The country’s general elections in June had already undermined fiscal credibility with grand spending promises that have encouraged inflation.
President Recep Tayyip Erdoğan’s handling of the economy – arguing that high interest rates cause high inflation – has panicked global investors amid claims high interest rates were “the mother and father of all evil” and pledges to take more control over the central bank.
The global macro background, meanwhile, has not been favourable as global asset-buying programmes slowly come to an end and the US Federal Reserve tightens policy and the dollar strengthens.
Prior to the military coup in July 2016, Turkey had been popular with international investors, GDP averaged about 7%.
“Pro-business policies and a youthful entrepreneurial population enhanced the attraction for overseas investors at a time of loose global monetary policy and low returns elsewhere,” Deutsche Bank analysts Jim Reid and Craig Nicol wrote in a report published Monday.
FDI has soared during President Erdoğan’s 15-year rule to about $13bn (£10.2bn, €11.4bn) a year, according to Deutsche Bank.
The straw that broke the camel’s back is has been the diplomatic row over Turkey’s detention of the American pastor Andrew Brunson, who was arrested in October 2016 in the aftermath of the attempted coup.
“New US sanctions have further focused the market’s attention on how small, open, indebted and reliant on overseas capital the Turkish economy has become,” according to Deutsche Bank’s report.
A looming debt crisis
“The worsening of political tensions between the US and Turkey has been the final blow to an already dire economic situation, with the collapse of the lira now rapidly fuelling concern of a full-blown currency and debt crisis given the amount of USD-denominated debt in the private sector,” said Delphine Arrighi, portfolio manager, Old Mutual Global Investors.
Meetings between the banking regulator and the central bank over the weekend haven’t yielded the results the market was expecting. Although the recent measures announced by the Central Bank of the Republic of Turkey (CBRT) will aim to ease onshore liquidity, they will fall short of restoring investors’ confidence, Arrighi said.
“At this stage, the lack of credible policy response is pushing Turkish asset prices into a tailspin. Local rates are now pricing in close to 900 basis points of rate hikes to stem the currency depreciation. However, given the reluctance of the CBRT to hike rates at its previous meeting and president Erdoğan’s recent comments blaming an international conspiracy rather than acknowledging the real economic crisis resulting from an overheating economy faced with tighter global financial conditions, there is little hope for a return to orthodox policies at this stage,” she added.
A Turkey-specific problem
Edward Park, investment director at Brooks Macdonald, said: “The market is beginning to price in this US dollar liquidity risk into the broader emerging markets. The first round of economic sanctions in Turkey were the straw that broke the camel’s back for the country’s economic sentiment.
“Investors are looking at it and thinking if the initially very small US economic sanctions have catalysed a complete loss of face in the Turkish government then other, similarly small, shocks may be enough cause issues in other emerging market nations.”
Most analysts view Turkey’s problems as relatively idiosyncratic and should be contained – outside of the risk of a short-term risk-off – unless there’s a widespread investor retrenchment from emerging markets generally.
“We believe this is a Turkey-specific problem,” Park added.
“However, the actual root cause is shared by quite a few nations, of which Argentina is the most obvious example. Turkey has tripled its US dollar liabilities in the last 10 years, taking advantage of cheap money to refinance itself. However, at the start of the year the US federal reserve started to embark on quantitative tightening, essentially withdrawing its liquidity, at the same time as raising rates, which means it is much more expensive to finance in US dollars which is a problem for emerging markets.
“With Turkey doing relatively little to calm investors, it will certainly be a volatile few days.”
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