Turkey’s referendum was meant to be a milestone vote that would carve out the country’s future either as a traditional republic or something more autocratic and inward looking. But the vote was remarkably close, with only 51.4% voting to increase President Recep Tayyip Erdogan’s executive powers. Investors are no surer about the direction Turkey, and its economy, will take.
The referendum on April 18 was billed as a defining moment, a stimulus for change that would see Erdogan either sharply improve Turkey’s fortunes or play a despotic hand that exacerbated its many structural problems.
Turkey faces a myriad of challenges ranging beyond a new direction in politics and religious and constitutional affairs. Twin deficits, a heavy reliance on foreign borrowing and unorthodox monetary policy are all dragging on growth. Tourism, one of the biggest contributors to GDP, has all but collapsed.
There are two prevailing schools of thought when assessing Turkey in the aftermath of the referendum, says Carmen Altenkirch, emerging market sovereign analyst at Axa Investment Managers in London. The first is that Erdogan, having achieved his ambition of establishing an executive presidency, will get on with the business of reform. The second is less optimistic.
There is good precedence to argue that the former will be the case, says Roger Kelly, the EBRD’s lead economist for Turkey. Kelly takes the view that the government can focus on the economy. He recognises that his view may be a leap of faith but says that the Justice and Development Party (AKP) has in the past proven its commitment to spurring growth.
Blessing in disguise
Other economists agree that reforms are needed to modernise the economy, tackle high youth unemployment, increase female participation rates and increase the savings rate so that Turkey can become less reliant on foreign investors.
“The AKP is very conscious of the fact that it has been successful in the past because of its ability to produce growth,” Kelly says. “The government recognises that it needs to undertake structural reforms to achieve lasting growth before the next election cycle and we hope it will do so.
“It’s easy to take a cynical view of the economy but there are opportunities,” he says. “It would be unwise to turn back on the successes of the last 16 years. I can’t see the incentives to upset investors.”
While Erdogan’s narrow victory is evidence of an increasingly polarised Turkish society, the slim majority could be a blessing in disguise for the economy.
Greg Saichin, chief investment officer of Allianz Global Investors, believes Erdogan will focus on improving the economy to shore up support ahead of the 2019 election.
“Yes, there are some ideological hang-ups on interest rates and a lack of understanding of how global and money markets work, but the bottom line is that he has to improve the macro outlook to be successful in the next election. If he doesn’t do well, the opposition may seize the opportunity to not only challenge the referendum but also his leadership.”
Indeed, Erdogan’s strength as a leader has translated favourably into a strong support for Turkish assets, particularly in the face of rising geopolitical risks.
“Of course people are concerned,” says Jan Dehn, head of research at emerging markets specialist Ashmore in London. “But the one thing they like less than a powerful leader is a weak government and political instability.”
Dehn points to the relief rally in Turkish assets every time Erdogan wins an election as evidence of this. “It’s a case of better the enemy you know,” he says.
Bright spots
There is plenty that appeals to investors. Turkey’s favourable public debt dynamics (29% debt to GDP ratio) and well-capitalised banks have helped the sovereign to weather shocks, both internal and external.
Investors have held firm in their belief in Turkey’s strong growth prospects, favourable demographics and strong, independent institutions, particularly the banks. In the last 12 months investors have stuck by it through a roller coaster of terrorist attacks, an attempted coup and ensuing purge.
In addition, the sovereign has maintained its ability to fund and has a proven track record of debt repayments. As such it had already raised $4.5bn in the capital markets by the end of April 2017. Bank debt has also proved popular, with financial institutions placing some $2.65bn worth of Eurobonds over the same time frame.
EM bankers have no doubt that favourable market conditions, specifically accommodative monetary policies worldwide, have worked in Turkey’s favour. Low global returns have fuelled a hunt for yield that has helped stabilise Turkish spreads.
Structural problems
But there is much to be concerned about, and the second camp has a much more negative outlook. Many portfolio managers and market commentators believe that over the medium to short term, Erdogan’s executive presidency will serve only to exacerbate long term structural problems and that it is the continuation of a trend that has been in existence for some time.
The question investors should be asking about Turkey, says Tim Ash, emerging markets strategist at BlueBay Asset Management, is why growth is not better.
The EBRD expects GDP growth to be 2.6% in 2017, and while country head Paul Kelly takes a positive view on Turkey’s economic outlook, he says that potential growth is 4.5%.
“Everyone is always amazed how durable Turkey is, how despite everything including two parliamentary elections, a coup and all the news flow around Syria, growth is 2.9%,” says BlueBay’s Ash. “But they’re looking at it the wrong way. Considering public finances and demographics, the question is, why isn’t growth better, particularly given that global financing conditions are so favourable.”
