Timothy Ash on trying to figure out the Turkish sacking of the central bank governor story

Timothy Ash on trying to figure out the Turkish sacking of the central bank governor story
Turkish president Recep Tayyip Erdogan used his new executive president to sacked the governor of the Turkish central bank and markets tanked
By Timothy Ash Senior Sovereign Strategist at BlueBay Asset Management in London July 8, 2019

On June 6 Turkish president Recep Tayyip Erdogan used his new executive president to sacked the governor of the Turkish central bank in a move that is widely seen as the executive encroaching on the independence of the regulator.

Erdogan has long complained that interest rates are too high and believes that if you lower interest rates then inflation will fall – in stark contradiction orthodox economic theory.

Predictable unsettled investors dumped the lira when markets opened on the following Monday and Turkey could possibility face a new bout of instability as a result of the decision. Veteran Turkish analyst Tim Ash, Senior Sovereign Strategist at BlueBay Asset Management chewed over the implications in a note to clients reproduced below.

Thought it useful to put the plus/negative points around Turkey, which is again in the headlines/headlights. Feedback welcome - I don't have all the answers.

Reasons to constructive Turkey:

(+) The economy has re-balanced, as a result of the 1,600bps in rate hikes delivered in 2018 – despite kicking and screaming from Erdogan. From 7% plus real GDP growth in 2017, the economy slowed to 3% growth in 2018, and is expected to flat-line in 2019, with perhaps 1-2% growth at best in 2020. The economy dipped into recession in Q42018, peered out of it in Q119 (due to pre-election pump priming) and will struggle to get legs for the rest of this year. Inflation peaked at 25% in Q418, but deflation will drive the disinflation process. Indeed, the CPI already dipped to 15.8% in June, and looks set to go to 10-12% in Q3 on base effects, assuming another FX sell-off is avoided. This does open the way for rate cuts, from the elevated 24% CBRT repo rate – but again depending on “macro financial stability” the central bank wording for avoiding another spate of devaluation. Rate cuts will attract bond inflows, helping support the TRY, and creating a positive script around the Turkey story.

(+) Whichever way you cut it the TRY looks cheap – REER back to 2003 levels still – and this has been seen in the adjustment of the current account from a deficit of over USD50bn in mid-2018, likely to flat this year. Indeed, over the summer months as the strong tourism season kicks in the monthly current account will be in surplus. Meanwhile, with FX deposits near record highs, dollarization levels are already very high, raising question as to how much is still left to go – indeed, when it might turn to locals buying TRY. Foreigners, meanwhile, are on the side-lines, not really willing to fight the CBRT at this stage after official action to break the market in effect (killing the offshore FX SWAP market for one).

(+) While Cetinkaya’s firing is disappointing, is anyone really that surprised? We all knew that CBRT independence was shot to hell already – as far back as 2018, if not 2011. And Cetinkaya himself had few fans in the market – most analysts have spent the period since his appointment in 2016 criticising him. Murat Uysal has a decent CV (a monetary economist, unlike Cetinkaya who was a banker) and will monetary policy formulation change that much from Cetinkaya to Uysal? Indeed, you might argue that the new trend in central banking is towards less, not more independence therein, with Mssrs Turmp, Modi and Erdogan setting the script. So what is Erdogan doing differently herein?

(+) Valuations look cheap – in Turkey credit, it trades flat/wide to credits with much worse credit ratios (current account, public finance ratios), e.g. the likes of Egypt, Pakistan, Sri Lanka, Brazil and South Africa. We can debate the individual stories herein, but assuming some stability in the Turkey story, Turkey credit screams value.

(+) While the S400 issue is making a lot of noise, it seemed at the G20 meeting between Trump and Erdogan that POTUS will shield Turkey and his friend Tayyip from the worst excesses of CAATSA sanctions. Simply put Turkey is too geopolitically important to the US for the WH to levy overly aggressive sanctions. Meanwhile, Erdogan can easily assuage pressure on Trump by still announcing large arms deals to buy Patriots, F35s, et al – and Trump can sell these as delivering “jobs, jobs, jobs”.

