Turkey: A return to more orthodox monetary policy improves the country risk outlook, but will it last?

A more orthodox monetary policy

Following his re-election in May 2023, President Erdogan appointed a new, more orthodox, economic team led by the Minister of Finance, Mehmet Simsek, and central bank Governor, Hafize Gaye Erkan.

Since taking office, Ms Erkan has implemented a more orthodox monetary policy by gradually increasing benchmark interest rates to 40% (up from 8.5% in early June 2023), allowing the Turkish lira to depreciate, but also by gradually removing some unorthodox financial instruments (such as an FX-protected deposit scheme). The return to a more orthodox monetary policy is putting heavy pressure on the Turkish lira, which depreciated sharply. As a result, inflation (see graph below) is once again on the rise.

Fiscal deficit expected to be higher in 2023 than in the 2021–2022 period

Since taking office, Mr Simsek has tightened fiscal policy by, among other things, increasing the rate of VAT, hiking tax on fuels and adopting cost-cutting measures in the public sector. Despite these measures, the aggregated fiscal deficit (in Turkish lira) is expected to be larger in 2023 than in previous years (see the graph representing the aggregated fiscal balance per year). This is largely explained by high fiscal spending before the parliamentary and presidential elections (May 2023), and the reconstruction costs after the devastating earthquake of February 2023. Despite the larger deficit, public debt should remain moderate, at 35% of GDP at the end of 2023. Looking forward, the overall public deficit (relative to GDP) is expected to decrease despite an expected increase in the interest payments-to-revenue ratio.

Slowdown in real GDP growth expected

In the past few years, real GDP growth has been very strong and resilient to external shocks (Covid and war in Ukraine). It was boosted by a very expansionary monetary policy that boosted credit growth and created large macroeconomic imbalances such as high corporate debt, heavy pressures on foreign exchange reserves and continued pressure on the Turkish lira. In this context, the implementation of less expansionary fiscal and monetary policies since President Erdogan’s re-election would inevitably lead to a slowdown in economic growth and a welcome rebalancing of macroeconomic conditions. However, it remains to be seen to what extent the authorities will accept the slowdown, ahead of the forthcoming municipal elections in March 2024. More broadly, it remains to be seen whether President Erdogan – who is opposed to high interest rates – would ultimately agree to a more orthodox monetary policy being implemented for an extended period. Indeed, in recent years, President Erdogan had already nominated a more orthodox central bank governor, only to sack him later.

Implementing orthodox policies for an extended period is essential to reduce imbalances

The implementation of orthodox policies for an extended period would continue to gradually reduce domestic and external imbalances. The current account imbalance is already reducing, with even a temporary current account surplus in June and September, as imports grew less rapidly than exports. Gross foreign exchange reserves are again on the rise (as shown in the graph on the liquidity position) while the central bank’s short-term external debt has stopped rising. Indeed, the central bank has ceased to borrow externally in the short term (and in the domestic banking sector), to boost its foreign exchange reserves. This should gradually lead to an improvement in liquidity position and boost foreign and domestic confidence (which should reduce gold imports, which are used by residents as a safety net against depreciation of the lira). Such an improvement, if it continues, would incline Credendo to upgrade its short-term political risk, which represents the country’s liquidity.

Strong solvency

Turkey’s solvency situation is good. Indeed, the gross external debt and debt service ratios are moderate. Despite the recent deterioration, public finances remain sound. Moreover, the economy is well diversified, even though tourism accounts for almost 12% of current account receipts. The main Achilles heel remains the high reliance on short-term external borrowing and capital inflows. Other weaknesses stem from high corporate indebtedness. However, this has decreased markedly recently, and is largely owned by the banking sector. The latter is largely financed by external loans, even if the net foreign asset position of the banking sector relative to GDP has improved. In this context, any upgrade of the medium- to long-term political risk depends largely on continuing to implement more orthodox policies. As real GDP growth is slowing down and inflation is rising, a major test will be the forthcoming municipal elections. As a matter of fact, given the high external financing requirements and a heavy reliance on short-term external financing, any return to unorthodox monetary policy would lead to renewed capital outflows and renewed pressure on gross foreign exchange reserves. If this materialises, the country risk classifications might be downgraded.

Analyst: Pascaline della Faille - P.dellaFaille@credendo.com