One of the reasons for lower growth is that the government has not implemented the necessary reforms to increase savings as well as other measures needed to encourage foreign investment.
While Nomura’s EM economist Inan Demir says he can understand why people expect structural reforms, he does not expect this to be the case. “The indicators we have seen so far suggest that we will see a greater role from the new sovereign wealth fund on fiscal policy and lower rates/credit support measures on monetary policy, which doesn’t quite fit the reform agenda that the markets expect,” he says.
Turkey’s newly created sovereign wealth fund has a murky mandate. The government transferred the control of two state owned banks — Ziraat Bank and Halkbank — to it as well as Turkish Airlines, oil company TPAO and Turk Telecom among others, and plans to use the fund to finance large infrastructure projects. But investors believe that the fund will reduce transparency, which will not help Turkey attract the funding it needs.
Investors are expecting a calming down of political tensions but Erdogan’s victory speech did not show this, Demir points out. The president’s confrontational attitude is evidence that he will take full advantage of weakened checks and balances that once constrained policy making, particularly economic policy making, he says.
“On a structural level, there are serious questions raised by international observers about the referendum results, and the accusations of the contraction of the rule of law is an important consideration for anyone long term investing in Turkey. FDI has begun to slow down substantially.”
Axa’s Altenkirch agrees that undermining institutions and reducing checks and balances seldom has a good long term outcome. “The risk over the medium term is that Turkey returns to its old boom and bust cycle,” she says. “Loose monetary and fiscal policy aimed at boosting growth and supporting the regime adds to external imbalances. This would leave Turkey extremely vulnerable in the event that markets turned sour towards EMs.”
Bank independence
Once a key driver for investment, the independence of Turkey’s institutions has already begun to erode, and with Erdogan’s increasing ability to drive policy making, his influence over the Central Bank of Turkey is expected to increase. This is bad news for an economy that is reliant on benign external funding conditions.
Commentators already believe Erdogan is to blame for the CBT’s refusal to raise interest rates and to adopt a more orthodox monetary policy to help ease the burden on Turkey’s current account deficit.
Turkey is the only one of the five countries — Indonesia, South Africa, Brazil, Turkey and India — dubbed by Morgan Stanley as the “fragile five” on account of being most at risk once tapering begins, to have failed to correct its current account deficit.
“Turkey’s economic strategy is not appropriate to the characteristics Turkey has,” says Ashmore’s Dehn. “Turkey has a low savings rate so it can’t finance a high investment, high growth economy domestically. The president is trying to force investment by putting pressure on the central bank to lower interest rates.”
Oliver Weeks, CEEMEA economist at Emso Asset Management, an EM-focused fixed income manager with $3.3bn of assets under management, agrees that an end to European quantitative easing and a big FX move could have material consequences for the economy.
“At the moment, export numbers are strong just thanks to global demand, and banks are having no trouble rolling over short term debt from European banks given where we are in the central bank policy cycle.
“But the banks have lent to companies that won’t be able to pay them back when there is a big FX move and there will be a point when they [the banks] can’t just roll over their debt.”
Dehn acknowledges that the government’s loose fiscal policy is fine when there is a steady flow of foreign investment, which in the benign global environment continues.
“As soon as something bad happens, this money will turn away leading to a duration mismatch. This means that Turkey sits on a ticking time bomb in terms of stability of its primary source of growth.”
Interest rate risk
The weak lira is expected to help reduce the current account deficit as are low oil prices, but Erdogan is not expected to allow the central bank to raise rates or to check government spending.
“A lot of people had thought they would unwind some of the pre-referendum fiscal tightening over the next few months and that that would give them the chance to ease on the monetary policy side but that is not the message they are giving,” says Weeks.
Weeks says he is surprised by the government’s stance as it is not an obvious one “given where we are in the electoral cycle”.
In short, the balance of Turkey’s economy remains extremely vulnerable to changes in the global interest rate environment. A tightening of European monetary policy could be devastating.
Ultimately, investors are aware of the risks, and as Allianz IG’s Saichin points out, have been “ever since Erdogan moved the axis of Turkey away from the EU”. But Saichin believes the next two to three years are key to what sort of country Turkey will become.
And in the meantime, however, with global valuations so low, concern about Turkey’s fundamentals is not enough to stop investment. “Most EM investors share the concerns I have but that doesn’t preclude them from trading it aggressively,” says Ashmore’s Dehn. “We have a smaller position than we would have [were it not for the political noise] but we are very value orientated, which doesn’t mean we can’t trade it from the long side.”