Time to Settle Your Tab, President Erdogan

By David Austerweil
Deputy Portfolio Manager, Emerging Markets Fixed Income

Turkey’s May elections are the most important in a generation and will have a major impact on its debt market.

(UPDATE as of May 19, 2023) President Erdogan and his Parliamentary coalition significantly outperformed expectations in the first-round electoral vote with Erdogan’s vote share of 49.5% coming just 0.5% short of winning the Presidency in the first round. With 322 seats won, Erdogan’s People’s Alliance coalition won a majority of seats in Parliament. In contrast, Kılıçdaroğlu won 44.9% of the votes. With 5.2% vote share, Sinan Oğan came in third place. Almost all of Oğan’s voters would need to support Kılıçdaroğlu in the second round vote for him to win. Pre-election polling showed that only 60% of Oğan’s voters would support Kılıçdaroğlu in a second round vote making Erdogan’s re-election a near certainty.

The most likely post-election outcome remains an adjustment toward a weaker Turkish lira combined with fiscal consolidation. Turkey is dangerously low on foreign-exchange (FX) reserves and President Erdogan should be aware of this. The only objective of ongoing FX interventions and controls imposed by the central bank is to keep the lira stable before the election. Lira stability, however flimsily achieved, combined with a fiscal expansion that included sharply higher public sector wages and subsidies on energy costs, will help boost voting intentions for Erdogan’s ruling party. However, in order to secure future foreign funding for Turkey’s persistent current account deficit, the lira needs to become more competitive. After Erdogan secures a new 5-year term on May 28, his incentives will change toward stabilizing the economy in order to avoid a hard economic landing.

The Emerging Markets Debt team still finds value in long dated, low dollar price sovereign bonds. After the first round vote, spreads on Turkey 2047 widened by 150 basis points (bps). Foreign investors had reluctantly covered underweight positions in the months before the vote in order to not underperform the index in the case of an opposition win. The moment that hope faded, they cut their positions aggressively. If Erdogan makes the needed economic adjustment, the recent spread widening can be reversed. In the scenario where Erdogan is too slow to make the necessary economic adjustments, the low dollar price bonds should outperform high dollar price bonds at the front end of the curve where refinancing risk will need to be priced.

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(April 13, 2023) Deputy Portfolio Manager David Austerweil recently returned from Istanbul where he met with government officials, multilateral institutions and the private sector.

Turkey faces its most consequential elections in a generation on May 14 with President Erdogan facing the real possibility of losing power after 20 years. Post-election, whoever wins will need to make difficult economic choices to stabilize inflation, improve exchange rate competitiveness and rebuild foreign reserves.
In the most likely electoral outcome, Kemal Kılıçdaroğlu defeats President Recep Tayyip Erdogan in the second round on May 28 and implements orthodox economic reforms including large interest rate hikes. If his CHP led alliance also wins a majority in parliament, Kılıçdaroğlu promised to restore the parliamentary system of government in place before the 2017 referendum that created an executive presidency.
The Emerging Markets (EM) Debt team finds the most value in long-dated, low-dollar price Turkish sovereign bonds. In the event the opposition wins, there is room for significant total returns of more than 20%. Additionally, the EM Debt team will look to purchase local currency debt at Turkish lira levels above 30. If Erdogan wins, the low dollar price and limited foreign ownership will provide downside protection in a sell-off of Turkish sovereign debt.

Election Overview

On May 14, Turkish voters will go to the polls to elect both president and parliament to new 5-year terms. Out of roughly 55 million likely voters, there are 4 million first time voters and an additional 4 million voters who were displaced due to the earthquake, which makes accurate polling more challenging. With inflation currently running somewhere between 55% and 100% per annum, and an incumbent president who has been in power for over 20 years, the range of potential electoral and subsequent market outcomes is large.

