Crashing the Turkish ballot box and its economic consequences -Part 1 : Inflation wave
In a move that was both predictable, but also unprecedented, Turkey’s Supreme Election Council (YSK) last week annulled the March 31 polls to elect a mayor of Istanbul, narrowly won by the secular opposition’s rising star Ekrem İmamoğlu.
The policy mistakes of the ruling Justice and Development Party (AKP), President Recep Tayyip Erdoğan’s coercive governing style, a crooked presidential system and an economic contraction - the by-product of all the bad choices the ruling party has made over the past couple of years - combined to gift the country’s biggest urban centres to the opposition.
The decision to annul the Istanbul election will no doubt have a serious political impact. But creating such political chaos to keep control of the municipality of Istanbul, which accounts for nearly a third of Turkish GDP and has a budget of almost $4 billion, at a time when the economy is immersed in a recession, is going to be costly for the economy.
In an apparent effort to cap the lira’s slide, state-run banks sold $1 billion on Wednesday through ongoing swap operations at the cost of more foreign exchange reserve losses for Turkey’s central bank. They apparently followed that up by selling $1 billion more on Thursday and in Asia trading on Friday.
Such operations, which began at the start of the year, have brought the foreign currency reserves of the central bank into “red alert territory” and beyond. The central bank cannot afford to spend more, yet assuming it extends these misguided operations up to the election rerun on June 23, the lira is set to lose ground. Now the whole market is aware of the details of these unfortunate interventions even though the central bank has declined to provide details.
The planned delivery of Russian-made S-400 missile systems to Turkey in July, U.S. warnings about the quality of democracy after the YSK decision to nullify the elections, and developments in Syria all threaten to add to the existing strain on Turkey-U.S. relations. In the absence of a strong, positive diplomatic move from Turkey and in the midst of continuing domestic political uncertainty, the lira seems bound to lose ground as tensions with Washington persist.
The lira lost some 28 percent of its value in 2018 and 15 percent more so far this year. As can be understood from the central bank’s backdoor foreign exchange interventions, stopping the losses is of huge political importance. Last year’s August currency crisis pushed up Turkey’s consumer price inflation (CPI) to 25 percent by October and it has been floating around 20 percent ever since. Food price inflation is even higher at 32 percent, hurting the AKP’s voter base very hard.
It would be safe to assume that the lira will depreciate towards 7 per dollar this year versus levels of around 6.2 today. The resultant impact of this future currency weakness on inflation is obvious. Further downward momentum on the lira is also likely because Turkey has no credible economic programme, or any economic programme at all. The financial pressures of external debt payments on Turkish corporates are intensifying and general risk premiums for emerging markets are on the rise.
As can be grasped from the chart above, lira depreciation has a direct impact on production costs in Turkey with imports having a share of about 70 percent in all exports. Thus, inflation will remain plagued by the lira’s weakness. As the lira is likely to fall by a further 10 to 12 percent this year, reducing inflation below 18 percent, let alone to the government’s 2019 target of 15.9 percent, just does not seem likely.
That brings us to the central bank once again.
With seven elections over the past five years, the bank has been under political pressure from President Recep Tayyip Erdoğan and his economic team to keep interest rates low and support economic growth. Giving in to that pressure has turned out, in hindsight, to lie at the core of the central bank’s monetary policy mistakes. In turn, that policy has had a devastating effect on inflation, when combined with heavy fiscal spending by the government.
Because of last year’s currency crisis, the central bank “had to do what it had to do” in raising the policy rate substantially to 24 percent. But during the countdown to the March 31 local elections, monetary policymakers, through the state-run banks, were politically obliged to support the lira. Consequently, that approach has damaged the central bank’s reputation as an inflation-targeting institution because it has openly targeted the lira’s value instead. And market pressures to raise the policy rate from the current 24 percent have been counter-pressured by the AKP government. In its April monetary policy board meeting, the bank, to everyone’s surprise, signalled rate cuts for the months ahead, abandoning its interest-rate tightening language.
On Thursday, instead of a simple rate increase to stem the lira’s slide to a seven-month low, the central bank abandoned the benchmark rate and said it would start to lend to the nation’s banks at its higher rate of 25.5 percent. When that was not enough to reverse the lira’s losses, and despite calls to increase interest rates in a classical manner, state-run banks then reportedly intervened once more to buy liras for dollars.
The central bank may now be deterred from cutting rates due to the impact on the lira from last week’s decision to rerun the Istanbul election. But while the momentum for higher inflation is building again, elections will be held in two months. Therefore, policymakers will also have a hard time turning hawkish.
In short, until the central bank regains credibility, there is no fundamental argument to support exposure to Turkish assets. Inflation is set to remain elevated at around 18 to 20 percent and bond yields will stay high, trading around current levels at least.
Winning credibility of course means that the central bank must act independently from the AKP government. It should also be transparent in reporting its interventions in the foreign exchange market and create tangible signs of disinflation in the country.
In “Crashing the Turkish ballot box and its economic consequences -Part 2”, I will highlight Turkey’s worsening economic fundamentals during the recent political turmoil. Of particular focus will be the high debt obligations of Turkish corporates, declining foreign direct investment, and the ability of Turkish firms to survive in such a rough economic environment and during such persistent political uncertainty.