(+) The banking sector is proving remarkably durable – thanks in no small part I think to the reforms instigated under the last IMF programme and as a result of the 2000/01 banking crisis. But a sufficient dose of forbearance and state support is being applied to buy time – and the hope in the Turkish banking sector is that growth will quickly re-emerge, generating healthy profits with which to rebuild capital buffers. But the sector is proving resilient in the face of distress – and remember, despite everything, there have been no bank runs, and no bank failures. Remarkable to all the arm chair Turkey experts now out there.

Reasons to be less constructive:

(-) Cetinkaya’s firing is just the latest manifestation of the reality that a rubicon has been crossed, and the Erdogan administration is moving away from markets, and towards a much less orthodox policy orientation – which is anti market. It may also be a reflection of the damaging impact from the introduction of the presidential system, where power is over concentrated, there are few checks and balances, and bad policy too often gets thru the system.

But Turkey is overall moving in a different direction, away from the West, and given that two thirds of Turkey’s trade, investment and financing have hitherto come from the West that has to be a concern.

(-) Cetinkaya’s firing is just the straw that broke the camel’s back in terms of central bank independence – which is now non-existent in Turkey. Now this might not matter in a macro environment where disinflation seems to be the dominant theme. But just wait until the situation turns and the pressure is on for the CBRT to hike policy rates – it is almost impossible seeing the new governor Uysal being able to persuade Erdogan to green light rate hikes. And remember, in the end, Cetinkaya with Simsek and then Albayrak, was able to get an audience with Erdogan in 2018 to persuade him to allow rate hikes. It is hard to see Uysal being able to do that. In the next re-run of 2018, the CBRT will react even later to pressure to hike policy rates, suggesting the damage on the lira, and Turkish markets will be even more severe, even terminal for some.

And I think this future crisis/test will come, as what we know is Erdogan wants growth and jobs to shore up his political support and that means another effort of stimulating a credit boom is looming, which will surely end the same way, with the accumulation of imbalances, and overheating. It is just a question of time.

(-) The current account deficit might have adjusted lower – possibly to flat/even surplus – but Turkey still has a weight of short term external debts to roll, around USD180bn, and FX reserve cover is still modest. Gross FX reserves of the CBRT stand at around USD90bn - still only giving 50% coverage of gross external financing needs which is low by international comparison – and while net reserves are just under USD30bn, there is now a huge amount of uncertainty as to how FX swap transactions have impacted the net number in a meaningful way.

(-) While Turkey credit might appear cheap I guess it’s not a static story, direction of travel is important. Turkey feels still like a deteriorating credit story, and it’s not clear yet where the end point destination is yet. Hence, it’s likely cheap, but could easily get cheaper.

(-) Markets may have been too quick to rule out/downplay risks from the S400 issue. Trump might be able to delay CAATSA sanctions but not indefinitely, and he will need to choose from a fairly aggressive list of five out of 12 sanction options. If Trump delays too long though in rolling out sanctions, then the danger is that Congress fills the void – there is already a bill in Congress to build an eastern energy/security alliance, between Turkey’s regional foes (Greece, ROC, Egypt and Israel) and including the US. Any such move will surely infuriate Erdogan and push Turkey further away from the West. But surely the question is why should Trump expend political capital on Erdogan, to save him from Congress? What is in it for Trump – what can Erdogan give the US? Therein the only thing I can think of is support to Kushner’s Middle East peace plan, but this would be a seismic shift for Erdogan, likely much more difficult than a turnaround on the issue of S400s, not to take delivery from Russia. So it seems to me that S400s will be delivered and Turkey will suffer significant US sanctions – and the only question then is how durable are Turkish markets to ride through these. I guess currently global markets are in clement mood – but we know that this could easily change, depending on how the Fed policy cycle plays out. But if we see some change in the global beta environment, and this dovetails with US sanctions (even moderate) being rolled out against Turkey, the impact could easily be as painful as in 2018. And remember this time, with a new CBRT governor at the helm, the CBRT might not be as willing to tighten policy to defend the lira – and we know that FX reserve cover is insufficient.

Tim Ash is the Senior Sovereign Strategist at BlueBay Asset Management and a veteran Turkey-watcher. This note first appeared as an email to his clients.