What will happen to Erdogan and Erdonomics? Turkey and its markets at an electoral crossroads

ISTANBUL/LONDON, Jan 20 (Reuters) – Turkish voters, plagued by years of soaring inflation and currency collapses, will soon have to decide whether to continue with President Tayyip Erdogan’s vision of a tightly managed economy or abandon it for a painful return to a liberal ideology.

Presidential and parliamentary elections, perhaps the most significant in the republic’s 100-year history, are likely to take place in May and determine whether the 68-year-old Erdogan enters his third decade in power.

The elections will be a watershed moment for Turks, tormented by a cost-of-living crisis that has just begun to ease.

International investors, many of whom have pulled out of Turkey over the past five years due to persistent market turmoil and Ankara’s unorthodox economic policies, are closely watching developments.

Fund managers told Reuters that even the slightest signal of an opposition victory could spark a strong rally in Turkish assets, given promises to roll back the “erdonomics.”

But the radical transformation of the economy and financial markets under Erdogan’s rule means that such a reversal will lead to great uncertainty.

Blaise Entin of TCW noted that even if Erdogan loses the election, it is unlikely that investors will make a quick profit from the strengthening of the lira.

The bullish mood in the markets will only be able to gain a foothold in the medium term – it will be necessary to solve the problem of an overvalued currency and the return of interest rates to “much higher levels,” Entin said.

Opinion polls show that Erdogan could keep the presidency while his Justice and Development Party (AKP) loses control of parliament.

This is probably the worst option, Entin said, as it leads to short-term policy uncertainty and market volatility.

The six-party opposition alliance has yet to determine its presidential candidate. One of the popular contenders, the mayor of Istanbul, is challenging the prison sentence and a ban on political activity.

Critics claim that the courts are hindering Erdogan’s opponents, but the government denies the allegation.

The elections will also determine what role Turkey – a member of NATO and the largest military force in the region – will play in conflicts between Russia and Ukraine, where Erdogan mediates negotiations, and in Syria.

ACHILLES’ HEEL Erdogan has never looked so vulnerable, and his Achilles’ heel has been the economy.

The determination of Erdogan – a self-proclaimed “enemy of interest rates” – to cut borrowing costs to 9% from 19% led to the collapse of the lira at the end of 2021 and another 30% last year. The Turkish currency fell for the tenth year in a row. Inflation hit a 24-year high of 85% in October as spending on food, fuel and rent soared.

To compensate for voter discontent, Ankara has rolled out a massive social assistance program of about 1.4% of the annual budget, which includes subsidies for electricity, a doubling of the minimum wage and allowing more than 2 million Turks to retire immediately.

“Erdogan is proposing one package of support after another, which will put significant pressure on the state budget,” said Chatham House’s Galip Dalai. “But if he loses the election, it won’t be his problem.”

Turkey’s debt levels are still far below those of most countries, but years of depleting foreign exchange reserves, weakening central bank and judiciary independence, and general heterodoxy have left an indelible mark.

Moody’s and Fitch downgraded Turkey’s credit rating from investment grade in 2016 to junk rating, on par with Bolivia and Cameroon.

“The policy just doesn’t look sustainable,” Fitch’s Paul Gamble said.

EXODUS

Investors say the free-market model of the Turkish economy began to change around 2017, as Turkey consolidated its presidential system of government, concentrating power in Erdogan’s hands.

In 2019, the government, worried about destabilizing speculation, tightened the international markets for the lira. Turkish currency trading volume in centers like London now averages less than $10 billion per day, compared to $56 billion in 2018, according to the Bank of England.

The share of foreign investors in the Turkish public debt market has fallen below 1% from 20% in 2017, and in the stock market they own only 30% of the shares compared to 65% a few years ago.

This vacuum has been filled by the Turks, who are looking for a way to hedge against skyrocketing prices and thus lifted the Istanbul index by 200% last year. They now account for 70% of the shares, up from 35% in 2020.

Mehmet Hasim Akanal, a farmer from southeastern Turkey, sold one field and invested 10 million liras ($533,620) in shares.

“I thought it would protect against inflation and provide more returns than dollars and gold,” he said.

The bank deposit protection mechanism introduced by the government to stop the lira from depreciating in 2021 has become an example of an unorthodox and rather costly approach.

In the short term, however, it appears to have worked, halting years of growth in Turkish lira-to-dollar conversions.

Treasury inflows from ‘friendly’ countries such as Qatar and Russia, as well as a recovery in tourism, have helped keep the lira in the 18.0-18.8 per dollar range since August – around the time that Erdogan’s ratings in the polls public opinion began to rise.

The authorities are also constantly amending regulations, adding about 100 additional rules to keep the currency stable.

One of the bankers told Reuters that some foreign investors began betting short-term on the lira as the central bank’s net foreign exchange reserves nearly doubled in November.

However, the lira, which has lost more than 90% of value against the dollar since 2008, is still overvalued by 15% due to economic imbalances and fiscal stimulus, said Robin Brooks of the Institute of International Finance. “Credit stimulus keeps growth higher than Turkey can realistically sustain,” he added.

But predictions that Erdogan’s policies would lead to disaster have not materialized, said Sergei Goncharov of Vontobel. Last week, Turkey raised $2.75 billion in international capital markets without any problems.

That makes the choice harder for voters, who could face a painful initial economic downturn if an opposition victory results in the return of the free market.

“This is an unstable balance,” suggested Goncharov. “But it’s hard to get out of it.”

($1 = 18.7400 Lira)

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(Jonathan Spicer, Mark Jones and Kanan Sevgili with Nevzat Devranoglu in Ankara, graphic artist Vincent Flusser, Riddhima Talvani and Sumanta Sen, translated by Tomas Kanik)

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