The past two weeks has been a roller-coaster ride for the Turkish lira, which has already lost more than 5% of its value against the dollar since the start of the year, making it one of the worst performing emerging market currencies.
Domestic political concerns, the economic outlook and regional issues continue to keep the lira under pressure. At one point this week, the currency touched a fresh record low of 3.1140 per dollar, though it bounced off this level later as some of investors’ worries receded.
The immediate concern in the week of October 17 was the possibility of yet another - and untimely - rate cut by the central bank. The markets, however, were relieved when the monetary authority decided on October 20 to hold fire this time, choosing to pause its cycle of rate cuts in the face of the market turbulence. The lira reversed some of its earlier loses immediately after the bank’s rate decision.
So are the troubles of the Turkish currency over? Probably not. The risks that have kept the lira under pressure have not yet disappeared and will not any time soon: Turkey is heading towards a referendum that could change the country’s political system, a US Fed hike looms, and there is a risk of a rating downgrade by Fitch, all of which are hanging over Turkish markets like a sword of Damocles. Tensions between Turkey and Iraq have also recently escalated over the Turkish military presence in northern Iraq, amid Ankara’s demand to take part in the ongoing Mosul offensive.
Add all these political and geopolitical tensions to a slowing economy, a sticky inflation rate and a large current account deficit, then you end up with a perfect recipe for a weaker currency. The lira is expected to decline further to 3.2559 per dollar over the next 12 months, a recent central bank survey showed.
Investors are concerned that social polarisation and political tensions will flare up in the run-up to the high-stakes referendum, which may further delay much-needed economic reforms as the government will spend much of its and time and energy on the referendum campaign.
The details, however, are still unknown over what kind of presidency the AKP envisions for Turkey, and the date of the vote. Senior AKP officials suggest that the referendum could be held as early as April and they will seek to find a common ground to secure support from the opposition Nationalist Movement Party (MHP), which has already hinted that it could back the AKP’s plans in parliament.
Investors are holding their breath. “The real market risk, in our view, is that of increased political uncertainty and tension during the referendum process. The risk of populism in the run up to the referendum cannot be disregarded,” Yarkin Cebeci, an analyst at JP Morgan, wrote in a note on October 19.
At the same time the government plans to spend more this year and next to restart the engine of economic growth, which will inevitably lead to a larger budget deficit. According to the revised medium-term programme, the budget deficit will reach 1.6% of GDP (TRY34.6bn) this year, versus a previous target of 1.3%. The gap will widen to 1.9% of national income (or TRY46.9bn) in 2017, compared to the 1% expected previously.
Given the low debt/GDP ratio, Inan Demir, an analyst at Nomura, thinks Turkey has space to use fiscal policy to stimulate the economy. “However, taken in the context of the broader projections, a looser fiscal policy target illustrates where the government’s priorities lie. The higher inflation and current account deficit targets show the government is prioritising growth over disinflation and external rebalancing,” Demir wrote in a report, published on October 17.
The hitherto strong economic growth has helped the ruling party win consecutive elections since 2002 when it first came to power. But Turkey’s $720bn economy is now losing steam and unemployment is rising. The AKP cannot risk a deep economic slump that would create more jobless people if it wants to score another victory.
The ruling party is probably revisiting its contentious presidential plans now, because it wants to move by the time the expected economic slowdown takes its political toll, as Ismet Akca, associate professor of political science and international relations at Yildiz Technical University, told bne IntelliNews.
Faced with all these political and economic challenges, the government has to get its balancing act right and that’s a tall order: it wants to have a reasonable growth rate - through more public and private spending - to keep its supporter base intact, but at the same time it has to avoid any moves - such as more rate cuts - that could undermine investor confidence.
“The adverse turn in the global backdrop has coincided with numerous domestic concerns as growth slows, the external balance starts moves in the wrong direction and the macro policy mix is set to loosen. We think this combination will continue to hurt TRY,” argues Inan Demir at Nomura.
A weaker currency is not always bad news as it can potentially help an economy boost its exports. But Turkey’s export performance story is not very promising. Twelve-month annualised exports (in the year to September) shrank by 4.1% to $140.4bn, according to data of the Exporters’ Assembly (TIM). In September alone, exports were down 0.8% y/y to $10.45bn.
Even if it a weaker currency has the potential to make Turkish companies more competitive, Turkey’s export performance also depends on how its trading partners’ economies fare. The IMF predicts that the Eurozone, Turkey’s largest export market, will grow by 1.7% this year and 1.6% in 2017.
Analysts seem to be more concerned about the weaker lira’s effects on inflation and Turkish corporates.
“The greater issue for us is what the Turkish lira does. A weaker lira is always at risk of starting a vicious inflation recession spiral. This is more than just the inflation pass-through and the constraint a weaker lira imposes on the central bank,” Michael Harris at Renaissance Capital wrote in an emailed note. “The fundamental risk that leaves Turkey much more vulnerable than other similarly rated emerging markets is the disproportionate FX mismatch of Turkish corporates.”
Inan notes that Turkish corporates run a large short FX position that has now exceeded $200bn, above 25% of GDP. “This has been an area of focus for investors since TRY began depreciating in 2013 with frequent questions about where the threshold exchange rate that would cause repayment difficulties. The short answer is we do not know.”
According to Inan, it is very difficult to pinpoint a single threshold that would create solvency issues for the corporate sector. However, the damage inflicted on corporate balance sheets has shown up in weak private investment growth in recent years, he adds.
Private investments fell 0.1% in 2014, declined by another 2% in 2015. The government forecasts that private investments will shrink 1.9% this year but will rise 4.1% in 2017.
Despite all these concerns voiced by analyst, the government is still confident that Turkey’s economic fundamentals are strong enough to weather what they describe as “temporary and speculative” volatility the markets has experienced over the past two weeks. President Erdogan’s top aides are expecting the lira to strengthen back to around 3 per dollar.
Comments by another top adviser, Yigit Bulut, also provided some comfort as he implied that the central bank would handle the rate cuts carefully. “The central bank will do whatever the global economic conditions require. The bank knows better than us what to do. If it needs to stop cutting rates, it will,” Bulut said on October 19.
Indeed, the bank said in a statement after October 20’s rate setting meeting that “the recent developments in exchange rates and other cost factors restrain the improvement in inflation outlook and thus necessitate the maintenance of a cautious monetary policy stance”.
This came only hours after President Erdogan reiterated his dislike for interest rates. “I am an enemy of interest rates that I see as a means of exploitation,” he said in a speech in Istanbul. Erdogan believe high interest rate causes inflation. He has repeatedly called for lower rates to boost investments and economic activity.
It is yet to be seen whether the government will once again increase the pressure on the central bank to slash its rates in the run up to the referendum or will let the rate setters do their jobs to avoid more turbulence ahead.