The main presidential candidates are current President Recep Tayyip Erdogan, opposition leader Kemal Kılıçdaroğlu and Muharram Ince. Kılıçdaroğlu’s CHP party formed an alliance with a very diverse group of opposition parties whose main unifying factor is their desire to see President Erdogan out of power. He is a compromise candidate who has lost many previous elections to Erdogan and does not have a passionate base of support. He promises to be a transition president who will move Turkey back to a parliamentary system. Ince, who was CHP’s 2018 presidential candidate, broke with the opposition coalition and is likely to capture a sizable youth protest vote who do not feel represented by Kılıçdaroğlu’s candidacy.

In the most recent polls, Kılıçdaroğlu is polling close to 10 percentage points above Erdogan which, if it were to translate into realized votes, would give Kılıçdaroğlu a first round victory. However, since Ince is polling between 5% and 10%, he is likely to force a second round vote between Kılıçdaroğlu and Erdogan. The second round vote would take place on May 28 and the intervening two weeks would give President Erdogan a lot of room to recover lost votes. During this period, the results of the parliamentary elections will be known. If Erdogan’s alliance gains control of parliament, he may argue that giving the opposition the presidency would leave the country ungovernable. Alternatively, if the opposition controls parliament, they could try to limit Erdogan’s power to govern. Any outcome where the presidency and the parliament are controlled by opposing alliances would be inherently risky and unstable.

Before considering how the many potential electoral outcomes could translate into market scenarios, it is important to review the state of the economy given the large imbalances that have built up over many years. No matter who wins, the next president will need to pay Turkey’s deferred economic costs.

Macroeconomic Overview

Turkey has a low general government debt stock of just 31.7% of GDP for year-end 2022. In our cross-country analysis, this is over half a standard deviation better than the global average. Fiscal policy has also remained responsible with the government running primary surplus’ for more than a decade before moving to a modest primary deficit in 2019. This low stock and accumulation of government debt is the major positive when considering Turkey’s creditworthiness and gives Turkey room on its balance sheet to pay the cost of years of unorthodox monetary policy and micromanagement of banking regulations that have built up major imbalances.

The main causes of the imbalances are interrelated: ultra-easy monetary policy combined with off balance fiscal spending via state-owned banks helped fuel a large, persistent current account deficit driven by energy imports, domestic overconsumption and dollarization of domestic savings via gold imports. By keeping monetary policy loose and providing state subsidized loans in Turkish lira, the government indirectly increased import demand and allowed inflation expectations to become unanchored. The result of this policy is clear both in the very high level of foreign currency debt service relative to the economy’s ability to earn foreign currency (XDS/CAX in the below chart), in the low level of foreign currency reserves relative to imports (RES/IMP), and in the large current account balance relative to GDP (CAB/GDP).

Turkey Has Worse Than Average Liquidity Measures

Source: VanEck; IMF; World Bank; Moody’s; Bloomberg, as of December 31, 2022.

The timing of the upcoming election is so important because these imbalances have reached a point where the status quo is no longer sustainable and stark policy choices are required to avoid a balance of payments crisis. Last year, Turkey was able to finance its large current account deficit of 5.5% of GDP and even increase reserves by $12.3bn due to deposits into the banking sector from offshore, including friendly countries such as Qatar and Saudi Arabia but also by large unexplained inflows. However, the current account deficit is starting the year in even worse shape with a $9.8bn deficit for January alone, which was almost entirely financed by spending central bank reserves. Estimates for Turkey’s full year current account deficit are as high as $75bn, up from $48.8bn in 2022. Without additional financing from friendly nations and help from unexplained inflows, Turkey does not have enough usable foreign reserves at the central bank to cover the cost. Additionally, there is reason to believe that a lot of the financing received in 2022 was due to Erdogan’s geopolitical connections and may not be available heading into an election where he could lose his hold on power.

In that case, Turkey will need to have a more competitive exchange rate to reduce the trade deficit by compressing import demand and making exports more attractive. At current prices, it is more affordable for exporters to produce goods from European Union (EU) members Romania and Hungary than from Turkey.

