Emerging Perspectives

Turkey at a crossroads

Grant Webster and Roger Mark look at how markets have reacted to uncertainty around this month’s historic elections in Turkey and find a more nuanced outlook for fixed income investors than recent market moves imply.

10 May 2023

6 minutes

Grant Webster
Roger Mark

Fast view

  • Ahead of the 14 May general election in Turkey, a tight race between incumbent President Recep Tayyip Erdoğan’s AKP party and an opposition coalition is impossible to call.
  • The two sides have vastly different political agendas, meaning the outlook for Turkey’s economy and society is polarised.
  • Faced with heightened uncertainty, many foreign investors have retreated from Turkish assets, but a more nuanced perspective may be warranted.
  • Even if the opposition coalition wins, it is likely that a further adjustment is required before investors re-engage with Turkish local bonds. However, some forecasts around the extent of a lira sell-off appear excessive.
  • In the hard currency debt market, spreads have rallied but have room to tighten further on an opposition victory.

An historic and unpredictable election

Ahead of Turkey’s general election on 14 May, nothing is certain. Polls point to a close race between incumbent President Erdoğan’s AKP party and a six-party opposition alliance, which has formed a common electoral platform spanning the social-democratic left to the centre-right.

The potential for media manipulation given the erosion of press freedom in recent years – one of the factors behind Turkey scoring negatively in our proprietary ESG framework – plus the significant cohort of voters (up to 10%) estimated to be undecided just adds to the uncertainty. But for the first time in 20 years, the opposition has a chance of victory. This raises the prospect of an abrupt change in direction for the country, with major implications on the global stage.

The rise and fall of Erdoğan's star

Over recent years, Turkey’s economy has faced a barrage of increasingly unorthodox policymaking, reflected in soaring inflation and persistent currency market pressure. Towards the end of 2022, this led some pollsters to almost write off President Erdoğan’s chances of re-election.

However, a period of lira stability along with peaking inflation boosted consumer sentiment early this year, sparking a rise in Erdoğan’s approval ratings. Erdoğan has sought to build on this momentum, pursuing a two-pronged approach. First, he has engaged in a pre-election spending campaign by hiking minimum and public-sector wages, removing the age criteria on the early retirement pension scheme, and implementing price freezes for staple goods through political pressure. He has also used his power over the state’s institutions to tilt the electoral balance further in his favour, for instance through limiting opposition media coverage and changing electoral laws. He has also meddled with opposition politics, threatening to jail popular Istanbul mayor, Ekrem İmamoğlu, to keep him out of the race; threatening the Kurdish party with an electoral ban; and providing support for third-party opposition candidates to split the vote.

Many political analysts speculated that the government’s poor response to the earthquake in February would prove a knockout blow for Erdoğan, but his popularity has proved resilient, even gaining momentum in some recent polls.

A polarised outlook for the Turkish economy and society

While expectations vary on what a new term for Erdoğan regime might bring, at best these fall into a ‘more of the same’ camp, at worst are fears of a pursuit of an even more extreme and polarising agenda. In contrast, the opposition coalition – headed by Kemal Kılıçdaroğlu – has telegraphed a return to orthodoxy, including:

  • The return to an independent central bank with price stability at the core of its mandate.
  • The (likely gradual) withdrawal of the central bank’s distorting and unorthodox macroprudential regulations.
  • The appointment of a top team of technocrats to both the central bank and ministry of finance (where institutional capacity has been steadily eroded in recent years).
  • A comprehensive audit of the state balance sheet and banking sector.

As well as this return to orthodox policy, the opposition coalition has committed to structural reforms aimed at re-entrenching the rule of law and stamping out corruption. It also wants to move away from the presidential system, but this may be challenging given the significant parliamentary majority required.

Neither side appears likely to secure a majority in parliament, which suggests the People’s Democratic Party (HDP) would have a ‘king maker’ role. HDP is the main pro-Kurdish party in Turkey, and although it is not a member of the six-party opposition alliance, it is broadly expected to lend its support to the coalition, rather than to Erdoğan’s party.

This all paints a picture of a highly divergent outlook for Turkey’s economy – and society – and a complex landscape for investors in the country’s debt to navigate.

A potentially constructive outlook for Turkish investors

At this stage we think the election outcome is too close to call with any conviction, although at the time of writing polls lead us to believe there is a slightly higher chance of the opposition candidate beating President Erdoğan. Given that in recent years non-resident investors have abandoned Turkey (positioning across all assets is at or close to record lows), we expect significant inflows if the opposition coalition wins and follows through with its policy priorities. Here we consider the potential implications for different fixed income market components.

Local currency bonds and FX

As noted above, in the event of an opposition win, a sudden shift in the macroeconomic regime is expected. Interest rates are likely to be hiked from 8.5% to in excess of 30%. The bond market has already started to adjust but is still a long way from pricing in rate hikes of this magnitude. We think foreign investors are likely to remain on the sidelines until this adjustment takes place.

Turning to the FX market, if the opposition coalition wins it is broadly expected that the Turkish lira will be allowed to move more freely according to market dynamics, and for many restrictions that have been propping up the lira (as outlined above) to be unwound. Therefore, we would expect the lira to adjust from its current 19.5 lira-to-US dollar level. That said, some forecasts of the lira selling off to a 25-30 range on an opposition win seem overly pessimistic to us – we do not think the currency would necessarily need to adjust as much as that, for two reasons:

  • From a fundamentals perspective the current account (adjusted for energy and gold imports) has undergone a multi-year adjustment into a surplus – suggesting the currency is not necessarily overvalued. The real effective exchange rate – while rising over the last 12-18 months – remains far from highs.
  • Moreover, from a flows perspective, we think investors will start to re-engage with the country’s bond, FX and equity market once interest rates are hiked and the currency starts to adjust.

So, while there may be some near-term overshooting, we believe the scope of the FX adjustment required may be more modest than many market participants forecast. Much will depend on the credibility of the opposition’s appointments to the central bank as well as its messaging to investors and the pace of the withdrawal of capital controls.

Investors should also note that the outlook for the lira under an Erdoğan administration is also less clear-cut than it may seem; it is not a foregone conclusion that the current path of propping up the currency will continue. Useable FX reserves have dwindled, so while Erdoğan would prefer to keep the lira stable he may be forced into accelerating the adjustment after the election.

Hard currency debt

In the hard currency debt space, the prospect of an opposition win has led to some outperformance year to date, with foreign investors at least partially covering their underweight positioning. Despite this, we think there is still room for spread outperformance in the event of an opposition win given the prospect for credit rating upgrades if the opposition follows through with its reform commitments. In the event of an Erdoğan win, however, the recent foreign inflows are likely to reverse, putting pressure on spreads (all else equal) given the prospect of a continuation of unorthodox policies and the increasing probability of a balance-of-payment crisis if Erdoğan doesn’t change course.

Authored by

Grant Webster
Roger Mark

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