Analysis: Turkey and its markets are heading for an election crossroads

  • Turkey’s presidential election represents a major split. Side effects of unorthodox economics crucial for voters
  • Repeated periods of market turmoil have led investors to leave Turkey
  • Economists recognize that a return to orthodoxy is painful

ISTANBUL/LONDON 18 Jan. – Turks who have been plagued for years by skyrocketing inflation and currency crashes will soon decide whether to continue with President Tayyip Erdogan’s vision of a heavily managed economy, or give up for a painful return to liberal orthodoxy.

Presidential and parliamentary elections, arguably the most sweeping in the republic’s centuries-long history, are likely to take place in May and determine whether 68-year-old Erdogan takes power for a third decade.

The vote marks a fork in the road for Turks weighed down by an inflation-driven cost-of-living crisis that is only just beginning to abate.

International investors, many of whom have bailed out over the past five years amid recurring market turmoil and Ankara’s embrace of unorthodox economic policies, are watching the situation closely.

Fund managers told Reuters that even the hint of an opposition victory could lead to a significant rally in Turkish assets given promises to reverse “erdonomy.”

But its drastic transformation of the economy and financial markets means that such change brings its own uncertainties.

Blaise Antin, head of EM sovereign research at Los Angeles asset manager TCW, said an immediate “quick death on FX valuation seems unlikely” even if Erdogan loses.

Only in the medium term could markets turn sustainably bullish given the need to address an overvalued currency and reset interest rates to “a much higher level,” he said.

Opinion polls suggest Erdogan could retain the presidency as his Islamist-rooted AK party loses control of parliament.

That could be “the worst case scenario,” Antin said, which could lead to near-term policy uncertainty and market volatility.

There’s still a long way to go.

A six-party opposition alliance has yet to elect a presidential candidate. A popular option, the mayor of Istanbul is appealing against a prison sentence and a political ban.

Critics say courts are muzzling Erdogan’s opponents, a claim the government denies.

The elections will also determine the role regional military power and NATO member Turkey play in conflicts in Ukraine, where Erdogan has helped broker talks, and in neighboring Syria.

ACHILLES HEEL

Erdogan has never looked so fragile, with the economy his Achilles heel.

A self-proclaimed “enemy” of interest rates, its determination to cut rates from 9% to 19% caused the lira to crash in late 2021, falling another 30% last year – its 10th consecutive annual plunge. Inflation roared to a 24-year high of 85% in October as food, fuel and rent costs soared.

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To offset voter tensions, Ankara spent a record amount on social aid worth about 1.4% of its annual budget, including energy subsidies, doubling the minimum wage and allowing more than 2 million Turks to to retire immediately.

“Erdogan is offering one (aid) package after another,” which will put “considerable strain” on the state coffers, said Galip Dalay, an associate fellow at Chatham House in London. “But if he loses the election, that’s someone else’s problem.”

Turkey still has much lower debt than most countries, but years of depletion of foreign exchange reserves, erosion of the central bank and the independence of the judiciary and unorthodoxy in general have left their mark.

Credit ratings from Moody’s and Fitch fell from investment grade to “junk” in 2016 – similar to Bolivia and Cameroon.

“The policy just doesn’t look sustainable,” Fitch’s Paul Gamble said.

EXODUS

According to investors, Turkey’s free-market model began metamorphosis around 2017 when it adopted an executive presidential system that concentrated power in the hands of Erdogan.

In 2019, authorities became concerned about destabilizing speculation straining international lira markets. Trade in centers such as London now averages less than $10 billion a day, compared to $56 billion in 2018, according to Bank of England data.

Foreigners have reduced ownership of Turkish government bonds to less than 1% from 20% in 2017 and now own only 30% of the stock market, compared to 65% a few years ago.

Turks looking for a way to hedge against rising prices have filled the gap and helped boost the Istanbul index (.XU100) by 200% last year. They now account for 70% of the stock, up from 35% in 2020.

Mehmet Hasim Acanal, a farmer in southeastern Turkey, sold one of his fields and tapped into savings to put 10 million liras ($533,620) in stocks.

“I thought it would protect against inflation … and yield more returns than dollars and gold,” he said.

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Turkey’s devaluation-protected bank deposit scheme, introduced to stop the lira’s plunge in 2021, is an example of its unorthodox and sometimes costly approach.

In the short term, however, it seems to have worked, halting a years-long rise in the number of Turks converting lira into dollars.

Meanwhile, injections into the treasury of “friendly” countries such as Qatar and Russia, as well as an uptick in tourism, have helped keep the lira roughly between $18.0 and $18.8 since August – around the time the Erdogan’s opinion polls began to recover.

Authorities have also been constantly tinkering, introducing some 100 additional rules to bolster currency stability.

A banker told Reuters that some foreign investors had begun short-term bets on the lira given the central bank’s net foreign exchange reserves have nearly doubled since November.

Yet the lira, which has lost more than 90% of its value against the dollar since 2008, is still 15% overvalued on economic imbalances and fiscal stimulus, said Robin Brooks, chief economist at the Washington-based Institute of International Finance. “The credit stimulus is keeping growth higher than Turkey can really sustain,” he added.

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But predictions that Erdogan’s policies would lead to disaster have failed to materialize, says Sergey Goncharov, EM fund manager at Vontobel. Last week, Turkey had no problem borrowing $2.75 billion from international capital markets.

That complicates the choice for voters who could face a painful initial economic downturn if an opposition victory led to a return to free-market policies.

“It’s an unstable equilibrium,” Goncharov said. “But it’s hard to get out.”

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($1 = 18.7400 lira)

Additional reporting by Nevzat Devranoglu in Ankara; Additional images by Vincent Flasseur, Riddhima Talwani and Sumanta Sen; Edited by Catherine Evans

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