Emerging-market focus: Political limbo in Turkey following the failed coup

Economic outlook - 27/07/2016

Turkey has been caught up in a cloud of political uncertainty for some time now. Domestic assets will remain under pressure, although another overthrow attempt seems unlikely.

President Recep Erdogan and Prime Minister Binali Yildirim remain in place following the aborted military coup. The overthrow attempt met with little support from the people, who filled the streets in a show of defiance against the plotters. The experience served to strengthen President Erdogan and legitimise his efforts to modify the constitution from a parliamentary democracy to a presidential democracy. Such a change would give the president broader decision-making authority.

The government quickly regained control over the situation, but the political uncertainty is not over. It will affect the country’s growth outlook and the valuation of domestic assets, with investors demanding more in terms of risk premium. While the coup attempt was not expected, it is not an isolated event. Turkey has been fraught with political tensions for a long time. These tensions are evident at the international level (exposure to the political situation in the Middle East, likelihood of further terrorist attacks and the country’s role in the migrant crisis in Europe) and domestically (constitutional amendments desired by the AK Party, the chance of early elections and the Kurdish dilemma).  

These sources of instability weigh heavily on investment decisions concerning a country whose net foreign asset position is one of the weakest among the major economies. The government’s declaration of a three-month state of emergency and the spiral of arrests – mainly among civil servants, judges and teachers – create institutional uncertainty that will complicate economic matters and hold back investment. Nor will these developments help get the tourism sector – 4% of GDP and a key source of foreign currencies – out of its current rut.

The current account deficit has improved recently but remains high at 4.1% of GDP. This means that the country depends on foreign financing, which is mainly in the form of foreign bank loans along with bond flows.

While the consequences of the coup attempt remain to be assessed, the Central Bank of the Republic of Turkey (CBRT) reacted carefully by moderating its reflationary monetary policy. It trimmed its overnight lending rate by only 0.25% to 8.75%, which is a smaller cut than in recent months (-0.5%). The decision to keep key rates relatively high was aimed at stabilising the lira, which is needed to ensure foreign capital inflows. This monetary tweaking seems judicious given the low chances of another overthrow attempt. The upper ranks of the Turkish military were not involved in the coup, and the scope of arrests and suspensions – some 60,000 people are said to be affected – is certainly dissuasive. Once current tensions abate, selling pressure on the lira subsides and capital flows stabilise, the central bank will resume its monetary policy cycle.

Persistent worries and a shortage of foreign capital flows would eventually have a negative impact. The CBRT cannot afford to keep interest rates high for too long because of the dampening effect on private consumption and demand for credit. The low level of foreign currency reserves limits the scope for open-market operations, while high external debt is another constraint. This scenario would call for a significant cut to interest rates in order to boost domestic economic activity. Forex would be the adjustment variable in this case, as a sharp drop in the lira would spark inflation, cut into consumer spending and directly threaten GDP growth.

The shock of uncertainty following the coup attempt is bound to disappear sooner or later. That said, international investors will probably require a higher return to hold Turkish assets, as the political risk will remain more acute for a long time to come. President Erdogan’s ability to bring the situation under control was good news, but his insistence on expanding his own decision-making authority is fuelling fears of authoritarianism. This will destabilise the business environment and lead to a decrease in investment in the country.

Domestic assets are therefore expected to remain under pressure. Real returns on the bond market, for example, are certainly attractive compared to those of developed countries but are not much better than what can be found in other emerging countries with lower political risk. The boom in private debt in recent years raises two important questions – that of refinancing the loans and bad debts – especially since the banking sector accounts for 41% of the domestic stock index. Unfavourable comments by the rating agencies will not help matters.