A new era for the Turkish economy?

President Recep Tayyip Erdoğan’s victory over the alliance of opposition parties in Turkey’s May elections, in which he secured another term as president and maintained his alliance’s majority in parliament, came as a surprise to many, as credible pollsters had forecast just the opposite. Investors had to quickly adjust their market positioning as a result. At the same time, Erdoğan was making rapid adjustments of his own, backtracking on his campaign promise that he would maintain the existing economic model, which has been a major source of financial instability over the past five years. His change was likely driven by the high likelihood of a balance of payments crisis — that is, an inability to redeem external debt or pay for imported goods. His only other options were to impose strict capital controls, a move that would be perceived negatively by both business owners and households alike or to sign a stand-by agreement with the International Monetary Fund (IMF), a dramatic policy shift with unmeasurable domestic and external political outcomes. Not wanting to go down these paths, Erdoğan retreated from the so-called “Turkish economic model,” at least temporarily or partially, and brought in a new economic team.

New economic leadership

Mehmet Şimşek was appointed as the new minister of treasury and finance. He had previously served as minister of finance between 2009 and 2015, when the ruling Justice and Development Party’s (AKP) economic policies were more market-friendly, and was subsequently promoted to the role of deputy prime minister, responsible for coordinating ministries and other departments related to the economy. In the aftermath of the failed coup attempt of July 15, 2016, the influence of Erdoğan’s son-in-law Berat Albayrak, then serving as energy minister, in the cabinet and state bureaucracy limited Şimşek’s power. He stepped down in 2018 and Albayrak became his successor. While both of the new right-wing parties set up by former AKP figures Ali Babacan and Ahmet Davutoğlu tried to court him, Şimşek did not join either of them. He was out of politics, managed to preserve his dignity, and maintained his relationship with Erdoğan.

Of Kurdish origin and a dual citizen of Turkey and the United Kingdom, Şimşek has a strong CV. He previously worked as an economist with the United States’ embassy in Ankara and as a market strategist for Merrill Lynch. He is currently an independent financial advisor for particularly Gulf investors. Şimşek is a proponent of mainstream economics and thus not a supporter of Erdoğan’s “unorthodox” economic theories. He is smart enough to know, however, that even if Erdoğan realizes he needs a fresh economic approach, he will not suddenly or completely change his personal beliefs. Therefore, Şimşek’s presence and authority suggest that while there will be a change in the current policies, the degree and longevity of those changes is uncertain.

There was a second major change to the economic team as well. Gaye Erkan, former co-CEO of the recently failed U.S. financial institution First Republic Bank, became the new governor of the Central Bank of the Republic of Turkey (CBRT). Erkan, born in 1979 and a dual citizen of Turkey and the U.S., is the first woman governor of the 93-year-old institution. She has a strong educational background both in Turkey and the U.S. During her business career, she has worked in risk management at Goldman Sachs and served as a board member at Tiffany & Co. Nonetheless, concerns over her role at First Republic Bank, where she worked from 2016 to 2021 and served as co-CEO in her last six months before quitting just 15 months before its bankruptcy, have overshadowed her other professional achievements. Some institutional investors have already filed a lawsuit naming her in an effort to win compensation for the losses they suffered when the bank collapsed. If this turns into an indictment, the governor of the CBRT could stand trial in a New York court.

But not all of the names on the economic team are new. As part of the reshuffle, Şahap Kavcıoğlu, previously the governor of the CBRT, was appointed the new chair of the Banking Regulation and Supervisory Agency (BRSA). Macroprudential policies have been widely employed in Turkey given Erdoğan’s strong position against the use of policy interest rates; the BRSA is the main body implementing these policies, particularly on the distribution and supply of loans. Kavcıoğlu is very close to Erdoğan’s son-in-law Albayrak and is a vocal supporter of Erdoğan’s unconventional economic views. During his time at the CBRT, the official consumer inflation rate peaked at 85.5% and the U.S dollar-Turkish lira exchange rate shot from 7.40 to 23.40 in just over two years’ time. His reappointment to another key post suggests that, despite the need for a change at the top to placate the markets, Erdoğan is satisfied with his performance.

