Photographer: Kerem Uzel/Bloomberg

Turkey Overheating Means Race Against Time for Erdogan

Updated on
  • Pro-growth policies are aggravating imbalances, investors say
  • Speculation is growing that Erdogan may seek early elections

The Turkish economy is overheating. That could be a problem for President Recep Tayyip Erdogan as much as it is for the nation’s creditors.

The lira is buckling under the weight of a ballooning current-account deficit and double-digit inflation after its $851-billion gross domestic product expanded 7.4 percent last year, faster than any other major economy. Erdogan, who’s seeking to formalize effective one-man rule at an election next year, needs to make sure any turbulence doesn’t thwart his chances. But signs of trouble are growing.

Turkish companies have amassed a foreign debt load equivalent to about 40 percent of economic output. Big-ticket loans like the $7 billion that sweets company Yildiz Holding is seeking to renegotiate and an unpaid $4.75 billion related to the purchase of Turkey’s leading telecommunications company are starting to raise questions about the health of corporate balance sheets. Payment difficulties would affect the banks that make up about a third of the value of the stock market.

Policy Choice

While investors are urging more cautious economic policies, the government is loath to do anything that might temper consumption-led growth. The exchange rate is the first place to take the hit of that policy choice: the lira has weakened in all but four of the Justice and Development Party’s 15 years in power.

That’s become costly for foreign bond holders and international banks, who are seeing returns on their investments eroded after years of supporting expansion of the Middle East’s largest economy. It’s also reinforcing the perception among some investors that the economy is living off borrowed time before the next election.

“Engineering a meaningful slowdown in the economy is not Erdogan’s style,” Nigel Rendell, a strategist at Medley Global Advisors in London, said by email. “Investors are questioning how long all this can continue without a further adjustment, sell-off, in the lira.”

The currency capped its worst quarter in over a year and hit a record low last month as Moody’s Investors Service downgraded Turkey’s credit rating further into junk territory, warning that the government’s short-term focus is undermining effective policy. The possibility of a balance-of-payments crisis, while still low, has increased beyond what was expected a year ago, Moody’s said.

Cemil Ertem, a chief economic adviser to Erdogan, said on March 30 that Turkey’s growth rate is sustainable and inflation should decelerate rapidly in the second half of the year. Mehmet Simsek, the deputy prime minister, said the same day that overheating was last year’s story and indicators now point at a “more reasonable" growth path.

Interest Rates

In an effort to keep foreign capital coming, Turkey’s central bank has raised interest rates by more than 400 basis points since the beginning of 2017, offering investors one of the juiciest nominal yields across emerging markets.

But last year’s government-backed credit stimulus rendered much of that tightening irrelevant by pushing loan growth as high as 40 percent. The impact of the expansionary measures are still filtering through the economy, with inflation above 10 percent for eight straight months through March, more than double the central bank’s target. Core inflation, which filters out volatile items such as energy and food, was 11.44 percent in March.

A fragile global backdrop also means history may not be a guide to Turkey’s ability to sustain one of the world’s largest current-account gaps. The last time its reliance on foreign funding was so high, cash was cheap, inflation in the U.S. was nowhere to be seen, and a global trade war wasn’t weighing on investor sentiment.

Foreign Funds

Net foreign direct investment fell to $8 billion in the 12 months through January, which means less than 20 percent of Turkey’s deficit is funded by long-term investors, leaving local assets dependent on portfolio flows that fluctuate with global market sentiment. A jump in market volatility more recently has investors turning cautious, which makes foreign borrowing even more expensive for Turkish banks.

“It takes a major improvement in global credit and risk conditions for the the lira to strengthen," said Manik Narain, a strategist at UBS in London. “You need a major flood of portfolio flows to plug these external financing gaps, even with a stable current-account.”

Should the lira continue to plunge, headline inflation could hit 13 or 14 percent, forcing the central bank to raise rates even further, Umit Ozlale, a professor of economics at Istanbul-based Ozyegin University, said by phone. He says the political cost of a currency crash could be greater than another leg higher in rates.

More Growth

Predictions of economic turbulence are stoking speculation of an early election. Investors say Erdogan, who’s riding a wave of nationalist fervor after the Turkish army’s capture of Syrian territory from Kurdish militant groups, could move the vote forward rather than take the risk of polls during a sharp economic slowdown.

“He needs the economy to keep growing strongly to ensure electoral success,” Rendell said. “It’s unlikely the economy will be performing as strongly in 2019 as in 2018, and in the intervening period we may have to live through another current-account crisis.”

The government is preparing to announce a new investment incentive package worth 128 billion liras ($32 billion) soon, Prime Minister Binali Yildirim said on March 28. Measures will also be taken to help companies access bank financing, he said. The post of prime minister will be eliminated at the next vote, and most of its authority transferred to the president.

In a speech on Friday, Erdogan acknowledged the lira’s plunge and doubled down on his favored solution: more growth.

“I’ve got some bad news for those who are trying to use the exchange rate like a boogeyman to confuse our people," he said. “With the high growth rate Turkey’s going to achieve in 2018, all those games they’re trying to play against us will be upset once again."

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