Turkey: Close Election Outcome Worsens Long-running Uncertainty Over Economic Policy

Turkey’s leader Recep Tayyip Erdoğan appears on course to extend and consolidate his rule, after he goes head-to-head with opposition rival Kemal Kılıçdaroğlu in a run-off vote on 28 May.

Tackling large external imbalances will require both President Recep Tayyip Erdoğan to shift the policy mix post-election and for the opposition alliance, should it manage to win in the second round, to speak with one voice on important policies. The magnitude of the economic challenges and complexity of resetting policy will require delicate trade-offs for either camp.

An Upside for Turkey’s Ratings is Unlikely in the Near to Medium Term

As tensions in financial markets during the close first round of the presidential vote on Sunday showed, any upside for Turkey’s ratings (of B-/Negative from Scope Ratings) is unlikely in the near to medium term, whatever the outcome of the highly contested presidential second-round ballot. Still, the yield on 10-year government bonds peaked above 15% days before the 14 May first-round election, before declining to 8.5% by Wednesday, 17 May.

Pressure on the lira (-33% against the dollar since January 2022), near record-low net foreign-exchange reserves ex-swaps (negative USD 54.5bn as of end-March 2023), wide current-account deficits, and elevated inflation (43.7% YoY in April 2023) will persist with or without new political leadership, given the time needed for any policy normalisation and economic convalescence.

President Erdoğan staying in power after 2023 elections, which has been our baseline scenario during past years, would most likely translate to policy continuity and continued uncertainty. Loose monetary policy (Figure 1), increasingly complex macroprudential regulations, and expansionary budgetary policy would leave the economy durably exposed to a disorderly adjustment through a growing currency crisis and deeper balance-of-payments problems.

In the absence of multilateral institutional support, Turkey would require ad-hoc, short-term agreements with bilateral partners – which in the past have included Gulf Cooperation Council states and Russia – to access hard currency and modestly contribute to meeting external financing requirements.

Figure 1. Receding inflation supports return to higher real interest rates amid still-loose monetary policy

Uphill Economic Challenge Awaits Opposition Parties Should They Take Power

Similarly, a victory of the opposition alliance, less likely at this stage but still possible, would entail large policy uncertainty given it would lack a majority in parliament. Although a reversal of the policy mix will be credit positive in the longer run by reducing imbalances, it would test the unity of a very diverse and inexperienced coalition of opposition parties, which would need to build credibility and demonstrate capacity for an orderly return to more conventional policies.

Sequencing policy reforms, first and foremost on monetary policy and macroprudential measures, including the deposit protection scheme, will be difficult. Tighter monetary policy and lower inflation would help, but Turkey has large, deeply rooted imbalances built up over time under the Erdoğan presidency.

Whatever Turkey’s political circumstances after this month’s elections, downside risks will persist in the near term, with the worst-case scenario being some sort of political deadlock, with no clear or a challenged electoral outcome and economic policy making left in limbo.

The lack of a landslide victory for Erdoğan’s People’s Alliance party or opposition leader Kılıçdaroğlu (Nation Alliance), amid high election turnout, would increase the risk of instability. This would further slow the economy, despite likely GDP growth of a forecast 2.7% this year, running below potential of around 3.9%.

The uncertainty on the policy stance post-election entails significant risks that are captured in the Negative Outlook attached to Turkey’s B- foreign-currency issuer ratings since March 2022. Scope Ratings’ next calendar rating review is on 4 August 2023.

For a look at all of today’s economic events, check out our economic calendar.

Thomas Gillet is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.