I spent the week in Turkey, visiting Istanbul and Ankara, meeting the usual mix of policy makers, diplomats, journalists, analysts, bankers and industrialists.
The worst macro mix since 2000/01 crisis
At the outset the big picture economic take out is I think the worst I have seen since the 2000/01 crisis. With interest rates effectively taken out of the central bank toolkit, the CBRT under successive governors dating back to 2011, has been forced to macro manage the economy and the exchange rate mostly thru an overly complicated set of rules and macro prudential regulations. High inflation has been the consequence of years of these policies and overstimulation in the run up to elections - Erdogan is almost perennially in election mode. And in the run up to the last election in May, and in an attempt to use the exchange rate as a nominal anchor against inflation, the lira was artificially held more or less fixed through direct intervention and indirect moral soasion of business to limit selling pressure on the lira.
The results of all this has been to create an economic mess of distortions, resource misallocation and price and market distortions.
As the new Simsek-led economy team took office after elections, inflation was high (40% albeit half the peak of last year due to more favourable base period effects), FX reserves close to danger levels - likely intervention in recent years has topped the $200bn mark, and net international reserves are negative to the tune of something like $60bn plus. The lira was overvalued around the 20 mark to the dollar, and consequently the current account deficit wide, running at close to $50 billion on an annualised basis.
Banks were pushed to fight the government’s fight against dollarisation by a range of macro prudential measures which penalised them when the share of lira deposits fell under certain thresholds. They were forced to keep deposit rates high to attract lira deposits - over 40% - while lending rates were capped and averaged only around 17% thru the sector. Banks are currently saddled with large negative net interest margins (average cost of deposits around 26%, average lending rates around 17%), and many have just chosen not to lend as a result. Banks were also forced to buy TURKGBs as an offset for high FX deposits on their balance sheets at massively negative real rates, which appears as a time bomb in their balance sheets as rates are hiked/normalised.
The government, meanwhile, introduced an FX protected deposit scheme - where the state compensates for any FX depreciation beyond rate returns - again as a ploy to counter dedollarisarion and to compensate for the lack of the interest rate tool by the CBRT. This has been hugely popular - rising to over $100bn - but at a huge contingent and now actual cost the budget. We heard one estimate that if the lira now moves to 30 to the dollar that the fiscal cost could be $30bn, or close to 4% of GDP.
Companies are being starved of FX liquidity and credit as a result of all this. Working capital is scarce and production is suffering - industrial production has flatlined this year.
Exporters are struggling with weak demand in Europe, an overvalued lira and competiveness problems associated with big recent hikes in the minimum wage and public sector pay.
Perversely, domestic demand has been strong - partially reflecting big hikes in pensions and public sector wages, and the minimum wage before the election, but also as inflation hoarding is pervasive.
I was told that it’s almost impossible to buy a car - there are long delivery times, even though it’s impossible to get finance for more than 10% of the purchase price.
The fiscal deficit has blown out from 2-3% pa in recent years to around 9% on annualised basis earlier this year, reflective of election spending and the cost of the earthquake reconstruction. Public debt ratios remain low though at sub-40% of GDP still.
What’s the good news?
While Erdogan’s unorthodox, and just plain wrong, views on interest rates (high interest rates cause inflation) have been intrumental in creating the crisis conditions as detailed above, for whatever reason he seems to be understanding finally (again) that his policies are no longer sustainable - it’s clear from the above that without change, that Turkey is heading for a systemic crisis - BOP to banking then likely to sovereign debt. Thus, after winning the elections, against the odds, again, in May, he appointed the trusted and orthodox economist, Mehmet Simsek, as finance minister soon after the election. Simsek then seems to have been instrumental in the appointment of another orthodox thinker, Hafize Gaye Erkan, as central bank governor. Erkan’s appointment is landmark appointment for so many reasons, the first women to head the central bank, and the first with a young family. Both Simsek and Erkan are credible and clearly know the problems and can plan a route out of crisis - let’s see if they are allowed to follow this path. Simsek has a decade of policy making experience and Erkan is an acknowledged expert on banks and bank balance sheets - with the banking sector teetering on the brink she will need all these skills.
Soon after her appointment Erkan delivered a much needed 650bps hike in policy rates to 15%, and more seems to be being promised, at least reading the last MPC statement which spells out I think the need for further policy tightening.
