On May 6 ratings agency Standard & Poor’s, which holds Turkey’s rating one notch below investment grade, confirming its current rating but raising the outlook from negative to stable.
The news came at a time when political tension was at a peak in Turkey. Just a day before S&P’s action, Ahmet Davutoğlu announced that he was stepping down as Prime Minister and bowing out of the AKP congress for the new party leadership election, scheduled for May 22.
The first blood was spilled when Davutoğlu was stripped of his authority to appoint provincial officials. Following the Pelican Brief, a one-entry blog heavily criticizing Davutoğlu and giving hints on the heated discussions between Erdoğan and the Prime Minister, the tension between the two became tangible.
Erdoğan was first to announce the Prime Minister would be stepping down, after a meeting with Davutoğlu who later made his resignation public at a press conference while praising his performance and his government.
Political Risk Hurts the Lira
Moody’s, another ratings agency, said that this kind of political uncertainty could put pressure on Turkey’s rating since proposed reforms to eliminate external vulnerabilities could be delayed due to possible early elections. Moody’s assessment was critical, since Moody’s, unlike S&P’s, rates Turkey at investment grade. In the case of a downgrade, capital outflows are inevitable.
The economic impact of this political risk was felt immediately. In a week when emerging market currencies were hit badly in general, the Turkish Lira negatively diverged from its counterparts. The loss of value reached 6.72% against the dollar in three days, with the lira trading at 2.9760. During the same period, the lira was devalued against the euro at a rate of 7.36%, reaching 3.4230.
Further concerns were raised when the risk of Mehmet Şimşek being ruled out of his position as economy minister in the next government emerged. Despite making claims that“especially women are contributing to the growing labor force and rising unemployment” during his term, Şimşek was considered to be one of the most influential figures during Turkey’s rapid growth years.
Good Start, Bad Turn
In 2015 the Turkish economy grew by 4%, the original impetus for S&P revising the Turkish economy’s outlook from negative to stable. However, the components of this growth are more important than the headline growth figure.
Although the rumor mill is saying that Turkey is producing better electric cars then Tesla, agriculture was the fastest growing sector in Turkey by 7.6%, outpacing manufacturing and service sectors in 2015. Construction only contributed an anemic 1.7% to growth.
Turkey’s fiscal discipline was a major anchor for the last 15 years, but government expenditure rose 6.7% in 2015. In the absence of government expenditure, the Turkish economy was expected to contract or stall at best.
In 2016, the country faces numerous risks. Trade with Russia has stalled. Moreover, Putin all but banned Russian tourists from going to Turkey, reducing the number of visitors by up to 90% in 2016.
Turkey enjoyed lower commodity prices as an oil importing country, although some of the benefits were swept away due to devalued currency. Lower crude oil prices worked similarly to a tax cut, increasing the disposable income of the household by reducing the energy bill.
After trading in the proximity of $26 a barrel, oil prices jumped back to $46 and are currently hovering around $46. The lack of global demand due to sluggish growth and growing US crude oil reserves might cause a more significant pullback in oil prices.
The tricky point is that commodity prices usually fall due to strength in the dollar across the board. When oil prices fell from $107.50 to $26.05, the USD/TRL exchange rate spiked from 2,1350 to 3,0750.
A Rate Cut Gamble
The Central Bank can help slow the devaluation of domestic currency, either by intervening in the market or by hiking interest rates. Intervention would not be efficient however, as the US is in a tightening cycle and thus fighting it by keeping rates constant. Selling international reserves would only deplete crucial currency stockpiles.
The Central Bank is left with just one tool if it wants to control the depreciation of the currency: a (substantial) rate hike.
The previous Central Bank Chief Erdem Başçı had significant clashes regarding monetary policy: while AKP political leaders defended a rate cut, Başçı was reluctant to cut rates aggressively. The new chief Murat Çetinkaya cut the marginal funding rate from 10.50% to 10%. For further cuts, he will have to focus on consumer price inflation, which hit 6.57% in April.
A rate cut could be reasonable since the economy is clinging to life by the skin of its teeth. But it comes with a cost. A lower yield, especially in an environment where the US is expected to hike rates, will risk a skyrocketing exchange rate.
The Long View: Increasing Weakness
Letting the exchange rate shoot up is a plausible scenario. Before former economy minister and World Bank economist Kemal Derviş’s program and its implementation by the AKP government from 2001, Turkey was characterized by a highly leveraged government and private-sector lending.
After 2000, the roles were exchanged. The Turkish government’s debt-to-GDP ratio fell to levels lower than 50%, according to Undersecretariat of Turkish Treasury, whereas the private sector’s debt was 130% of GDP in 2014 according to OECD data. $200 billion of this debt is foreign exchange denominated however and every time the lira depreciates, that debt goes up in lira terms.
Intuition suggests that letting the exchange rate go up is not an easy decision. A higher exchange rate will surely weaken the private sector’s balance sheet. The number of Turkish companies looking for temporary relief from their creditors hit 240 this May, equal to the number of companies that requested relief in all of 2015.
The question mark over Mehmet Şimşek’s economic leadership has now created another question mark that will make investors wary. Since the ruling government will select one candidate for the congress, it is now even more important to pick a market-friendly name. Şimşek is such a character but whether he is included or not remains to be seen. An equally important question is who will replace him in case he is removed.