As ever, lots of moving parts in Turkiye, so though the best way to address these was from a Q&A.
Q? So 18 months into the Simsek programme where are we?
Answer - Mixed bag, to be fair. But I would tend to view things thru a glass half full prism. To mix metaphors, Turkiye was facing a systemic crisis in mid 2023, with a freight train coming head on towards it in the tunnel. That train seems to have been diverted and there is now light at the end of the tunnel. Simsek and team have engineered a way thru to avoid that systemic train crash. But they are not there yet, and need to maintain reform speed for sometime yet.
To be fair to Simsek and team, it is pretty remarkable what they have achieved, given the extreme situation they faced upon taking office of rising inflation, uncapped inflationary expectations, a basically bankrupt central bank with no credibility, limited gross FX reserve cover, and a massive negative net international reserve position, with the currency on a strong depreciating trend, a wide current account deficit, large gross external financing needs, the ticking time bomb of the KKM, and zero credibility in the economic policy settings and team they inherited. My base case, had Simsek and team not been hired was a systemic banking, balance of payments and sovereign debt crises, akin to 2001. That was avoided which was a result in itself, but over the past year, they have managed to:
* Hike policy rates, against expectations from 8.5% to 50%, and remember here most expectations had been for an opposition win in the May 2023 elections to push policy rates to nearer to 35-40%. Note also on a compound basis policy rates are actually closer to 65%, which implies real rates of over 15%, amongst the highest across EM;
* Stabilise the lira, managing modest nominal depreciation and some real appreciation;
* Rebuilt gross reserves by over $100 billion, now to record highs of over $150 billion and close to a year’s adequate reserve coverage as per IMF definitions, plus cut the negative NIR position from $60bn to plus $30 billion plus;
* Reduced the current account deficit from the prior 3-4% of GDP to nearer to 1% of GDP;
* Cut the KKM liability by over $100 billion without the expected acceleration in FX reserve depletion;
* Made some progress in bringing down inflation, with headline cut from over 70% to just under 50%, and likely to end the year around the 42-43%;
* Improved risk perceptions of Turkiye, with 5 year CDS cut from over 700bps just after the May 2023 election to around 270bps now;
* New found confidence in Turkiye has been reflected in over $22 billion in portfolio inflows over the past year, helping underpin the lira and FX reserve coverage;
* secure numerous ratings upgrades - two notches by Fitch and Moodys, and likely a similar move expected this week from S&P.
Disappointingly, inflation, while falling, remains very high and sticky, as are inflationary expectations. And at this stage it feels as though, while it has been relatively painless to cut inflation from the highs (real GDP growth has not slowed that much, and unemployment remains remarkably low despite the hike in rates and the real appreciation of the lira, at around 8.5%), taking inflation much lower will be difficult without additional hefty sacrifices on the growth front. The CBRT is struggling to kill inflation expectations with household expectations showing 67.2% one year ahead inflation.
So far there has been very little growth give up, but I do not know any country which achieved such a large disinflation without a growth sacrifice and I worry still that Turks are not yet prepared for this. To some extent this has been reflected in the wishful thinking we have seen in recent months around early CBRT rate cuts. If the CBRT is to break the back of inflationary expectations and inflation it needs to hold policy rates high, and higher for as long as possible.
Now true, Simsek and team would argue that their efforts on the disinflation front have been clobbered to a degree with electoral maths, and the large 49% minimum wage hike in 2023, then the early retirement reform as part of the give away for the last election. The latter cost the budget an estimated 1% of GDP in 2023 and 1.7% this year. The combined fiscal impulse with the earthquake response was 4.6% of GDP in 2023 and 3.3% of GDP in 2024. This meant the CBRT has been fighting against a fiscal tide, boosting inflation in both 2023 and 2024. The hope is that we finally see fiscal policy tighten in 2025 and this helps the disinflation, but perhaps a lot of the damage has been done via now elevated and entrenched inflationary expectations. All this means that unless fiscal policy and incomes policy really work to do some of the heavy lifting for the CBRT, the central bank will have to remain very hawkish for much of 2025 - perhaps holding policy rates thru to mid 2025, at least. Now that will be politically very challenging.
Q? What do you expect on the incomes policy front?
Answer: Well messaging from official sources is that the target is to keep the minimum wage hike to the mid twenties, half the year earlier level, and no more than 30% in a worst case scenario. The decision will be made on the last working day of the year, so December 31, a week or so before the last MPC meeting of the year. That would suggest zero scope for an early rate cut from the CBRT this year and until clarity around incomes policy and the minimum wage hike in particular.