Obviously even with the 650bps rate hike in June, policy rates remain deeply negative. The question remains as to why policy makers did not go for an immediate, much bigger hike, perhaps to 25%. Likely this reflects concern that the system is fragile, and their is concern that a larger hike could shock the system into collapse. I sense also that, given the real complexities of the macro prudential mix which they inherited, that there are not entirely clear the where shoes would fall from a shock therapy early and more aggressive hike. They clearly prefer a more gradual move to hike rates. That said, I expect a further hike in rates at the next MPC meeting in July - likely to 20%, and then further moves in August and September to take policy rates to perhaps 25-30%. Will this be enough? Time will tell, but it will be a good first move from the disastrous policy mix that they inherited.
There is still some scope to use macro prudential policies to limit demand pressures and to help the disinflation process. Credit growth is already being self constrained by banks unwillingness to lend, but something needs to be done to unblock the financial architecture to ensure credit goes to where it is most needed. At present it is not going to manufacturing.
That said, given the FX correction, post election to 26 to the dollar, inflation will remain high and sticky - the consensus is that inflation again picks up steam over the next few months, and ends the year in the 45-50% range.
The obvious fear is that the new economy team is being constrained by the obvious political timetable as local elections are due in March 2024, and Erdogan will no doubt targeting the recapture of the important cities of Ankara and Istanbul.
Fiscal policy has already been reined in aggressively over the past month or so, with aggressive tax hikes. Many of the private sector economists I met criticised the balance of overall economic policy now, arguing that fiscal policy is now too tight, and monetary policy too loose, a mix which is unlikely to do the trick in terms of reining in inflation as the pressure point will remain the lira which could continue to weaken creating significant exchange rate pass thru.
Obvioualy there was much debate over the logic of upfront monetary tightening versus a more gradual process. Simsek/Erkan seem to prefer a gradual approach - perhaps assuming that the availability of Gulf money will buy them time.
All feels very jenga like - Simsek and Erkan are trying to remove the bricks gradually to avoid a collapse, but that might still be inevitable. The shock therapy crew would perhaps argue better to just go to positive real rates ASAP and remove all the distorting macro prudential regulations ASAP, and then use Gulf or IMF money to fill the gaps, but at least all the skeletons would have been exposed. As is it’s just very difficult to identify where the next problem, or skeleton, is going to come from. History might suggest that a shock therapy would be the better option, and give the best chance of stabilising the economy this side of local elections.
The Gulf to the rescue?
Reports suggested that Simsek and Erkan visited Saudi Arabia last week, and Simsek had visited the UAE soon after taking office. The media, meanwhile, is awash with talk of $30bn in commitments from UAE, after the trade minister had hinted as much. It’s quite possible that Turkey will get similar amounts from Saudi Arabia, some from Qatar and other rich Gulf states. That could amount to $75-$100bn total, which could do the trick, albeit I don’t think this will be the usual swaps, deposits at the CBRT. The media has spoken about potential Gulf commitments to real economy investments, via export credits, and investments in renewables, IT, logistics et al. The obvious question is whether such bankable projects can be identified quickly enough - and the history of Gulf investment promises to crisis hit economies, like Egypt or Pakistan, is that such investment monies are very difficult to deliver quickly.
It seems as though the Gulf guys will only invest if they see rational, orthodox policies - as with recent bailouts of Bahrain, Egypt and Pakistan. I think this means a competitive currency, policy rates set at levels which better reflect inflation and structural reform. The Gulf money will therefore be an anchor and I think it’s a political backstop for Simsek/Erkan - they can go back to Erdogan and say, “hey the Gulf guys will back us with $ but we have to maintain orthodox policies”. I think Erdogan will listen to the Gulf guys especially as he has spent a lot of political capital rebuilding relations in the region.
Reset also with the West
The trip also coincided with the NATO summit in Vilnius. The Turkish and Western diplomats all spoke about an ongoing reset in relations between Turkey and the West, and hopes of a new fresh page being turned. Turkey gave the concession of green lighting Sweden’s NATO bid, against expectations (albeit not my own) and there were also other significant changes which were seen as a Turkey outreach - including freeing Azov commanders and agreeing big new arms deliveries to Ukraine which have angered Moscow. The view is that the Wagner coup in Russia has concentrated minds in Ankara that it might now be better to realign back with the West rather than pin too many colours to Putin’s mast when he might not be in office much longer.
