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13 August 2018

Turkey at risk of slipping into utter chaos 

Recent events in Turkey have led to the emergence of a crisis for the country’s currency, the lira, and investors fear that contagion could spread to European markets.

Financial markets have not been kind to Turkey lately. The lira has been in a complete tailspin and is now hitting new record lows almost every day. While the EUR/TRY currency pair was still at 5.5 in July, we closed at 7.32 on Friday, an all-time high for the pair. There are multiple factors behind the lira slide. The first is a loss of credibility in the central bank. As inflation has been rapidly rising, investors expected the CBRT to raise interest rates steadily. In fact, it is perceived to be behind the curve. Consumer inflation jumped to 15.8% in July, but the producer price index is already at 25%, indicating that the general level of price inflation is rapidly climbing. Investors had expected to see a rise in the central rate but it seems to be stuck at 17.75%. Meanwhile, the budget deficit is heading towards 2% of GDP, leaving investors with an uneasy feeling of unorthodox fiscal policy. 

It all comes down to policy. 

President Erdogan has appointed his son-in-law, Berat Albayrak, as the new finance minister, part of his policy of increasing his grip on the country after the recent election victory gave additional power to the president.  And Erdogan is a fierce opponent of higher rates. Over the weekend, the President claimed that higher interest rates are a gift to the rich and a drag on the poor. At the same time, he sees the pressure from the financial markets as proof of economic warfare against Turkey. 

The current spat with the US does not help, of course. The detention of a US pastor, believed by Turkey to have been engaged in terrorist actions, has enraged US President Trump, and as a result, he ordered tariffs on imported steel and aluminium from Turkey to be doubled. The news was another blow to the beleaguered Turkish lira.

Meanwhile, things seem to be spiralling out of control. If Turkey wants to calm the situation and stop the rout it has to come clean on four fronts:

  1. It needs to hike rates to levels where the markets believe the risk for runaway inflation will be limited. This entails letting the CBRT put nominal rates at a level where real interest ratesclimb to anything between 3 or 5% and keep them there as long as necessary; 
  2. implement orthodox fiscal policies which would not spur inflation and leave state finances less fragile;
  3. end the quarrel with the US;
  4. regain credibility with the international investor community.

Unfortunately, last week’s events, and comments made by Erdogan over the weekend, are not very promising in this respect. Speaking to supporters, the Turkish president stated 'interest rates were a tool of exploitation' and that Turkey was preparing new financial tools versus the US dollar. He also spoke of finding new alliances now that the US has ‘switched a NATO partner for a priest’.

These comments are a clear sign that Turkey looks to be in no hurry to meet the four points mentioned above.

Hence the lira might be in for another turbulent week. There could be more fall-out for Turkish assets or any institution exposed to them. Last week the European Central Bank signalled its unease over the exposure of some eurozone banks to Turkish assets. Over the weekend, middle-eastern banks with links to Turkey saw their shares suffer. That said, contagion for other emerging countries is so far limited. The other currencies under pressure were either those of countries also hit by US sanctions, or of countries having low forex reserves and/or weak fundamentals. Hence, the Russian ruble, the Argentinean peso, the South African rand and the Brazilian real are weaker. 

Coming to back to Turkey, a lot will also depend on what Turkish citizens do. Apparently, it has already become much harder to take out currencies from the bank or to make electronic fund transfers. 

And if the lira plunges further will panic spread?

All this is very hard to predict. Turkey and its leaders seem very unwilling to turn to the IMF for now. Will stopping lira convertibility become an option? Investors would obviously take that badly and it could wreck foreign direct investment.

EM markets after all could also succumb to some selling pressure, as markets fear contagion even if Turkey looks to be an isolated case. 

The conclusion is that one should steer clear from Turkish assets for now. It is way too early to hope for a buying opportunity. Caution should prevail.

Our strategists meanwhile have recently reduced the call on emerging equity within our asset allocation from positive to neutral. Our total weight for equity within the asset allocation stands at neutral. They will analyse this stance this week in the light of ongoing developments. 

One of the remaining outstanding calls was on emerging debt. Together with our macro economists, they will weigh all options on this sub-asset class. One might believe all emerging bonds would suffer from the Turkish crisis but recently Mexican bonds clearly outperformed in this tough environment, showing the divergence between countries. 

As the situation unfolds, we will communicate on our strategy.