilised the lira. Now real FX depreciation, depressed domestic demand, and base effects are crashing inflation lower—from 25% a year ago to 8-9% at present. To some extent, the turnaround is remarkable—and policy elites are now quick to take the credit, albeit some of them were on watch in the run-up to the crisis. The CBRT has been able to cut policy rates by 1000bps or so now in the past six months, and this is all creating hopes of a V-shaped recovery, with the government’s medium-term programme suggesting 5% real GDP growth in 2020. The MTP also assumes the current account deficit holds to just 1.2% of GDP, and the budget deficit keeps to below 3% of GDP.

Frankly, this rosy outlook seems unrealistic. 

First, there is much to suggest that the 2017-2018 downturn/recession was different to other crises in Turkey, in that the recession was balance sheet in nature—driven by too much FX leverage in banks, and across the system, and the extreme FX devaluation resulting, left NPLs across the system, many still likely hidden by pressures to extend and pretend. Banks and corporates are as a result likely to be slow to go back down the credit growth channel—and official hopes of 15% annual credit growth in 2020 might prove optimistic. Signs are that private sector banks are deleveraging, while they are struggling to access longer term TRY liquidity.

Second, consumers also seem likely to be reluctant to get back to old spending ways quickly. Unemployment remains high, while few people seem to believe the official inflation data. Perceptions will be that real living standards remain under pressure, and any feelgood factor is likely to be in short supply. Demand for credit, from SMEs in particular seems weak.

Third, on the inflation front, dollarisation has continued apace—at least nominally, albeit the authorities point out that with TRY deposit growth now outpacing FX deposit growth the dollarisation ratio is stabilising, even falling, but from now high levels. But still a high level of dollarisation suggests a fundamental lack of confidence not only in the inflation data, but the broader economic policy making. And I would think that this will be reflected in stalled consumption.

Fourth, global and European growth remains weak, and this has been reflected in export growth data—despite a highly competitive lira now, dollar export growth has disappointed, relatively speaking at least. 

I would hence contend that growth will tend to surprise on the downside, perhap coming in more like 3% in 2020. The upside from this is that the current account deficit might actually remain more manageable—closer in fact, to the 1.2% MTP programme. We could also see inflation, at least that reported, also come in towards the bottom end of CBRT forecasts. And this could then see more scope for the CBRT to extend and deepen its current rate-cutting cycle—thereby pleasing its political master.

It’s possible then to present a benign outlook for fixed income markets, with growth and inflation surprising on the downside, and with the authorities continuing to micromanage the exchange rate, the lira might remain relatively stable (surprising towards appreciation)— notwithstanding potential geopolitics, hiccups. 

But then returning to the political context, with support for the ruling AKP and Erdogan lagging and risks of early elections due to potential leadership changes at the MHP, can Erdogan risk low-balling growth? It seems unlikely—and this suggests extreme pressure then on the CBRT to do more to cut policy rates, on the Treasury to loosen fiscal policy and on banks to boost credit expansion.

Another Credit Guarantee Programme?

Now if developed markets policymakers keep policy loose, and global liquidity plentiful, the market might be forgiving of a scenario where nominal policy rates might be pushed well into single digits, real policy rates close to zero, and fiscal policy loosened, with risks to a rising current account deficit again. But I have my doubts in the context of the past two years’ experience of the Turkish policy setting where we know that if the lira cracks, and the CBRT needs to hike policy rates, Erdogan will only allow policy tightening when it is too late.

I would also question the willingness of portfolio investors to commit to local TRY GB trades, when the offshore swap market remains broken, and hedging opportunities are limited. We pushed policymakers on this very issue. The response was not very credible. A first response was that this was not a policy prescription but just reflected the result of dollarisation, which resulted in local banks being flush with dollar liquidity and in need of no more provided through offshore SWAPS—they also preferred TRY. A second, was that the blame rested with foreign banks which could provide TRY liquidity onshore to foreigners, but had been unwilling to sufficiently boost their capital to enable such liquidity provision. There was little acceptance that this was a specific policy response to offshore shorting of the lira in the summer of 2018, and restricting liquidity to the offshore market helped to stabilise the lira, albeit at the price of limiting portfolio inflows subsequently to the TurkGB market. Indeed, on the latter note it is striking that in an environment where policy rates have collapsed by over 1,000bps, and the lira has remained stable, portfolio inflows have flatlined this year, and foreign holdings of TurkGBs have stayed only around 10%, from peaks closer to 25%. In previous years when similar disinflationary trends have been evident, portfolio inflows have totalled around the USD20bn mark.

This now seems a very micromanaged market. Dollarisation means banks are flush with dollar liquidity and can meet offshore FX liabilities falling due. This dollar liquidity is also available to state-owned banks which if market makers are to be believed have been supporting the TRY at times of geopolitical stress and post recent rate cuts. Long-term TRY liquidity is though in short supply—banks complain that swapping FX liabilities for TRY is expensive and longer-term liquidity is in short supply. With foreigners also reluctant to participate in Turk GBs, while the CBRT continues to aim to push short-term rates lower, this would suggest a steepening of the yield curve and crowding out at the longer end of the funding equation.

This also comes as the Treasury likely needs to borrow more and will want to move back out of the Turk GB curve to extend its maturity profile again. Net-net this again suggests that credit growth will disappoint and with it real GDP growth and job creation. The so called V-shaped recovery required to list Erdogan’s lagging poll ratings will be elusive. And this then risks more risky and unorthodox policy responses from the Erdogan administration. This might be a year or so out from here but the concern is that when this reckoning comes, what we know is that the CBRT will be unable to respond as it did in 2018. It will be unable to hike policy rates, because President Erdogan has made his position totally clear in this regard—interest rates cause inflation. 

** Please note that any views expressed herein are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions. The views expressed do not reflect the opinions of all portfolio managers at BlueBay Asset Management, or the views of the firm as a whole. In addition, these conclusions are speculative in nature, may not come to pass and are not intended to predict the future of any specific investment. No representation or warranty can be given with respect to the accuracy or completeness of the information.