Erdogan push at Vilnius to resurrect Turkey’s EU bid is interesting - not that anyone is stupid enough to think that Turkey’s EU bid is going anywhere quickly, but that the Turks want a new Customs Union with the EU. Western diplomats were upbeat about this prospect and both sides I think are really hopeful now of much better relations going forward.
The new Erdogan cabinet is also seen as being much more moderate, and pro-Western, reform minded in outlook.
Vilnius was a huge success for Erdogan, as he was the star attraction and seems to have secured the concession from the US on getting F16 upgrades.
The Agbal factor?
You could argue that despite the terrible macro backdrop, that the appointment of a new credible, economic policy team, the first steps to policy normalisation, and then the prospect of a big Gulf bailout plus better relations with the West and prospect of a new Customs Union provides a path out of crisis.
It does in my view but the biggest risk here is a repeat of the fate of Nagi Agbal, the last
Turkish central bank governor who tried to move to tighten monetary policy thru rate hikes and then paid the price of being removed by Erdogan after just a few months in the job. The consensus is that Erdogan just cannot help himself, that he is fundamentally opposed to higher policy rates, and is just so hands on over monetary policy he just cannot help himself from intervening in economic policy and that Simsek and Erkan will ultimately not be given the free hand they need to sort out the massive economic problems that Turkey faces, or else they will be fired at some point in the run up to local elections in 2024 as Erdogan will again want to go back to running the ecomomy on hot.
Fair point all - Erdogan has form. He has done this before.
But why might it be different this time around?
First, the shear extent of the economic headwinds facing the Turkish economy are so severe, that its hard to ignore. Turkish banks and industry is on the edge, and I think even AKP friendly business people will have made the extent of the crisis clear to Erdogan. This simply cannot go on. Enough people have finally told truth to power.
Second, and related to the first point, I see change behind the scenes at the palace, as a crew of new more orthodox, credible advisers seems to be gaining ascendency over the forces of unorthodoxy.
Some of this seems to be related to family politics, thoughts I think around succession, and the rising prominence of the Bayraktar family, of drone fame. The Bayraktar family have a hugely successful drone and technology business, and were instrumental in the election campaign just gone, helping to centre stage Turkey’s rising technological prowess in drones, electric cars, military technology more generally, AI, et al. While respected and socially conservative, Bayraktor is a meritocracy - the company staffed by hundreds of the best and brightest that MIT, et al have to offer. They are rational and logical and listen to reason.
I personally don’t think Erdogan will stand in the next election - he is aged, has been ill and if a chance for a smooth succession to a trusted member of the family appears, surely he will take it. With the other son in law, Berat Albayrak’s star having faded for economic mismanagement - the way has opened up possibly for Selcuk Bayraktor to slip into succession thinking. Selcuk is Turkey’s Elon Musk, hugely popular - regularly mobbed by adoring youth when he sets foot in public. I think if Selcuk had, for any reason, to run in a presidential campaign, in place of Erdogan, he would win a landslide victory on his own account. Notable also in the cabinet reshuffle, two political heavyweights and mooted rivals to succeed Erdogan were removed, in the interior minister, Soylu (hardcore nationalist) and the former head of the army and defence secretary (Akar).
So I think what we are seeing is Erdogan beginning to delegate to those around the Bayraktars and the appointment of Simsek and Erkan is part of that process.
Third, on the Agbal dismissal, credible sources tell me that it was not the rate hiking that cost him his job, but the fact that he had threatened an investigation of the $128bn in lost FX reserves used to defend the lira. That was under the watch of Berat Albayrak and would have been simply too close to the bone.
Fourth, and as noted above, if Erdogan wants Gulf money they will demand orthodoxy. Gone are the days when the Gulf states throw money around the region to secure spurious geopolitical advantage. Geopolitics still count, but they want to know that they will get their money back, and with an investment return. So they will demand credible policies.
Things to watch:
* Obviously news around Gulf money, expect some announcements over the next few days, as Erdogan is visiting Saudi et al over the next week;
* The next MPC meeting in July - anything less than a move to hike the policy rate to 20% will be seen as disappointing and a signal that Erdogan is constraining what Simsek and Erkan can do;
* Hiring and firing at the MOF and CBRT - one key player at the MPC is Emrah Sener, the arch guru of Erdogan’s unorthodox monetary policy views. If he is removed then I think it sends a very positive signal. Likewise if he stays it will make life very difficult for Erkan et al.
Hi,
Your points are excellent and on point. But you don't have any comments and foresight. We welcome your personal comments and insights.
Thanks..