The minimum wage hike will be such a key signal as to the Erdogan administration’s willingness/ability to hold to its disinflation agenda. It will set the tone for the market and for inflationary expectations for the year.
Q? So you expect no early rate cuts by the CBRT?
Answer - the new team at the CBRT have achieved so much over the past 18 months - as noted above - but their core battle has to be against inflation. And the reality is that headline, core and expectations are proving very sticky. There are no easy choices now, but the hard fact is that the tighter the policy in the short term the bigger longer term gains on inflation. It is not rocket science but just economic reality. The longer the CBRT can hold off cutting policy rates, the tighter monetary and fiscal policy is in the short term, the faster the disinflation. Finally the tyres have to hit the tarmac, and there has to be a growth give up. Partly the problem for the CBRT is still one of credibility, given the excesses of the past. Even with policy rates at 50% and with the MPC trying to signal higher for longer the market and the population simply do not believe them. The expectation is that they bow to popular and presidential pressure and cut rates early to go back to the growth agenda. Their own communication in recent months has struggled a bit - hence the expectations a few months back still of early rate cuts in 2024. Arguably now the CBRT needs to spell it out much more forcefullly -“READ OUR LIPS, NO EARLY RATE CUTS”.
Q? Do you worry about the real appreciation of the lira, and competitiveness?
Answer - Well the proof of pudding is in the eating, and while I don’t trust FX valuation models much, I trust the balance of payments data and the current account deficit is down to 1% of GDP and FX reserves higher by over $100 billion. That does not smack to me of a particularly overvalued exchange rate. Exporters will whinge about the exchange rate, they always do. But a bigger issue is broader competitiveness and on that Simsek does need to push forward the structural reform agenda which is lagging. Productivity needs improving, and a devaluation of the lira would do nothing to help that, actually it may well put off the time for those same structural reforms. Important herein still are issues around the rule of law, the business environment, deregulation, planning, education and skills, labour market reform, plus making sure Turkiye does not get left behind in the green transition, but also energy security, et al. Simsek is promising an ambitious agenda, we are still waiting for the fine detail.
Q? Does Simsek and his team have political backing?
Answer - obviously the critical question, given the memory still of Agbal and the unorthodox policy stint.
I still think he has the backing of President Erdogan, and for a number of reasons. Prime here is I think the fact that there has been a clearout at the presidential palace and more orthodox thinkers are in the ascendency. I think they have made a clear case to the President that the prior unorthodox policy was proving catastrophic and that there is simply no alternative to monetary and fiscal tightening if inflation is to be beaten. I would add that I think the same message has been imparted on Erdogan from his friends in the Gulf - who I think have offered financial support to Turkey, through investments, but only if they see a route to securing the return of their investments with interest which demands orthodox and solid macro policy. I also think the ruling AKP’s dismal showing in local elections in March just affirmed here that inflation is the number one issue for the electorate, and that if Erdogan has any chance to win the next election that he has to get a grip on inflation, and the orthodox approach is the only proven means to get inflation lower.
Q? Are early elections a risk?
Answer - absolutely, as Simsek’s programme needs time to work and the fear obviously is that if we go back into an early election cycle he would be forced to curb the policy tightening and go back to pro growth and inflationary policies.
Q? What are your views on constitutional reform?
Answer - well it appears that Erdogan has put back talk of a succession and is minded to run in the next elections which would require constitutional reform as he currently faces a two term limit as president. To secure the required votes in parliament - 400 to avoid a referendum - he has been manoeuvring in talks with the opposition CHP, and now seemingly with Democratic
Party which is seen as an ethnic Kurdish party. The CHP appeared willing to agree constitutional reform but at a price of early elections, which would be terminal for the disinflation programme of Simsek et al. The pivot to the Kurds seems to suggest that Erdogan knows he needs to drag out the election timetable. Incredibly Erdogan seems to be enrhineering some repapproachment with the Kurds while also supported by the national MHP, and now even some kind of deal with nationalist and former IYI party leader, Aksener. It is just incredible to think that Erdogan has somehow managed to get sign off for concessions to the Kurds, in exchange for constitutional reform and green lighted by Turkish nationalists. Erdogan is forever the deal maker, and is able to do 180 degree turns, with full somersault, on skis. Love or hate Erdogan, he is a supreme political strategist who has tended so far to run rings around his political opponents in Türkiye. Eventually his luck/skill might run out, but he remains in the game. And for Simsek, et al, as long as he can delay going to the polls, then this gives more time to allow the disinflation process time run its course.
Important here though that is if Erdogan can manage to pull off some agreement with the Kurds, as part of a broader Kurdish peace deal, this would be a huge positive for Türkiye. It would enhance security in Turkiye and the region and open up huge additional investment opportunities in the region. Erdogan would be able to unleash a huge economic peace dividend.
