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The writer is global head of research at Ashmore Group
For emerging market investors, there has been a marked change in the signals from Turkey. A set of reforms has placed it back in the universe of countries with investable local currency assets.
For years, heterodox policies that combined low interest rates and state-led credit expansion led to high inflation and a very vulnerable lira. Consequently, Turkish local assets became a structural underweight position for emerging market investors.
However, after Recep Tayyip Erdoğan’s 2023 re-election as president, this radical policy stance pivoted. Bringing in technocrats to manage the central bank and Mehmet Şimşek as finance minister, meant a much-needed return to monetary and fiscal orthodoxy began.
The lira depreciated 38 per cent between March and July 2023. Then to anchor the currency and runaway inflation, which reached 75 per cent in May 2023, the central bank hiked interest rates from 8.5 per cent to 50 per cent in nine months, adjusting macroprudential policies to further tighten credit conditions.
A sharp decline in inflation ensued. This June, month-on-month inflation dropped to 1.6 per cent (which equates to 21.6 per cent if annualised), which is likely to become the new normal, in our view. Inflation steadying at these levels would bring the Turkish real interest rate to around 20 per cent.
Steadier prices are crucial for lira stabilisation, encouraging further de-dollarisation from locals and inflows from foreign investors.
Indeed, currency depreciation and high interest rates have already brought the current account deficit from 5.5 per cent of GDP in the first quarter of 2023 to 2.8 per cent in the same period this year, with tourism revenues set to provide a further boost over summer.
Alongside the central bank tightening, the finance minister is pushing for a fiscal consolidation. In 2023, utility prices and consumption taxes were hiked to this end, which alongside lira depreciation, exacerbated the inflation problem in the short term.
However, new tax measures are focused on direct taxes, which tend to be disinflationary. Deficit reduction will also include some tough measures, like restrictions in public servant hiring for the coming years.
After many false starts in the past, the question on whether Erdoğan will “U-turn” on these orthodox policies remains. This time, however, the reforms seem to be based on solid ground. In our view, Erdoğan understands that lira stability is now correlated to his popularity.
Despite his previously unorthodox stance, the president is no stranger to the positive impact of orthodoxy on GDP.
During Erdogan’s first decade in power, to 2012, sensible monetary and fiscal policy supported a large surge in foreign investments. During the period, the economy expanded 64 per cent in real terms, leading to an increase in GDP per capita by 43 per cent.
This history can offer clues to the path forward. The 2002-12 growth bonanza happened after structural changes to the Turkish economy that took place post 1999 IMF-led reforms. The reforms were initially successful, allowing for a good trading opportunity.
But capital outflows from emerging markets during the dotcom bubble, coupled with local political instability, lowered confidence that the reforms would be fully implemented.
The true turning point happened at the end of 2001, after Turkey’s IMF programme expansion improved investor confidence. This coincided with the dotcom bubble deflation, driving capital away from the US and towards emerging markets, including Turkey.
Importantly, Turkey’s macroeconomic issues are much less acute than in 1999. Then, the country budget deficit reached 12 per cent of GDP, and currency depreciation was coupled with a large stock of short-term dollar debt. Today, Simsek’s measures aim to consolidate the deficit from a more manageable level, and most public debt is in lira.
The benign path entails Erdoğan convincing foreign investors that Turkey is once again an attractive investment opportunity. Taking steps to normalise relations with the EU, enforcing the rule of law and strengthening institutions would help do this.
More recently, Turkey has strengthened its connection with investors in the Gulf, who have increased their deposits with the Central Bank and provided other sources of support.
For now, it is too early to say whether the reforms will lead to long-term structural growth. But the signs are positive and for emerging markets investors like Ashmore, it is good to be back.
This article has been amended to clarify that Turkey’s deficit reduction will also include some tough measures, like plans to restrict public servant hiring for the coming years. Previously the article had referred to freezing public servant wages.
