Turkey: Weak liquidity is the biggest challenge in the short term for newly re-elected President Erdogan

Event

In a polarised country, President Erdogan won the second round of the presidential elections with 52.1% of the votes, extending its 20-year rule for a new five-year mandate. His opponent, Kemal Kilicdaroglu conceded defeat, paving the way for a smooth inauguration of Recep Tayyip Erdogan. President Erdogan’s Justice and Development Party (AKP) and its allies won the majority of the seats in parliament (323 out of 600 seats).

Impact

The presidential and parliamentary elections gave President Erdogan a strong mandate to pursue his policies in a country where the constitution – amended in 2017 – grants high executive power to the presidency. In the coming days, Mr Erdogan is likely to name his cabinet and define the direction of his economic policy. In the meantime, the Turkish lira depreciated sharply (see graph below, where the rising line represents the depreciation of the Turkish Lira against the US dollar). The Turkish authorities are expected to pursue their unorthodox monetary policy. In other words, the (non-independent) central bank is expected to keep its benchmark interest rate low, while implementing other policy measures to stem exchange rate and inflation pressures.

While the Turkish economy has been very resilient in the past, the country’s very low liquidity is the biggest threat in the short term. Indeed, gross foreign exchange reserves are under severe pressure (see graph below) as the monetary authorities intervened in the exchange rate market to stabilise the Lira ahead of the elections. In order to stem liquidity pressure, the central bank borrowed externally, raising the monetary authorities’ short-term external debt from USD 26 bn in December 2021 to USD 39.3 bn in March 2023. Moreover, the short-term external debt of the whole economy is high. Last but not least, amid low foreign direct investment inflows, the country is heavily reliant on other types of external funding to finance its large current account deficit. In this context, attracting enough external financing will be key to avoid a balance of payment crisis. Despite the strengths of the Turkish economy – such as moderate public and external indebtedness and a well-diversified and dynamic economy – attracting external financing has become more challenging and expensive in an environment of tighter global financial conditions. Restoring macroeconomic policy credibility would help attract Western financing and investments. Otherwise, Turkey might try to rely on financial support from other countries (e.g. swap lines with China, Qatar and the United Arab Emirates). 

In the coming days, President Erdogan will appoint his new cabinet. Even though its members might have strong orthodox policy credentials, it remains to be seen whether President Erdogan will allow the implementation of more orthodox macroeconomic policies. Indeed, in November 2020, Naci Agbal, an orthodox, was named as central bank governor and dismissed in March 2021 after he raised the interest rate to stem inflation pressure. Since then, the key benchmark interest rate has been cut, inflation has soared and exchange rate has sharply depreciated. Only recently, inflation and exchange rate pressures have eased amid heavy intervention. This episode highlights that to restore macroeconomic policy credibility, it will be key to implement credible and orthodox policies for a long-lasting period.

Looking ahead, Credendo’s country risk classification outlook remains very uncertain. Without the implementation of credible macroeconomic policies, which would – among others – restore liquidity, the ST and MLT political risk ratings (both in category 5/7) are likely to be downgraded to category 6/7. The main concern relates to the weak liquidity, a structural weakness of the Turkish economy. The country’s solvency and public finances remain good despite a recent deterioration of the public finances, which was notably driven by large fiscal spending before the elections (e.g. higher wages, free gas for a month) and large election pledges.

The business environment risk is likely to remain in the lowest category G/G. Indeed, the exchange rate is expected to remain under severe pressure, whereas inflation – despite its recent decline– remains very high and is likely to increase again amid renewed exchange rate pressure. Despite the devasting earthquakes in February, economic growth remained strong in the first quarter of the year, boosted by large public spending, ultra-loose monetary policy and reconstruction efforts. If macroeconomic policies become less supportive, economic growth is likely to moderate in the coming months.

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