The writer is senior emerging markets sovereign debt strategist at BlueBay Asset Management
Turkish markets have been given another shock with President Recep Tayyip Erdogan’s decision to fire a respected central bank governor after four months in the job and replace him with a relative unknown.
The messaging from Turkey when Naci Agbal was appointed in November, was that his task was to address underlying but well-known weaknesses in the economy. They included high and rising inflation (15.6 per cent in February) and a challenging position on external financing.
He responded with a welcome return to economic orthodoxy, raising the benchmark interest rate by 8.75 percentage points to 19 per cent to support the lira and stem inflation. Transparency and communication with the market were improved.
Investors rewarded Turkey, with the lira appreciating 18 per cent while the cost to protect against a default on Turkish debt fell nearly 3 percentage points in the period from November to last week. Light was appearing at the end of the tunnel. But after Agbal’s departure, the lira has initially sold off more than 10 per cent and credit spreads have widened by 150-175 bps.
Seemingly, Erdogan lost confidence in Agbal. It is hard to understand his reasoning but one can imagine the president may have baulked at the prospect of higher policy rates crimping growth ahead of rumoured early elections for later this year. Agbal’s removal has, though, made a difficult economic situation appear almost untenable.
The reality is that Agbal’s policy response has no alternative. While the new management at the central bank under Sahap Kavcioglu will try to hold the line on the lira with currency intervention, the market knows that this response has limitations.
Gross foreign exchange reserves amount to around $92bn, but usable liquid foreign exchange reserves might only amount to $25-30bn, excluding gold and borrowing through so-called swap agreements. Net foreign exchange reserves stand at a negative $46bn.
Further drawdown of gross reserves, pushing net reserves further into negative territory, risks a fundamental loss of confidence in the financial sector, and a more systemic crisis.
Turkey faces a gross external financing requirement of somewhere in the range of $250bn. This is the dollars it needs to repay maturing external debt, make coupon payments on short-term debt and cover its current account deficit over the next 12 months.
The options for the central bank are limited. They include keeping policy rates high to deflate domestic and import demand; letting the currency adjust downwards; or resorting to capital controls and/or IMF borrowing.
Erdogan has long ruled out going cap in hand to the IMF. With the president, we have long learned never say never. But we think the ruling AKP administration is averse to capital controls. It is in general a pro-business party, despite Erdogan’s dogmatic aversion to orthodox monetary policy.
It’s encouraging that Lutfi Elvan, finance minister, has reaffirmed a commitment to free markets and ruled out capital controls. But needs must, and unless the new economic management team wakes up quickly to the limited options it faces, then a worst-case outcome cannot be ruled out.
All this is sad because investors have shown great faith in Turkey, despite the obvious deterioration in its credit story since perhaps 2011.
This investor confidence is now clearly flagging — the $15bn in portfolio inflows which returned since November is likely to leave quickly. And it might not return so quickly unless we see a speedy return to orthodoxy. Is this possible under Erdogan? It is now perhaps fair to ask that question.
The developments at the central bank have laid bare the challenging political economy in Turkey, not helped by the overconcentration of power around Erdogan since constitutional changes instigated in 2017 ushered in an executive presidency.
Erdogan is known for his unorthodox economic policy views — an aversion to usury which habitually sees him railing against high interest rates. He has long held his opinions but, earlier in his rule, moderates and orthodox economic thinkers in the AKP helped to keep these views in check.
Unfortunately, what we are now seeing is Erdogan unchecked. Perhaps the only check or anchor on his rule now is the market, which seems to be voting with its feet. Let’s hope that Erdogan eventually listens and reverses his current course. Otherwise the outlook for Turkey is indeed grim.
BlueBay trades sovereign debt including that of Turkey