Turkey is hardly ever out of the news these days and there are always lots of moving parts, so I thought it useful perhaps to update my bigger picture views on Turkey, and a Q & A format just seems easiest.
Q: Geopolitical noise around Turkey seems to be rising, with tensions in the Eastern Mediterranean, Libya, a resurfacing of the S400 issue with the testing of those systems, and then the crisis in Nagorno-Karabakh where Turkey seems to be “active.” And then there are looming U.S. elections. How do you assess the risks to Turkey on the geopolitics front?
A: Well I guess it’s always relevant to remind everyone that Turkey is located in a tricky region and there always tends to be geopolitical risks and tensions. That’s just part of the Turkey story, the country has tended to learn to live with those, and sometimes even use those to its advantage. I always use the example of Turkish business understanding how to operate in challenging security settings, for example, in Syria, Iraq, and Libya. They tend to be willing to go where others fear to trade and do the trade – selling white goods or food products, at good prices in these difficult security settings. So there are clear geopolitical risks but this also presents opportunities.
Now, all that said, I think it is notable that we are seeing a much more assertive Turkish foreign and security policy in the region than I think at any time under Erdogan’s presidency. We have seen Turkey insert itself into the Libyan conflict, resort to gunboat diplomacy in effect in the Eastern Mediterranean over the gas issue, taking the new initiative in Cyprus (opening up the prior closed resort of Varosha) which rankles with the Greek Cypriots and the EU, and also adopt a much more belligerent role in the conflict in Nagorno-Karabakh in support of Azerbaijan and where the supply of Turkish military equipment seems to be proving decisive on the ground. Turkey has indeed been road showing its high tech drone technology in Nagorno-Karabakh and which proved so decisive also in the conflict in Libya.
Q: Why is Turkey doing all this?
Well, first I think Erdogan is taking a page here from Vladimir Putin’s playbook in Syria. He has learned that only by inserting oneself in a conflict, taking skin in the game, that you can extract leverage which can now be used elsewhere to your advantage. Turkey has gone from a bag carrier to the Russian fiddle in the conflict in Nagorno-Karabakh to a key member of the orchestra, and there is no music without Turkey – peace or war.
Q: And what about the relationship with the West and the risks of sanctions?
A: Well sure the West has warned of sanctions on Turkey over developments in the Eastern Mediterranean, on Cyprus, S400s, Halkbank, and trends generally on democracy and human rights in Turkey. But so far nothing has happened. I think Turkey has essentially called the West’s bluff. It knows it is just too strategic to the West in terms of its NATO membership and security role therein in defending Europe, the migrant issue, and its role in bringing peace in Syria. And I think it has now added leverage therein in Libya and Nagorno-Karabakh.
Q: How does all this fit into the U.S. elections?
A: Sure Recep Tayyip Erdogan wants Donald J. Trump to win, as Trump has shielded the Erdogan administration from congressional pressure for sanctions, and for whatever reason Trump likes Erdogan and has a special relationship with the Turkish leader. By contrast, Erdogan distrusts Biden because he was part of the Obama administration which most Turks think failed Turkey in its hour of need around the 2016 coup – many Turks think that the U.S. had some role in the coup. But I think the Erdogan administration is realizing that a Joe Biden win now seems like the default outcome, and I think all this foreign policy on steroids stuff in the region from Turkey is positioning for a time when there will have to be a summit or sit down with Biden. And I do think that happens, I do think there will be a clearing of the air summit, and that the Biden presidency will want a reset with Turkey. Simply put Turkey is just too important to the Western alliance, and despite all the concerns over trends in Turkey on democracy and human rights, realpolitik means that a Biden presidency would be loathed to lose Turkey to Russia. Simply put that would be a strategic disaster for the U.S. and the West. Now maybe some harsh words will have to be said from both sides, to clear the air, but the air will have to be cleared. But I think both sides ultimately do value the strategic relationship. Turks look West, not East or northeast to Russia. They send their kids for education in Europe or the U.S., not Moscow. The shopping is also a lot better in London, Paris or New York than in Moscow. And arguably Turkey is looking pretty isolated in the region these days.
Q: So you think all will end well, eventually in the Turkish-Western relationship?
Yes, because with two-thirds of Turkish trade, investment, and finance coming from the West, what real choice does Turkey have while the West needs Turkey as a bulwark for regional security? And in the Eastern Mediterranean, I think there are win-win outcomes over energy – the West and Turkey need new energy supplies to diversify away from its strategic rival, Russia, and there seems to be plenty of it in the Eastern Mediterranean. And while the Greeks and Greek Cypriots might not like it, Turkey is in the middle of all this development and for pipelines to remain secure, Turkey has to be built into any deals for them to be sustainable over the longer term. Now Western leadership is needed, and with Trump that was lacking but with Biden, I think the desire to re-cement Turkey’s position in the Western alliance, and freeze Russia out, will encourage direct US involvement in peacemaking.
Q: But what about the economy?
