Analysis-Turkey and its markets head for election crossroads

By Jonathan Spicer, Marc Jones and Canan Sevgili

ISTANBUL/LONDON – Turks beset for years by soaring inflation and currency crashes will soon decide whether to forge ahead with President Tayyip Erdogan’s vision of a heavily-managed economy, or ditch it for a painful return to liberal orthodoxy.

Presidential and parliamentary elections, perhaps the most consequential in the century-long history of the republic, will likely come in May and determine whether Erdogan, 68, enters a third decade in power.

The vote marks a fork in the road for Turks battered by an inflation-driven cost of living crisis that is only just easing.

International investors, many of whom have bailed out in the last five years amid recurring market turmoil and Ankara’s embrace of unorthodox economic policies, are watching closely.

Fund managers told Reuters even the hint of an opposition win could prompt a significant rally in Turkish assets given promises to roll back ‘Erdonomics’.

But his drastic transformation of the economy and financial markets means such a change would bring its own uncertainties.

Blaise Antin, head of EM sovereign research at asset manager TCW in Los Angeles, said an immediate “quick kill on FX appreciation seems unlikely to materialise” even if Erdogan loses.

Only in the medium-term could markets turn sustainably bullish given the need to address an overvalued currency and re-set interest rates to “a much higher level,” he said.

Opinion polls suggest Erdogan could retain the presidency while his Islamist-rooted AK Party loses control of parliament.

That could be “the worst case” outcome, Antin said, leading to short-term policy uncertainty and market volatility.

There is still a long way to go.

A six-party opposition alliance is yet to choose a presidential candidate. One popular option, Istanbul’s mayor, is appealing a jail sentence and political ban.

Critics say courts are muzzling Erdogan’s opponents, a claim the government denies.

The election will also determine what role regional military power and NATO member Turkey plays in conflicts in Ukraine, where Erdogan has helped broker talks, and in neighbour Syria.

Achilles heel

Erdogan has never looked more vulnerable, with the economy his Achilles heel.

A self-described “enemy” of interest rates, his determination to slash rates to 9% from 19% sent the lira crashing in late 2021 and down another 30% last year – its 10th consecutive annual plunge. Inflation roared to a 24-year peak of 85% in October as food, fuel and rent costs ballooned.

To offset voters’ strains, Ankara has rolled out record social aid spending worth some 1.4% of the annual budget, including energy subsidies, doubling the minimum wage, and allowing more than 2 million Turks to retire immediately.

“Erdogan is offering one (support) package after another”, which will put “significant pressure” on the public purse, said Galip Dalay, associate fellow at Chatham House in London. “But if he loses the election that will be someone else’s problem.”

Turkey still has much lower debt levels than most countries but years of FX reserve depletion, erosion of the central bank and judicial system’s independence and unorthodoxy more generally have left their mark.

Credit ratings from Moody’s and Fitch have slid from investment-grade in 2016 to “junk” – on a par with Bolivia and Cameroon.

“The policies just don’t look sustainable,” Fitch’s Paul Gamble said.

Exodus

Investors say Turkey’s free-market model began metamorphosing around 2017 when it adopted an executive presidential system concentrating power in Erdogan’s hands.

In 2019, authorities worried about destabilising speculation squeezed international lira markets. Trading in centres like London now averages under $10 billion a day, down from $56 billion in 2018, Bank of England data shows.

Foreigners have slashed holdings of Turkish government bonds to less than 1% from 20% in 2017 and now own just 30% of the equity market, compared to 65% a few years ago.

Turks seeking a way to hedge against soaring prices have filled the gap, helping lift the Istanbul index by 200% last year. They now account for 70% of stock holdings, up from 35% in 2020.

Mehmet Hasim Acanal, a farmer in Turkey’s southeast, sold one of his fields and tapped savings to put 10 million lira ($533,620) into stocks.

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

Turkey’s depreciation-protected bank deposit scheme, brought in to stop the lira’s 2021 plunge, is an example of its unorthodox and sometimes costly approach.

In the short-term it seems to have worked however, halting a years-long rise in Turks converting lira into dollars.

Injections into state coffers from “friendly” countries like Qatar and Russia, and from a tourism rebound, have meanwhile helped the lira stay roughly between 18.0 and 18.8 to the dollar since August – around the time Erdogan’s opinion poll ratings started rebounding.

Authorities have been constantly tinkering too, bringing in around 100 additional regulations to bolster currency stability.

One banker told Reuters some foreign investors had started putting short-term bets on the lira given an almost doubling of central bank net FX reserves since November.

Yet the lira, which has lost over 90% of its value against the dollar since 2008, is still 15% overvalued based on economic imbalances and fiscal stimulus, said Robin Brooks, chief economist at the Washington-based Institute of International Finance. “The credit stimulus keeps growth higher than Turkey can really sustain,” he added.

But predictions that Erdogan’s policies would lead to disaster have not materialised, noted Sergey Goncharov, EM fund manager at Vontobel. Last week, Turkey had no problem borrowing $2.75 billion from international capital markets.

That complicates the choice for voters who could face a painful initial economic downturn if an opposition victory were to bring a return to free market policies.

“It is an unstable equilibrium,” Goncharov said. “But it is a hard one to move out of.”

($1 = 18.7400 liras)

(Additional reporting by Nevzat Devranoglu in Ankara; Additional graphics by Vincent Flasseur, Riddhima Talwani and Sumanta Sen; Editing by Catherine Evans)