Mark Bentley
Jan 17 2018

Turkey-U.S. tensions on Syria highlight economic risks - expert

Inan Demir, an emerging markets economist at Nomura in London, answers Ahval’s questions about the state of Turkey’s economy and foreign relations as we look ahead to 2018.

While the economy grew 11.1 percent in the third quarter, Turkey ended the year with inflation of almost 12 percent, raising concern for overheating ahead of elections in 2019. Demir weighs in on this, and deteriorating relations with the United States, which he said could hurt Turkey’s economy this year.

First of all, a general question -- how are you looking at the economy for Turkey in 2018?

“The main question for me, and it appears for many investors as well, is whether the authorities will allow and tolerate a slowdown in economic activity to deliver the much-needed adjustment that would bring lower inflation and a narrower current account deficit.

“My suspicion is that they will not tolerate such a slowdown and continue to use tools available to them to support economic growth. Broadly, this seems to be shared by investors as well. Of course, there is the question then of whether the global backdrop will be accommodative enough to help the Turkish authorities deliver another year of above-trend economic growth, either thanks to looser fiscal policy or relying on banks via the credit channel. Whether that support will be there is obviously another question.

“The global environment for emerging markets may be less friendly this year, or the overall global economic environment may remain friendly but Turkey-specific risks may become more prominent such as the Halkbank issue, or other problems with the U.S., as we see very acutely today with Syria.”

What’s your feeling about foreign policy? Erdoğan seems to be talking in much the same way toward the U.S. – he hasn’t calmed down his rhetoric. Are there risks to investors there?

“I think this is worrying investors on two levels – firstly there is the obvious proximity risk of a military clash in Syria where Turkey finds itself alone, which could affect domestic security as well. The other level of concern is that investors are extrapolating this to other areas where relations with the U.S. remain strained.

“So, if Erdoğan is so hostile toward the U.S. stance in Syria, presumably he would be less willing to negotiate other issues as well. Those other issues would include missile defence purchases from Russia or the Halkbank case. I would speculate that most people would see a unilateral military action by Turkey in Syria as a low likelihood scenario, but the more important issue for many people seems to be that extrapolation problem to other aspects of the relationship.”

Do you think investors were expecting Erdoğan to up the rhetoric against the United States? There was a point where we thought things were calming down…

“Yes, but even at that point – shortly after the U.S. relaxed visa restrictions – I read in the local press that this could be a preparatory step by the U.S. towards sanctions in other areas. Since they were expecting to take other measures against Turkey, they wanted to drop this visa issue. Because if they didn’t drop it now it would be much harder to drop it later, kind of view. Even at that point we didn’t have much of an improvement in the relationship.

“Maybe the pro-government media’s take on this is correct. So, if that’s correct we never had the détente in relations at all. If it’s not correct, then most recent developments show that the problems are still very much there.”

Nomura economist, Inan Demir
Nomura economist, Inan Demir

How much of a chance is there of sanctions and what sort of sanctions could they be, in what form?

“I think the most important risk is still about Halkbank. My view is still a fine on the bank rather than sanctions. There is a risk that the fine could be of the size that would be seen as unreasonable by the Turkish government … that would definitely be seen as a political step. So, I think the risk of sanctions on Halkbank is still there even if the initial step is a fine. If Turkey drags its feet in cooperating, then we could see the risk of sanctions.

“Other sanctions could possibly involve the S-400 missile system purchase from Russia since the producer of these defence systems is on the U.S. sanctions list. Companies and banks who do business with that sanctioned entity could be subject to sanctions as well, unless there is a waiver. So, if the purchase goes ahead, presumably at the end of the day that could be a political decision but that could be another area where the U.S. can consider sanctions.”

On Erdoğan again – he seems to be more and more vocal on all kinds of issues related to Turkey. How much of a risk do you think it is for investors -- Erdoğan’s increasing authoritarianism? Do you think that’s an issue for investors, or not?

“I think for most investors that is very prominent. We could always distinguish between different investor segments ... But, I think it has been an important part of the investor discussion, especially since the failed coup attempt. I think for instance the constitutional court decision regarding Şahin Alpay and Mehmet Altan is followed by investors closely, this lack of response of the lower courts’ to the decision. I think this will continue to unnerve investors, but whether it will be a catalyst for near-term market performance, I’m not sure.

“We will need to see something else like, maybe if Alpay and Altan remain in prison despite the constitutional court ruling we could see decisions from the European Court of Human Rights. We could see many decisions in that case because the ECHR would rule that the domestic avenues are all tried and exhausted. In response to the ECHR decisions, if for instance Turkey refuses to release the applicants then we could see issues between the Council of Europe and Turkey. So I think we would need to see things moving to a different plateau altogether for this to be a catalyst for the markets.”