A: This is the really frustrating bit. It should be so good. Turkey should be the best emerging market out there. It has so many things going for it: strong public finance profile (sub-40% debt ratio), strong/durable/dynamics banks, good location for trade (the only country in the region to make anything) with some really dynamic international standard big industrial groups. It has a decent industrial skill base, with favorable demographics and an age-old pro-market and trading culture. It should be top of the emerging market growth stakes. But then there is the political economy of the Erdogan world. And simply put, Erdogan sees his electoral success in terms of jobs, investment, growth, and credit have been the way to achieve that. There is also this ideological aversion to interest rates and high-interest rates in particular, and this distorts monetary policy to the point that it is the biggest macro threat as I see it to the country.
Now you could question why Erdogan is always in election mode, why he so desperately needs growth to remain high – and I think that is because of the polarized nature of Turkish politics and his fear that if he ever loses office he and his family will be brought to account for any dubious activities in office. And given his reliance on the coalition with the Nationalist Movement Party in parliament, Erdogan can never really discount the risk of early elections, so he always has to run the economy hot, I would argue too hot.
Q: But what about interest rates?
Well, Erdogan wants to keep interest rates low to keep the credit channel flush and boosting investment and jobs. But I think he also has a theological aversion to usury, while also a practical view of high-interest rates causing inflation because of his background in small business and the shopkeeping power base of the Justice and Development Party, known as AKP. Simply put small business sees interest as a cost of production, and the higher the interest rates, the higher costs which they want to pass on in higher prices. Now classical monetary policy would dismiss this out of hand, but that’s I think where he gets it from.
But the reality of all this is the central bank is not independent in setting interest rates and with one hand tied behind its back it makes macroeconomic demand management acutely difficult. So in the current situation where the signs have been there for a year of overheating, with high inflation, accelerated dollarization, a widening current account deficit, which requires the brakes to be applied, they are not really able to do that in a clean and convincing way as per other central banks. Monetary policy tightening always appears as a grudging, backdoor, and smoke and mirrors to kind of hide the fact to Erdogan and his constituency that they are hiking. The result is that policy tightening is all too often too little, too late, meaning that pressure is felt on the exchange rate, which the CBRT has tried to alleviate through foreign exchange intervention – likely $100 billion-plus over the last year. Now, this does not really stop the origins of the pressure, it just plugs the gap for a while, like a finger in the dike. The longer term costs are there for all to see in the deterioration in the central bank balance sheet as a result, but the net international reserve position now significantly negative – likely to the tune of $30 billion to $40 billion
Q: Does the deterioration in the central bank of Turkey net international reserve position matter?
Well gross reserves matter for the here and now – this is the cash the CBRT has at hand to defend the currency. And the CBRT has around $80bn therein. Now this is not a lot – providing only sound 40% coverage of annual gross financing needs, where 100% coverage is normally seen as prudent floor. And we can perhaps question the level of actual liquid reserves. But gross reserves are like my current account position, they are the CBRT’s spending power. Net international reserves shows the CBRT balance sheet position, assets versus liabilites, and they show the CBRT heavily in debt – it’s been spending others peoples money defending the lira. And by other people, I mean here largely the country’s FX depositors. This is all fine until those people want their money back, and then the CBRT cupboard is bare. Now maybe they will never ask for the money back, or don’t realize the central bank cupboard is bare.
Q: And what about the current tightening through the interest rate channel, too little, too late?
A: Let’s give the central bank some credit for hiking the base rate by 200 basis points, against expectations in September to 10.25%. We expected them to do something similar in October but they fluffed their lines and went back to the smoke and mirror policy of widening the interest rate corridor.
I think what this shows is that the CBRT is not committed to tightening on a sustained basis which ultimately matters in terms of fighting inflation. By using the interest rate corridor they show that they want to maintain flexibility in setting rates on a daily basis. Sure today they are tightening by raising the average funding rates over the 12% level, but still only moderately positive in real terms. But past experience suggests that as soon as the lira stabilises they will go back to their bad ways of cutting rates too fast to overstimulate credit growth. At this stage, no one believes them in terms of their promises to keep policy tight to rein in inflation, so inflation and inflationary expectations remain elevated, and because of that dollarisation continues to weigh on the lira. They are in a vicious cycle they can only really get out of by hiking now in an orthodox way, and staying there for an extended period. It all feels very reminiscent of 2018 – and that the central bank of Turkey just never learns. So they are always behind the curve in hiking rates, and the outcome will be the same as in 2018.
Q: So where does all this end up, are you expecting a systemic crisis in Turkey?
A: It does feel very similar to 2018, in that we still see rate higher, the foreign exchange weaker, growth lower for a period, but I think a systemic crisis is still unlikely. The sovereign balance sheet is still strong, at least there is not a big debt burden albeit it does not have big cash buffers. Banks have some durability as was seen in 2018 and the regulatory forebearance which was rolled out than can be repeated.
If we see locals taking foreign exchange deposits out of banks, that would be a game-changer, and it would make a crisis in 2020 or 2021 look more like 2000/01 where a crisis could prove to move more systemic with a currency, banking, and even possibly sovereign debt crisis. That’s not my base case, but it’s no longer a low single-digit probability either. I would feel far more comfortable if the CBRT went back to the orthodoxy we saw with the initial 200 basis points hike in the base rate. It’s sad really as I think foreign investors are on the sidelines, but in the global environment of flush liquidity, they want to invest, and with half-decent monetary policy, I think they would quickly put significant funds back to work in Turkey. That could create a virtuous cycle of portfolio inflows, lira stability/strength, and even prospects then of early rate cuts.