Potential Paths for the Turkish Lira

Based on a real effective exchange rate, which is a measure of the competitiveness of a currency relative to its trading partners, the Turkish Lira has appreciated significantly since the shock depreciation of December 2021. The government was only able to anchor the exchange rate by creating a Turkish Lira deposit scheme that protected depositors from currency devaluation while also paying a high interest rate. Since the FX linked deposits paid higher interest rates than US dollar deposits in the banking sector, there was a large inflow into TRY deposits from US dollar deposits that supported the currency. While successful in stopping the exchange rate devaluation, the deposit scheme hides large costs for government finances should the Turkish Lira devalue.

The Turkish Lira Has Appreciated Significantly Despite Record Low Interest Rates

Source: JP Morgan, Bloomberg, as of March 31, 2023. Past performance is no guarantee of future results.

Since August 2022, the government has pursued a relatively stable exchange rate in nominal terms as it attempts to project the image of a strong economy to voters and bring inflation down from extremely high rates of over 50%. The longer this goes on, the costlier it becomes in terms of central bank reserves, and the more difficult it will become to control the devaluation once it finally arrives.

The electoral outcomes map directly into how this exchange rate adjustment will unfold.

If Kılıçdaroğlu wins the presidency in the first round, the central bank will most likely be unable to enforce the exchange controls recently created as the private sector expects the opposition to remove them and it will also stop selling US dollars to defend a specific rate. There will be a two week period before the opposition will be able fill the central bank’s management with their own people. In this temporary power vacuum, the exchange rate could devalue precipitously with price action similar to that of December 2021. The main difference is that once value is restored to the Turkish lira, both local depositors and foreign investors will begin to convert US dollars to lira as the new government will immediately adopt orthodox monetary policy including a large series of interest rate hikes to attract foreign capital to the lira.

If Kılıçdaroğlu wins the presidency in the second round, the adjustment becomes much riskier because both local depositors and foreign investors will need to wait for at least another two weeks before knowing the results and creating a policy anchor will become costlier. The larger the initial devaluation, the higher the burden to the government for paying the FX-linked deposits and phasing out the scheme.

While Erdogan isn’t polling well enough to win in the first round, there is still a clear path for him to win the presidency. If the Erdogan’s alliance wins a majority in the parliamentary elections and there is a second round vote for the presidency, Erdogan can argue that it is too risky for Turkey to have a divided government and that voters should switch from Kılıçdaroğlu. In this scenario, Erdogan’s government would most likely attempt to continue down the current policy path with a more gradual approach to release exchange rate pressures which would raise the likelihood of a disorderly adjustment in late 2023 or early 2024.

Where We See the Most Value

Due to the overvaluation of the exchange rate, there currently aren’t any opportunities to invest in local Turkish assets. If the opposition were to win, we would monitor the devaluation closely and look for levels of Turkish lira above 30 to build long positions in local inflation-linked bonds. The opposition will raise interest rates substantially undoing Erdogan’s failed experiment in ultra-easy monetary policy, but we are skeptical they will hike rates enough to create meaningfully positive real interest rates as they do not want to harm the economy and banking sector too much. There is an additional catalyst for inflation-linked bonds if the Turkish government’s statistics agency were to restate inflation higher under an opposition government as there are concerns about Erdogan’s government manipulating the inflation data to appear lower than reality.

Going into the election, we see the most value in long dated, low dollar price Turkish sovereign bonds. In our investment process, these bonds deserve a high allocation considering Turkey’s fundamentals. Additionally, under a win by the opposition, spreads could tighten by 150 basis points (bps) or more as foreign investors are underweight Turkish credit and will need to add positions while the government is undertaking meaningfully positive reforms.

In the scenario where Erdogan wins and there is policy continuity, these bonds should also outperform due to their relatively low US dollar price of 70. In this scenario, we would evaluate if it makes sense to continue to hold the position depending on the future policy stance of the government.

The Spread on Turkey 5.75 47 Remains High Relative to History and the Price Remains Far Below Par

Source: JP Morgan, as of April 7, 2023. Past performance is no guarantee of future results.

Originally published by VanEck on May 19, 2023.

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