Turkey Watch – Elections on the horizon

by: Peter de Bruin

  • President Erdogan wants to transform the constitution and introduce a presidential system
  • However, it is questionable whether the AKP will secure enough seats at the upcoming elections to accomplish this
  • After a period of ‘stealth’ tightening, CBRT is likely to hike rates in Q3 and Q4 to limit effects of Fed lift off
  • Still, Turkey’s current account deficit implies that a change in investor sentiment remains a main risk to the outlook


AKP to win upcoming elections,…

With less than two weeks before the elections, the question whether President Erdogan can turn the country’s political system into one where the political power is mostly concentrated in the hands of the president is increasingly drawing attention. Officially, the President is supposed to be non-partisan in his largely ceremonial role. However, after becoming the first directly elected President in August 2014, President Erdogan has started to run his own campaign. His aim is to transform the constitution in order to introduce a presidential system, akin to that seen in Russia. This would enable him to govern Turkey with less obstructions from parliament.

…but questionable whether majority will be large enough to change constitution

In order to change the constitution, Erdogan’s AKP must secure at least 330 of the 550 seats in the upcoming parliamentary elections on the 7th of June. This would give the party the right to put proposed constitutional changes to a referendum. While we expect that the AKP will secure a majority, it is questionable whether it will be large enough to change the constitution. This will, to a large extent, depend on whether the pro-Kurdish People’s Democratic Party (HDP) will exceed the 10% threshold to enter parliament. If the HDP obtains 10 per cent or more of all MPs, then the probability that the AKP will win 330 seats looks to be very slim. While the election outcome remains uncertain, recent polls are suggesting that the AKP will seize a majority that would enable it to create a new government, but that the party’s victory will fall short of the 330 seats needed to overhaul the constitution.

Political concerns weighing heavily on the lira,…

This has helped the lira to claw back some of its losses lately, though the potential political course of Turkey after the elections has weighed heavily on the currency. It has lost around 10% of its value against the dollar since the start of the year. This mainly reflects that investors have become increasingly worried that the central bank’s independence may be in jeopardy, in particular if President Erdogan were to acquire more power after the elections.

…as investors fear central bank will not fight inflation

The June elections are taking place against a backdrop of an economy suffering from stubbornly high inflation. After starting to come down at the end of last year on the back of falling energy prices, inflation recently picked up again to 7.9% in April. This is because food prices have surged by more than 14% as a drought hit agricultural production this year. Although a bout of rain in the past months suggests that food prices are likely to come down again, the recent weakening of the lira will continue to underpin consumer prices going forward. As a result, while we think that inflation will soften modestly later in the year, it is expected to remain stubbornly high, and well in excess of the central bank’s target of 5%

But CBRT has managed to implement ‘stealth’ tightening

With the central bank (CBRT) under immense political pressure, it has refrained from hiking any of its policy tools to combat inflation lately. Still, it has implemented a policy of ‘stealth’ tightening. The CBRT provides liquidity to banks either via its one-week repo funding facility at the 7.5% policy rate, or the Overnight-lending facility that has a rate of 10.75%. By increasing the share of liquidity provision through the latter, the CBRT has managed to gradually push up interbank rates to the upper bound of its interest rate corridor, and has thus tightened monetary policy conditions.

We think that the CBRT will keep its policy rates on hold, but will continue to pursue a policy of tight liquidity conditions, until the elections. Provided the AKP will not secure 330 seats that would possibly open the door for President Erdogan to acquire more power, the CBRT will most likely try to increase its policy rates by 50bp in the remainder of the year to counter inflationary pressures, lira weakness, and the possible adverse effects of the Fed starting to tighten policy. That said, the CBRT will likely continue to remain under much political scrutiny, which could hinder it in implementing its policy.

Economic growth has so far remained subdued,…

Meanwhile, economic data are suggesting that growth has remained soft. For instance, due to uncertainty surrounding the elections, consumer confidence has fallen to 64.3, the lowest level in more than six years. Meanwhile, the manufacturing PMI, despite rising modestly from 48.0 to 48.5 in April, has remained below the boom-bust mark for four months in a row. Industrial production growth has also remained weak. Although it picked up strongly in March, it grew by only 1.5% yoy in the first quarter as a whole, down from a 1.9% expansion recorded in the fourth quarter of last year. Given its close relationship to GDP growth, this suggests that economic growth has remained relatively subdued in the first quarter. Overall, we think that it slowed down modestly further from 2.6% yoy in Q4 to around 2.3%.

…but signs of some green shoots of recovery…

However, demand indicators of the economy have been more encouraging. For instance, real import growth, which can be seen as a proxy for the strength of domestic demand, increased by 4.9% in Q1, following a 4.3% rise the quarter before. We also saw that the volume of retail sales rose by 3.3% in Q1, which was a bit better than in the previous quarter. With domestic demand likely to have grown at a faster clip than the overall economy in Q1, we suspect (the first quarter GDP figures have not yet been released) that the overall economic performance was hampered by a negative contribution from trade and firms running down their inventories in Q1.

…as industrial production surges

We think that this process has gone into reverse now. This would explain the 2.2% mom gain in industrial production in March that build upon a 1.8% rise the month before, clearly suggesting that the economy picked up momentum going into the second quarter. Looking further down the road, while we are likely to see a bit of pent up demand as uncertainty recedes after the elections, we think that domestic demand will remain fairly muted due to relatively tight central bank policy. This should be partly compensated for by stronger exports, helped by the upswing in the eurozone. But taken everything together, we have reduced our 2015 GDP growth forecasts from 3.5% to 3.0% for this year.

Current account deficit remains Turkey’s Achilles’ heel…

In thinking about the main risks to the outlook, Turkey’s weak external position remains a concern. Although the country’s fiscal position is healthy, the pace of narrowing of the current account slowed in March. Due to a worsening in the trade deficit, the current account deficit rose from $3.5bn to almost $5bn in March. This brought the 12-m rolling deficit, a more stable measure, to $45.5bn, slightly more than 6% of GDP, on our estimates. What is more, Turkey’s current account deficit is mostly financed by portfolio investment inflows. In contrast to the inflows related to direct investment, these are much more volatile and can be easily withdrawn in the case investor sentiment deteriorates.

…implying that Fed exit remains the main risk

All this suggests that Turkey remains vulnerable if the Fed starts to tighten monetary policy in the autumn of this year. In particular, if the pace of rate increases were to be faster than what financial markets currently expect. Indeed, while our US economist only sees two rate hikes in 2015, the pace of tightening is expected to gradually increase in 2016, with the federal funds rate set to rise to 2.25% at year-end 2016. This is far above current market expectations. While the CBRT will most likely be forced to hike rates when the Fed tightens policy, and while we think that Fed rate hikes will lead to somewhat more lira weakening, a deterioration in investor sentiment hurting Turkey is a clear risk to the outlook.