Note the above also comes as we are the closest we have been in facades to a lasting Armenia - Azerbaijan peace deal which would also open the way for a similar agreement with Turkiye to finally opt up its border with Armenia. This would be a boon to all three states and the wider region, and would further bolster Türkiye’s economic and political ties through the Southern Caucasus and Central Asia. Trade and investment will flow, big wins all around, but also helping reduce risk perceptions around Turkiye and helping to reduce potential for tensions with the West.
Q? What about relations with the West, improving?
I think Türkiye’s economic problems two years back made the administration think hard and clear about the state of its foreign relations. We have seen efforts to warm/improve relations with the Gulf, Armenia, Egypt, even China and the push to resolve issues with the West has been part of this generalised effort to smooth foreign relations as a means to help Simsek and team. The hard reality for Turkey is that two thirds of trade, investment and financing comes from the West. So we have seen improved relations with the US, as reflected in the F16 upgrade deal, talk of an F35/S400 agreement, and efforts to beef up the existing customs Union with the EU. I think there is a desire to move the relationship into a better place on both sides - the war in Ukraine, and now the Middle East I think has just affirmed to both Turkiye and the West the advantages of trying to stabilise and improve the relationship which had appeared at one point just to be going from one crisis to the next.
Q? What about Erdogan’s criticism of Israel, does that not complicate relations with West?
Answer: The reality is that Erdogan is not saying anything that the Global South, most Muslims, and indeed even many in the West do not think - that the Israeli assault on Gaza and now Lebanon has gone too far. Erdogan speaks out against Israel because he can, because he knows that Türkiye’s strategic importance to the West means that there is little risk of sanction. Obviously his protests on the matter wins him some plaudits at home and in the Muslim world - albeit perhaps annoying some Gulf leaders. There has been a price though to Turkiye from the recent trade blockade on Israel, costing Turkey an estimated $5 billion in lost exports, and undermining the BOP. I doubt that Erdogan’s stance will risk long term relations - and both Erdogan and Netanyahu have shown an ability to put past hostilities beside them for the greater good, albeit this time around it might take some longer time for a reapproachment - both can do 180s.
Q? Do you worry about Erdogan’s close personal relationship with Putin?
Answer - I did, but over time I realised that Turkiye has a nuanced relationship with Russia, and indeed the West. Turkiye lives in a difficult neighbourhood, sharing borders with Ukraine and Russia, plus also Iran, et al. Whatever the personal relationship between Erdogan and Putin it has enabled Turkiye to provide very significant military support to Ukraine, support that has been critical in enabling Ukraine to defend itself against the Russian invasion. Bayraktar drones appeared to play a critical role in the early days of the invasion, in favour of Ukraine. Türkiye is also a conduit for capital flight out of Russia - which is a good thing - albeit I think it needs to do more to contain efforts by Russia to import materials useful for its war effort. Recent efforts by the West to tighten the sanctions regime around Russia, including sanctioning various Turkish entities and individuals I think will begin to have a greater effect at deterring efforts at sanctions evasion. But in the end Türkiye’s core strategic relationship is with NATO, and I think there is no scenario where Turkiye would appreciate a Russian victory against Ukraine. Such a scenario would be a disaster in terms of Türkiye’s own security, risking an enlarged Russian presence in the Black Sea and the potential for Russia’s own considerable military industrial complex to be enhanced with the addition of that of Ukraine - that would then pose a huge security risk to Turkiye. I think Ukraine and Western allies are increasingly understanding of Türkiye’s position - and potentially it could still be a conduit for peace talks, as it remains one of the few parties trusted by both Russia and Ukraine.
Q? How will Trump 2.0 play out for Turkey?
Answer - Trump 1.0 had a mixed scorecard for Turkiye - remember the Pastor Brunson incident, and then Trump’s famed and somewhat insulting letter to Erdogan. But Erdogan is, like Trump, good at the personal transactional relationship. I am sure Erdgoan will think he now knows Trump well and can play to Trump’s own vanity and insecurities. Turkey will be hoping that Trump can bring a speedy end to the war in Ukraine, albeit ensuring a balanced outcome which still contrains Russian ambition. I think there will be nervousness over how Trump 2.0 will play the Middle East, and risks of potential future US conflict with Iran - the risk there of higher oil prices which will hit Türkiye’s Achilles heel, its balance of payments and inflation. Erdogan might see opportunity in Trump’s penchant for undermining Europe, and Trump might perhaps be appreciative of Türkiye’s military might as a potential partner for the US and obviously a potential big market for the US defence industry and helping Trump deliver US “Jawbs”.