Fast view
- Turkey’s municipal election results were surprising, both in terms of the scale of the ruling party’s defeat and the uncharacteristically measured response by President Erdoğan – who has committed to allow his credible economic team to continue to right the economy.
- Investors’ fears have been assuaged, and although risks of a U-turn can never be fully discounted, there are signs that Turkey’s orthodox policy framework is here to stay.
- A clearer political calendar provides room for policymakers to continue to do what is needed to get inflation under control, bring back foreign investment flows, and stem local de-dollarisation.
- The path to economic stability will take time, and inflation will rise in the near term – which will likely weigh on the local rates market. But current FX yields mean the Turkish lira offers an attractive buffer for EM debt investors, in our view.
Erdogan’s worst election since 2002
An unexpectedly widescale defeat
In stark contrast to the general election last May, Turkey’s municipal elections on 31 March provided a stark wake-up call for President Recep Tayyip Erdoğan and the ruling Justice and Development party (AKP). The key target – the mayoral post of Istanbul – was lost by a wider margin than in 2019, with a host of other cities falling to opposition parties (including in the Anatolia heartland, where an Islamist conservative party claimed victory). In short, this was Erdoğan's worst election result since AKP won the 2002 parliamentary elections, with the scale of the defeat surprising pollsters and most political analysts.
A more measured political reaction
Perhaps even more surprising is Erdoğan's reaction to the results. In 2019, the authorities reacted to local election losses by exploiting their power over the state apparatus – annulling the initial Istanbul results and forcing a re-run (which ultimately backfired as the opposition subsequently secured an even more convincing win). This time the contrast was stark; Erdoğan struck a more conciliatory tone and pledged to learn from the defeat.
A pledge of ongoing support for orthodox policymaking
Crucially for investors, in a post-election speech, Erdoğan pledged to maintain Turkey’s economic policy set-up – the medium-term framework authored by Finance Minister Mehmet Şimşek last summer, which has paved the way for more orthodox monetary policy in an attempt to combat runaway inflation and rebuild confidence in the Turkish lira.
Erdoğan’s comments are maybe less surprising if we consider recent developments. He’s consistently backed Şimşek in recent months – both verbally and in his actions. In March, the central bank tightened interest rates through macroprudential measures before increasing the policy rate by 500 basis points to take the main policy rate to 50%. Such a move would have been unthinkable one year ago in the months leading up to general elections. Yes, there was significant pressure on the Turkish lira and the reserve bleed was alarming, but the rate hike in March was ultimately a policy choice and one that must have been endorsed by the president himself.
Investors’ fears assuaged
The policy tightening in March helped to stem the largely speculative US dollar demand from locals who feared a sharp depreciation of the lira after the elections (or even worse, Erdoğan changing his economic team). So far, both fears have proven unfounded; ultimately, we don’t think it is in the authorities’ interests to devalue the lira or in Erdoğan’s interests to fire Şimşek. Since the election, spot lira has rallied slightly while implied yields have fallen, reflecting a return of investor confidence.
A clear runway for orthodox policy to succeed?
Given Erdoğan's chequered history on orthodox monetary policy – as evidenced by a total of six central bank governors taking office in five years – an element of caution is warranted. However, the signs point to Turkey’s orthodox policy framework remaining in place and the factors listed below support this view.
1. Political room to make tough choices
Turkey now has a clear political calendar ahead of it. The next elections aren’t scheduled until 2028 and given the government’s defeat in the local elections, the prospect of a constitutional referendum in the near future appears remote. This could provide the necessary room for the central bank and the finance ministry to double down on the orthodox policy mix and show Erdoğan some results – namely concrete signs of inflation coming under control, foreign investment flows returning and local de-dollarisation.
2. Turning the inflation tanker…slowly
Inflation has soared in recent months in Turkey. The March inflation data published post-election shows only a modest slowdown in the monthly pace of inflation and in year-on-year terms; inflation is still on an upward trend with record high core inflation. But underneath the surface there are some constructive developments. Tight monetary policy is feeding into slower credit and money supply growth. This should start to filter into a slowdown in inflation, weaker growth and further rebalancing in the country’s trade balance.
In the last quarter of 2023, there were signs of a moderation in inflation. Much of the blame for the reacceleration observed this year rests with the 50% increase in the minimum wage in January combined with a matched increase in the state pension ahead of the local elections. Both the finance minister and the president have hinted at tighter fiscal policy in the months ahead as well as ruling out further wage increases this year. Together with tight monetary policy, this should start to bear results as the year progresses. It will, however, require patience. In year-on-year terms, inflation is likely to keep rising until the early summer, when base effects turn more favourable. That means that even with Turkish lira deposits offering 50-60% interest rates, the ex-post real return will remain negative until the third quarter, and that could keep pressure on the lira.
Not without risks
So far President Erdogan has shown a remarkable shift in stance to become tolerant of higher interest rates and more orthodox policies. But the results of the policy set-up have been sparse and his patience may start to wear thin if results are not forthcoming soon. At the same time, after he underlined that these elections were his last, he might be trying to forge his legacy, and deliver macroeconomic stability.
Asset class implications
With FX yields around the policy rate of 50%, we think the Turkish lira now offers an attractive buffer for EM debt investors. While the lira has rallied post-election, we think its depreciating trend will likely resume in the short term but the carry on offer should more than compensate for this. For now, we have a more neutral view on Turkish local debt given the complicated inflation outlook and potential for further rate hikes in coming months. Turkey’s external debt is – for good reasons – trading tight to its credit rating, and we retain a relatively cautious view as a result – there’s a lot of the ‘good news’ already in the price.
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Specific risks. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