We’re looking at Turkey, but Nomura also of course covers eastern European emerging markets. Just how different is Turkey to other countries in the region that are having similar authoritarian tendencies?

“It is definitely part of a broader trend. And also there is one important difference I would say between Turkey and those other countries - only Turkey has a current account deficit among them, a large one. Only Turkey has to rely on the kindness of strangers, really, in funding that deficit, in financing its economic growth, essentially. I think that sets Turkey apart from the other authoritarian countries.

“In a way you could argue that Russia, with its natural resources wealth and current account surplus, can afford to go ahead unilaterally on many issues and antagonise the West. Even Russia paid a price for that when oil prices collapsed, and its currency also collapsed in late 2014. But still having a current account surplus and not having to finance the deficit gives much more room for manoeuvre. Turkey doesn’t have that luxury.”

You’ve brought up Russia and Syria just came to mind. Erdoğan’s foreign policy seems to be increasingly assertive these days. Do you think he has real ambitions for Turkey to somehow become another superpower? He always had this rhetoric about Turkey somehow becoming a global power, or is it basically for public consumption in Turkey?

“I don’t think it’s only for domestic political consumption. My sense is that Turkey did at some point between 2011 and 2013 have the chance to rally especially the Muslim Brotherhood base in the regional countries and act, maybe not as a leader, but as a kind of big brother for the political Islamic movements in the region.

Erdogan and former Egyptian President Mohammad Morsi
Erdogan and former Egyptian President Mohammad Morsi

“The Muslim Brotherhood movements are on the back foot across the region, obviously, and they’re not represented in the region’s administrations, but there is still probably an undercurrent of popular support for this ideology and Erdoğan may be targeting that undercurrent of popular support.

“I suspect when he makes these political statements, they are not only well received by his domestic base in Turkey, but perhaps by the Muslim Brotherhood base in Egypt, maybe in Jordan and in Palestine. I think maybe he’s in this for the long run and counting on the day when Muslim Brotherhood groups in the region come back on the ascendency again.”

How close are we to some really serious problems with the United States because of Erdoğan’s approach, or are we close to it at all?

“It’s difficult to judge the timing, not least because I’m not sure if we have a unified, homogenous stance in the U.S. administration on this. But it’s definitely not helping the relationship – that’s an understatement perhaps but it’s really not helping.”

Back on the economy, do you still hold the view that inflation will be around 10 percent and it may dip below that toward the end of the year?

“On inflation, I’m expecting around 9.5 percent toward the end of the year. Only in the final months of the year will we see inflation returning to single digits, but that’s still conditional on not experiencing a currency sell-off later in the year ... The government will have to tolerate a slowdown in domestic demand. That tolerance and other calmer measures in domestic and international politics would prevent a currency sell-off. If those conditions are not in place, then the risk is we’ll have double-digit inflation again in 2018. I attach 60 percent probability of single-digit inflation by the end of this year, and 40 percent for double-digit inflation.”

What about the lira?

“I think people would prefer to wait until there is further deterioration in relations with the U.S. and stay long lira, because going short is expensive … If we see no negative news then we could have lira stability at these levels, but that is a big if.”

How about rate cuts?

“The central bank will have to be very fortunate with all the pieces falling into place to lead to single-digit inflation toward the end of the year. If they find that kind of inflation in front of them then they might find the temptation too strong. But I think they’ll have to keep the tightening bias in place in the short term. If we see single-digit inflation in November, then we could see the central bank cutting rates in December.”

Again on Halkbank. How much of a risk do you assign to the eventuality that there are other banks fined by U.S. authorities as well?

“I think there is a significant probability that there will be other banks fined, but I don’t suppose the prosecution would find evidence that they had the systematic intentional involvement that Halkbank had, so I’d be surprised if other banks face large fines like Halkbank would face. I think the fines in their case would be much smaller fines that take into account their neglect in not having good surveillance supervision mechanisms in place.

“Those fines may even serve the purpose of not singling out Halkbank. But I don’t think it will be a big systemic issue really – I don’t think in the case of other banks we’ll be looking at fines they can’t absorb. In Halkbank’s case that’s totally different of course.”

How big would you say the fine might be, in a range?

“It may the case that we may never hear such large numbers and behind the scenes negotiations may lower the figure to $1 billion to $2 billion. I think anything lower than $5 billion would be taken positively by the markets.”