Wed | Dec 12, 2018

Walter Molano | Turkey: Another fallen angel

Published:Friday | May 25, 2018 | 12:00 AM
Turkey's President Recep Tayyip Erdogan delivers a speech to supporters of his ruling Justice and Development Party, the AKP, to outline his plans for after the elections and present MP candidates, in a rally in Ankara, Turkey, on Thursday, May 24.

The Turkish lira has been one of the worst performing currencies of the emerging world since the start of this year.

While the devaluation of the currency was symptomatic of the pressures felt by other emerging market countries, President Recep Tayyip Erdogan's campaign against monetary prudence has made the situation much worse.

The Turkish strongman blames the country's double-digit inflation rate on high interest rates. He has repeatedly weighed in against the central bank, raising concerns about the independence of the monetary authorities.

Erdogan has demonstrated a complete disregard for institutional independence, especially after the aborted coup in 2016. Therefore, it is no surprise that investors have been heading for the door.

A few weeks ago, he was in London meeting with institutional investors and he broke into a rant against the credit-rating agencies and high interest rates, doing more to undermine investor confidence rather than to bolster it.

Presidential elections are only a few weeks away. They are scheduled for June 24, and the Turkish president is trying hard to boost economic activity before voters head to the polls.

The elections were initially mooted for August, but President Erdogan suddenly moved up the date. There were reports that he was very concerned that the slowdown in economic activity was turning public sentiment against him.

Under Turkish electoral rules, a presidential candidate needs to secure more than 50 per cent of the vote. Otherwise, the process moves into a second round. Recent polls cast doubts that Erdogan will be able to win in the first round. This may create an opportunity for the opposition to join forces, and it could end in his defeat.

One of the reasons Erdogan and his allies, are trying to get past the elections is, it will let them consolidate the dictatorial powers that they were able to amass through last year's referendum. Unfortunately, he does not seem to understand that high interest rates may be the best ally he has in stabilising the lira and reverting the pass-through inflation.

The problem is that like many other emerging market governments, Ankara fails to see that the pressure that their currency is facing is symptomatic of the asset class and not idiosyncratic of their particular situation.

However, there are some factors that are particular to the Turkish situation. The first is that the Turkish economy is overheating. Although the ruling AKP party was well known for its fiscal restraint, it has thrown caution into the wind by more than doubling the primary fiscal deficit to around 2-2.5 per cent of GDP. This puts it almost in line with Argentina's fiscal shortfall.

Part of the government outlays have been in the form of investment incentives and loan guarantees for the private sector. As a result, industrial production has moved into overdrive, surging 7.6 per cent year-on-year in March.

Cheap labour aiding growth

The reactivation of the European economy has also helped boost industrial production. Turkey serves a similar role that Mexico plays with the US. It is the centre of European light manufacturing and assembly. This brings light on a third driver of Turkish economic growth.

The 3.5 million Syrians that have flooded across the border have been a source of cheap labour, as well as a source of additional domestic demand. Unfortunately, the jump in economic activity has been a major factor in pushing the inflation rate to almost 11 per cent.

With the president jawboning down interest rates and fiscal restraint thrown out the window, it is no wonder that the Turkish economy is overheating. The economy grew 7.3 per cent year-on-year in 2017, and it may be higher this year. This is much more than the five per cent growth target that was initially set.

The economic imbalances are manifesting themselves into problems for the external accounts. Turkey's current account deficit is exploding, despite the increased embarkations slated for Europe. The country's current account shortfall spiked 54 per cent year-on-year in March, rising to US$4.81 billion. The 12-month current account deficit was US$53.7 billion in March, versus US$33.5 billion a year earlier. This represents a current account gap of 6.5 per cent of GDP.

Not surprisingly, the country's debt position has been expanding as fast. Short-term external obligations jumped 14 per cent year-on-year during the first quarter. The sharp deterioration of the country's external accounts was the main reason why S&P downgraded it to BB- at the beginning of May, earning President Erdogan's ire.

Edogan's gambit to stimulate economic activity may help get him past the finishing line during the first electoral round on June 24. However, it may also blow up in his face and destroy his chances. Either way, his actions are pushing the Turkish economy towards a hard landing, and the country may become another fallen angel of the emerging world.

- Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.