Turkiye - durability in times of crisis

Political events in Türkiye over the past week has shook Turkish markets.

In the immediate aftermath of the arrest of Istanbul Mayor Ekrem Imamoglu, and then the resulting onset of large scale opposition demonstrations, the lira fell 14% in one day, to record lows (42 plus against the USD, since recovering to around 38), while Turkish equity markets lost around one fifth of their value, Turkish bond prices dropped and Turkish 5Y CDS rose by around 80bps albeit has since come back in to trade around the 300bps mark.

The opposition has hoped that mass street protests, pressure from the West and I think market pressure would force a change of tack from the Erdogan administration - perhaps to pulling the case against Imamoglu, and re-installing him as Mayor and prime opposition contender to run against Erdogan in a future presidential election.

On the subject of Western pressure, or even sanction, on Türkiye to force Erdogan to change tack, the piece by Gonul Tol this week was quite atypical.

https://www.ft.com/content/b2b9d867-fc13-4d30-bc54-4f8f9084bd41

Hopes that markets, or even Western lobbying or sanction, would encourage a change of tack from the Erdogan administration appears though to be overdone as a range of factors come together at this point in time to work in Erdogan’s favour.

First, Western governments have been largely quiet in response to events in Türkiye, preferring to see this as an internal Turkish matter. The Trump administration for its part made its thoughts clear this week, hosting Turkish foreign minister, Hakan Fidan, in talks thought to focus on lifting CAATSA sanctions on Türkiye, the potential for new F16 sales to Türkiye and perhaps even welcoming Türkiye back on to the F35 programme. Trump, meanwhile, gushed warm praise on Türkiye and Erdogan just affirming that for the Trump administration foreign policy is no longer about pushing ‘so called’ Western values but on hard America first interests. And when it comes to Türkiye Trump needs Turkish cooperation in Syria to deliver on his campaign promise to pull US troops out of Syria. Türkiye will also likely be a key player for the US as it rolls out its maximum pressure campaign on Iran, which could even result in a U.S-Israel military strike on Iranian nuclear facilities. The latter might in some way involve US military assets in Türkiye.

Even for Europe, the Imamoglu crisis comes at a particularly inopportune time as the continent is struggling against the increased military threat from Russia, the weakening in the U.S. security guarantee and hence a desperate attempt now to rally European defence assets to the common cause of defending Europe against Russia. Türkiye’s huge military and military industrial complex is a game changer both in terms of enabling Europe to defend itself against

Russia but also in terms of policing any ceasefire agreement in Ukraine. Autonomous European security architecture simply does not work without Türkiye, at least in the short term. Obviously Erdogan is keenly aware of this which might have figured in the timing of the move against Imamoglu. But in the end European “values” are a nice have but unless hard defence “interests” are fully taken into account, there might be no Europe, and Putin might be setting the “value” offering across Europe.

Second, hopes of market discipline coming to the rescue are also probably overblown.

Numerous factors come into play herein in suggesting that market calm will eventually be restored.

I would highlight at the outset the perennial durability of the Turkish economy. Türkiye, and Turks, have survived numerous such crises in the past, it’s kind of part of Türkiye’s DNA. I have lost count as to how many times in the past I thought a systemic crisis was just around the corner and yet the country just seems to manage, or muddle thru.

One conclusion from this track record is that Turks are just great crisis managers. They have seen much worse, and don’t panic. They are very logical and sophisticated in terms of their own personal investment decisions.

Another is that there are plenty of inbuilt buffers - dollarisation has reduced but it is still high relative to its peers, and Turks have plenty of FX and gold buffers.

Turks are also great traders, and recent policy tightening by the CBRT, and the maintenance of strong real lira policy as part of the disinflation battle, on a risk/reward spectrum makes holding lira assets still attractive. This has stemmed dollarisation - indeed, according to CBRT data, of the $25 billion plus in outflows over the past week, only 10% or so has been local Turkish retail selling, and 60% has been foreign selling from perhaps over-positioned levels.

