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Turkey has suddenly taken on the role as the key market driver over the past week, with a sharp devaluation in the lira pointing to a huge loss of confidence in the economic trajectory of the country going forward. This devaluation is nothing new though, with the past decade seeing a decline from one, to seven (fleetingly) lira to the dollar. There are a number of factors why we have seen a substantial loss of confidence in the Turkish affairs. Recent years have seen a perceived deterioration in rule of law, press freedoms, democracy, and central bank independence. With Turkish President Recap Tayyip Erdogan shifting the country into a Presidential power structure, he has essentially obtained a role indefinitely, in an environment where political opposition is clamped down upon.
Markets generally like freer, safer, and more open markets to invest in, thus highlighting why we have seen an economic flight from Turkey over recent years. However, this is a double-edged sword, for the more a currency deteriorates, the more attractive their exports will become from a price perspective. However, the US has clearly moved to counteract this phenomenon, with last week’s announcement of a doubling of steel and aluminium tariffs to account for the competitive advantage gained through the fall in the lira. Interestingly, while the market reaction has been substantial, the actual impact is likely to be neglible, with the two of the biggest domestic steel producers (Erdemir and Kardemir) seeing 85%-90% of their revenues come from domestic demand. To a large extent, markets are reacting from the potential for further trade conflict rather than the actual impact of these measures.
Another issue that has been impacting relations between the US and Turkey are related to the Turkish detainment of US Pastor Andrew Brunson. His arrest has been a bone of contention between the two countries, with varying degrees of opinion over whether he is a missionary or international spy. In either case, his captivity is clearly being used as a pawn to enable the Turkish government to demand the extradition of Fethullah Gulen, whom Erdogan accuses of being behind the July 2016 coup. This is going to remain a key issue, and the continued withholding of the US citizen will remain a roadblock for relations between the two countries.
Politics and economics
The decline in global confidence in Turkey stems as much from the political environment as the economic one. With Turkish growth currently standing at 7.5%, there is certainly ground for Erdogan to claim that the market anxieties over the economy are ill-founded. However, with inflation standing at 15.85%, Turkish 10-year bonds yields rising from 12% to 21% in the past six months, and the stock market losing 25% since January, there are clear worries over the direction of the country.
Two of the biggest fears for markets surround the direction of the country now that Erdogan has consolidated power for an indefinite term after changing to constitution to respect the President rather than Prime Minster. His decision to appoint his son-in-law has eroded confidence in the central bank, with his aversion to further rate rises holding back market confidence that they will arrest this decline.
Thus far we have seen a very mixed bag of measures taken in response to this current crisis. Erdogan has blamed outside powers as being behind this move, denting confidence that they will take this issue seriously and seek to take appropriate measures. Instead of addressing the issue as something which is driven by his own actions, Erdogan has instead retaliated against the US, with rice, alcohol and car imports all hit with tariffs ranging from 50% to 140%. We also saw the imposition of limits on the amount of currency swaps a bank can undertake, reducing the amount to 25% after imposing a limit of 50% on Monday. However, this is more a case of treating the symptoms rather than the underlying cause.
Yesterday’s decision to offer liquidity to banks at a rate that was 150 basis points higher than the current repo rate felt to some like a de facto rate rise. However, markets want to see more decisive action to reverse the direction of the lira. Further lira devaluation brings about greater imported inflation, further denting real wages and disposable income. While Erdogan has claimed that this fall in the lira is simply a good opportunity for exporters, there is very little incentive for investors to hold Turkish assets when they could lose 10% over the space of a week. Thus, the key is to stabilise and strengthen the currency, which should lower inflation and improve confidence.
While this issue has seemed very localised to Turkey, the wider sell-off seen throughout markets highlights the fears that we could see contagion throughout the corporate world and emerging markets. Weakness across a handful of Spanish and French banks highlighted that it is those two nations which are most exposed to further demise for Turkish investors. The European Central Bank (ECB) recently declared that it saw BBVA, BNP Paribas and Unicredit as three banks which could be negatively impacted by the Turkish currency crisis. Given the rising cost of foreign loan repayments for someone in Turkey, it would come as no surprise if we saw losses taken by those banks in relation to their portfolio of Turkish debt.