Turkish markets, which have been one of the turnaround stories over the past year, have given up some gains over the past few weeks. In August, the lira, which has outperformed expectations for much of the past year, weakened around 3% over the month and offshore lira overnight forward rates have headed higher (>60%) suggesting that foreign portfolio investors have taken some risk off the table. This was evident from CBRT data showing a $1 billion outflow from TRY bonds in the week to August 23, the largest weekly outflow in three years. Locals also appear to have joined the selling of the lira, which has forced the CBRT to try and defend the lira - suggestions are that the central bank may have used around $10 billion defending the lira over the past week.
Explanations for the current change of mood are various:
First, the global market correction earlier in the month around the Yen, combined with US hard landing fears, might have seen global players square risk positions, reducing less convicted positions such as in Turkey. Herein there might also be some lightening up well ahead of US elections which is replete with global risks and uncertainties.
Second, and Turkey specific, rumours have abounded that finance minister, Mehmet Simsek, had threatened to resign - the presumption there was this was in resistance to calls for him to water down his economic adjustment programme.
Simsek and his team have come out strongly to deny these rumours, but some have held to the mantra that there is no smoke without fire, and seemingly continued selling.
Third, and perhaps more pertinently, an intense debate is currently underway in Turkey over the merits of the Simsek programme. Some are arguing that the programme is too harsh, that the lira is overvalued and (the real appreciation tack to secure disinflation) imposing an undue toll on key sectors of the economy - exporters and those reliant on credit (construction, real estate). A view is that even if Simsek survives in his job that he will be unable to resist calls, given the political imperative, to moderate his programme, perhaps easing policy rates sooner rather than later (policy rates are currently 50%) and perhaps allowing the lira to adjust weaker faster to moderate its significant real appreciation over the past year.
All this comes as the Simsek programme has delivered significant successes already:
* The return to orthodoxy, with policy rates hiked from 8.5% to 50%, and efforts to clean up and normalise the financial plumbing around monetary policy and banks, has seen a confidence/credibility boost. The week to August 23 might have seen portfolio outflows but the year before had seen more than $20 billion in net foreign portfolio inflows;
* Local sentiment had also improved, and the CBRT managed to successfully unwind much of the potentially catastrophic (for public finances, and also the CBRT balance sheet) FX protected deposit scheme (KKM) - cutting its share by half since the start of the year to now just over 10% of deposits, with limited draw on the lira or FX reserves, most attracted back into plain vanilla lira deposits whose share has increased to over 50%. De-dollarisation has accelerated as a result, adding to the demand for lira.
* Despite concerns over a strong lira, the current account position has continued to improve, with the deficit on an annualised basis cut from over $50 billion in June 2023 to less than half this total a year later and now just a few percentage points of GDP;
* And, despite still running a large current account deficit, the CBRT was able to rebuild gross FX reserves by close to $100 billion, to over $150 billion, record highs, while the ignominy of having negative net international reserves of close to $60 billion was reversed and this item moved into the black.
* And inflation trends seem to have turned the corner with the headline rate seeming to peak in May at 75% YOY, moderating to 61.8% in July and set to drop to a 50 handle in August.
All the above is remarkable given that Turkey appeared to be staring in the face of a systemic crisis in the aftermath of the 2023 elections, and because of the unorthodox monetary policies run for the prior decade. Instead of seeing no light at the end of the tunnel, Simsek and his team have presented an exit route to lower inflation and more sustainable growth. That just did not seem possible eighteen months ago.
That the above tightening and push lower in inflation came without that much growth give up is quite remarkable, and perhaps now explains the intense debate internally. Those close to the central bank had argued that first moves lower in inflation - the low hanging fruit - would come relatively easily due to base effects and because a positive confidence shock from better policy and the stabilisation of the lira which would help underpin economic activity. They warned though that while taking inflation from 70% plus to the thirties might be relatively easy, because of entrenched expectations, the next legs lower to the teens and single digits would be much harder. They would ultimately need a growth give up, and tighter policy for longer.
I think this message was also hinted at in the IMF Article IV review on Turkey published over the past week:
The hint, or even message, herein is that monetary policy will need to be held tighter for longer, and if it is to be succesful there also needs to be a tightening in fiscal policy as well.
Simsek and team have achieved great things over the past year or so, and have beaten expectations. They have provided light to the end of the tunnel, but much needs still to be done and the track out of the tunnel is still likely to be uphill. I think herein is why the debate in Turkey suddenly got very intense, as there is a recognition that over the fall and into year end really hard decisions will need to be taken. These will be have to be around fiscal policy - which will need further tightening, and for policy rates to be held where they are at least through years end, if not hiked further.
There are those calling for a currency adjustment weaker, or lower rates sooner, but this will only bake in high and higher inflation. It is simply not an alternative to the current policy path. Now I am sure that there are snake oil punters close to the centres of power in Turkey, but the harsh reality is that because of the sins of the past, there is simply no alternative to a sustained tightening of policy - a growth give up - to bring inflation meaningfully lower and to keep him there.
Now is not the time to give up on Simsek and his team, but it is time to double down in our support for them. If supported they will bring inflation back to target, which is still 5% for the CBRT, and the tighter we hold that policy in the near term the sooner the inflation target will be attained. I think there is the political backing for Simsek at the highest level in Turkey as I think there is recognition that there is simply no alternative to the current path. The path for Erdogan’s political survival is by beating inflation and only Simsek here presents the solutions.