- Turkey is more resilient to a shift in sentiment than a year ago…
- … but we expect a very modest recovery from the current low levels
- Inflation is rapidly decreasing, to an estimated 15% end-of-year
- CBRT cuts rates by 425bp, more than the market expected
- We foresee further aggressive cuts (425bp for this year)
- Sanctions – mainly from US – may turn sentiment negative again
A quick recap… what has happened in Turkey?
It has been a year since Turkey saw a sudden drop of the TRY, triggered by the escalation of a diplomatic spat with the US. Since then, a lot has happened on the economic and the political fronts. Turkey faced the backlash of an overheating economy financed by (external) credit growth and fell into a recession.
In the second quarter of 2018, growth dropped into negative territory (qoq), deepening to -2.4% in the last quarter of last year. During the first quarter of this year growth turned positive, reaching 1.3% qoq mainly on the back of strong credit stimuli in the run-up to the local elections. Thanks to the sharp adjustment over the last year, the economy is in better shape than a year ago to deal with a change in investor confidence. Inflation fell from a high of over 25% in October last year to 16.7% in July. The current account deficit as a percentage of GDP staged a partial recovery from a low of 6.5 in the second quarter of 2018 to 1.7 in the first quarter of this year.
Meanwhile, on the political front the ruling AK party lost the biggest cities in the local elections at the end of March. When President Erdogan demanded re-elections in Istanbul, the strategy backfired and the AK party was defeated by an overwhelming majority. These events have added to the split between Erdogan loyalists and those concerned over its political motivations. Senior AK Party politicians discussed forming a new political party that could draw away disillusioned members of the ruling party.
More resilient, but a sharp recovery is not expected
While more resilient to a shift in sentiment, the economy is still in the doldrums. The consumer confidence index recovered slightly in March and April this year, before suffering another blow in May. Retail sales were severely hit last September/October, and have slightly recovered since, though they have continued to hover around the same negative level since the beginning of this year. The PMI has picked up since September but has not yet moved above 50. In other words, the leading indicators paint a picture of modest recovery from the previous low levels but show no signs of a sharp bounce-back. The global backdrop of low growth and the risk of a recession scenario in the eurozone will weigh on Turkey’s exports and therefore on the economic recovery. Different side of the same coin, the expectation of more monetary easing by the Fed and ECB is fuelling investor appetite for higher yielding EM assets, including in Turkey. This should generally be positive for the inflow of capital.
Therefore while we have seen the worst, we only anticipate a modest recovery. We estimate annual growth to remain negative in 2019 at -1.5% and to pick up to 2.5% in 2020. This is still far below the long-term growth trend (6.5% in 2010-2018).
Inflation will come down further…
July showed a slight uptick in inflation, to 16.65%, mostly due to temporary factors such as the reversal of tax cuts and spikes in energy prices. The sluggish economy and negative consumption growth put further pressure on inflation. That said, the latest lending data from the central bank of Turkey (CBRT) show another credit expansion (mainly by state-owned banks), which will partly offset the deflationary pressures. While inflation my temporarily shoot up to around 12% in September and October this year (mainly due to base effects), we stick to our inflation forecast for end-2019 of 15%. In its latest inflation report the CBRT communicated that it expects inflation to come down to 13.9% in December.
… CBRT cut rates from 21.5% to 19.75%
On 25 July, the CBRT cut the key policy rate by 425bps. This was more than the 300bp the market expected and took place against a background in which President Erdogan replaced the former CBRT governor Çetinkaya by a new governor, Mr. Uysal, because of ‘disagreements’. Despite the gap between the rate cut and the market expectations, the USD/TRY remained largely unchanged. This was mainly due to a more accommodative monetary policy signalling by the Fed and ECB. Moreover, in June, inflation dropped to the lowest level in a year (15.7% annually), easing concerns over high inflationary pressures.
… and there is further easing ahead…
Little is known about Mr. Uysal’s views on monetary policy. However, he gave some clues during the press conference and an interview with Anadolu Agency by saying that he wants ‘reasonable’ real interest rates, in line with the real rates in comparable emerging markets (South Africa, Brazil). Turkey’s real interest rate was around 3% in July, compared to around 2% in South Africa and approximately 2.5% in Brazil. This does not seem to suggest there is much additional room for Turkey to move, especially given the elevated risks. That said, the CBRT seems to be trying to use tools other than the interest rate mechanism in its monetary toolbox to support financial stability, and therefore may be more willingly to lower rates going forward. A draft omnibus bill sent to the Turkish Parliament on 8 July expands the Central Bank’s mandate related to reserve requirements. Moreover, it is well known that President Erdogan fiercely opposes high interest rates and, given the good relationship between Mr. Erdogan and Mr. Uysal, the current governor may be more susceptible to rate cuts than his predecessor. Another element at play is that the market reacted quite modestly to the latest rate cut. This, presumably, is another argument for the CBRT to cut rates further.
Given the above factors, we think the Central Bank will cut rates by another 425bp in the course of the year, most likely during the 12 September and 24 October meetings. This would bring the interest rate to 15.5% at the end of the year. For next year we expect the CBRT to further ease, in line with the incoming inflation data, and we have pencilled in an interest rate of 11% end-2020.
The main short-term risk to the outlook remains sanctions
Currently, the main question is whether the US will follow through on sanctions. Given Turkey’s purchase of the S-400 missile defence system from Russia, US law requires President Trump to implement at least five of 12 sanctions categories. These measures include denying export licenses, loans and other banking transactions as well as visas to the United States. Mr. Trump has the power to waive those sanctions if he determines it is in the US’s ‘national security interest’, but the majority of senators oppose him using that authority. So far, Mr. Trump has been reluctant to come up with a sanctions list and finds the situation ‘complex’. Therefore, the discussion has moved on to whether Turkey will actually activate the S-400 (so far, the system has only been delivered). This gives Turkey some leeway. On the other hand, if Turkey does decide to activate the missile defence system – and this state-of-the-art weaponry was clearly not purchased to be stored in a container – sanctions seem to be inevitable. The situation is very unpredictable as it is largely dictated by the US political position towards another NATO member and – unfortunately – by the mood of Mr. Trump. That said, if sanctions are imposed, it will not rain but it will pour. The US is still the largest investor in Turkey and the mild sanctions imposed last August caused a widespread market panic.
Moreover, Turkey also faces further sanctions from the EU. Increasing tensions in the eastern Mediterranean prompted the EU to impose mild sanctions on Turkey, including a halt on lending from the European Investment bank (EIB) and a suspension of the negotiations on the Comprehensive Air Transport Agreement (see also: Turkey Watch – The dust has not settled yet). Future sanctions fully depend on the actions taken by Turkey. If it further interferes with exploration and drilling activities in the Mediterranean Sea, more sanctions will likely follow. The economic impact will probably be limited; the EU is tackling several issues concerning Turkey, including the refugee deal. For now, we don’t see the EU taking a much tougher stance on Turkey.