Looking at it in a different way, what’s the worst case, or for some best case, here that the Imamoglu scandal opens the way for a change of administration - but therein what does that mean from an economic policy perspective? Not very much as I think it would indeed be hard to distinguish between the economic impulses therein of an Imamoglu as to an Erdogan led administration. Faced by the core threat to the economy which is inflation, I think monetary and fiscal policy would need to be tight, and the lira held strong. There are simply no alternatives. So I think Turkish locals are reflecting this in their decisions with respect to dollarisation.

And therein a key anchor for the market is the Simsek - Karahan team. They are seen as credible, and market friendly. They are pushing an orthodox agenda, and are trusted by the investor base - actually local and foreign.

Do they have the mandate from Erdogan to continue to do whatever it takes to stabilise markets and fight inflation?

Well Erdogan re-affirmed his support for the team and the programme this week. But actually I would argue that domestic political flux makes it even more likely that Erdogan will need to support Simsek and team as the fight against inflation is now even more critical to Erdogan’s re-election chances. There will indeed be a large section of the population turned off by what they see as the unjust removal of Imamoglu, which will make securing another election win for Erdogan that much more difficult in some respects - but if Erdogan is going into an election with these lingering concerns around over concentration of power, then he will have to give the population something else, which has to be evidence of delivering on the economy front. And what is the number one economic issue for the population? Inflation. And did the prior unorthodox policy slant of Erdogan succeed? Absolutely not. Hence there is just no alternative to the orthodox policy responses now from Simsek and Karahan. There is no going back, but actually events over rhetoric past week make for a period for even higher rates, for longer, more, not less likely.

The Simsek, and CBRT teams defence of Turkish markets has certainly been helped by almost two years of quite successful delivery in terms of the orthodox agenda to fight inflation. Alongside a buffer of confidence/trust in their own abilities, we have also seen the FX reserve stock pile build by well over $100 billion, to levels of around $170bn gross just prior to this current crisis. The current account deficit, meanwhile, has been reigned in from close to 4% of GDP to nearer to 1% of GDP. Distortions in the monetary and financial architecture, accumulated under the rein of former governor Kavcioglu and well before, have been reduced, with the KKM reduced also by close to $100bn. The financial architecture, and the monetary transmission mechanism works much better now than it has in the past - and Simsek and Karahan talk of market friendly solutions to the current crisis. This is all very reassuring.

I have heard some journalists comment that this crisis is one too many for the international investor base, and having rebuilt foreign holdings in Türkiye, from the mid $20 billions to the mid $50 billions (actual highs back around the IG period were over $170 billion), and now with $20 billion having headed to the exits, it will never return. International investors are renown for their short memories, and I would wager that some easing of domestic political tensions, and if the CBRT manages to hold the line on the lira, and keeping rates sufficiently high for an extended period, then foreign investors will return to lira assets. Faith I think in Simsek and Karahan is strong, and the basic Turkish balance sheet is not looking that bad these days - as mentioned a 1% current account deficit, and a public sector debt to GDP ratio of just 25%, budget deficit of 3-4% of GDP (too high admittedly given the need to drive on with disinflation), albeit with inflation still way too high (but moderating). Trump I think assures of no new sanctions looming on Türkiye and with the prospect of Kurdish, Armenian, Syrian, and Ukrainian peace processes, all to the benefit of Türkiye, plus Türkiye set to massively benefit from European rearmament, there are enough positive signals that investors can still hang on to.

But investors still need to see an easing in domestic tensions, no escalation in street demonstrations, and hopes still of some political settlement. On the latter there is talk of the CHP majority being able still to elect a replacement to Imamoglu as Mayor of

Istanbul, which would be a concession to enable the CHP opposition to retain control of Istanbul’s huge public purse, likely critical in future elections.

And for those arguing that investors will be put off by ESG concerns about further restrictions around the Turkish political setting in the aftermath of the Imamoglu affair? Well I would just point out to the large number of Western investors who were long Russian rouble in the run up the full scale invasion of Ukraine by Russia, and after the long, long list of Putin’s malign actions against the West and the Russian opposition. I guess for the investment community it is all about risk versus reward. The counter would be that sometimes it’s hard to gauge the risks (and often investors get these badly wrong), whereas the rewards are easily to gauge.