Erdoğan remains a keen proponent of very low interest rates compared to realized and expected inflation rates, although he is also aware of the precarious nature of financial stability. Turkey will need to find new external debt channels since foreign exchange (FX) inflows, driven by bilateral political ties, do not meet the economy’s needs. Şimşek and Erkan have been brought in to address precisely this issue. At the same time, Erdoğan wants to keep economic activity strong, and thus the provision of cheap loans to the real sector will be crucial. Tight regulations obliging banks to hold government bonds make it easier to fund populist commitments, so Erdoğan will not let Erkan get rid of them quickly. The pro-growth stances of Vice President Cevdet Yılmaz and BRSA Chair Kavcıoğlu will likely offset the pro-investor policies of Minister Şimşek and Governor Erkan. The goals are to achieve strong economic output, reduce inflation, ensure looser capital restrictions, stabilize the exchange rate, and protect purchasing power while recovering from the damage done by the massive February earthquakes. Local elections are going to be held in late March 2024, and Erdoğan wants to take the metropolitan municipalities of Istanbul, Ankara, Antalya, and Adana back from the opposition. With less than 10 months until the elections, it will be difficult to realize all of these aims at the same time, especially as world economies lose momentum.

Difficult numbers and a challenging road ahead

As the key economic indicators make clear, Turkey is in a very difficult position. Short-term external debt (with less than a one-year maturity) has reached $203.3 billion, while the foreign trade deficit for goods and services is hovering at $39.4 billion. The CBRT’s gross gold and FX reserves are $98.5 billion, but when FX-denominated liabilities are deducted, net reserves are $-4.4 billion. When swaps with other central banks and commercial banks are omitted, this falls to $-60.5 billion, and when the Treasury’s $14 billion worth of FX accounts is also excluded, net reserves drop even further, to $-76 billion, the lowest figure to date. The central banks of Qatar, the United Arab Emirates, China, and South Korea have provided $23.7 billion via swap agreements, while Saudi Arabia, Libya, and Azerbaijan have $8 billion in deposits in CBRT accounts. The total deposits in bank accounts protected by the Treasury and CBRT against lira FX depreciation is $121.6 billion.

There is no need for international investors to carry out a speculative attack on the lira. Given the extremely low reserves, the difficulty of finding of new hard currency resources, and the record high trade deficit, the situation is already unsustainable. Şimşek and Erkan have a very difficult task ahead of them. The challenges they face include more than just Turkey’s domestic and external financial troubles: Erdoğan’s patience with their policies will also be a significant factor as well. If history is any guide, they may not be in office for long.

In November 2020, Minister Albayrak and CBRT Governor Murat Uysal were abruptly sacked and replaced by Lutfi Elvan and Naci Ağbal, both proponents of conventional economic policies. Governor Ağbal was fired without any real explanation by Erdoğan just four months later, and Elvan was eventually sacked in December 2021. Investors who bought 10-year government bonds when Elvan and Ağbal were first appointed lost nearly 30% of their portfolio in lira terms and 40% in dollar terms in just 10 working days. Thus, despite Şimşek and Erkan’s credibility, investors are likely to proceed carefully and be cautious with their money. At the same time, Erdoğan is clearly well aware of the parlous state of the economy and will likely try to remain patient for as long as possible. That may not be long, however: Erkan is the fifth governor and Şimşek the fourth finance minister in the last five years under the Erdoğan administration.

Clashing policies and three potential scenarios

Whose influence will prove more dominant in the end: Şimşek and Erkan’s pro-market policies or Kavcıoğlu and Yılmaz’s pro-growth ones? For now, the answer is unclear and much will depend on how investors respond. The first test will come on June 22, when the CBRT’s Monetary Policy Committee (MPC) meets with its new governor. There are three main scenarios for the following months. If the MPC decides not to hike rates or acts too timidly, the changes in the economic team will not have a successful outcome. A new currency crisis will likely follow and the country will end up imposing tight capital controls. On the contrary, if the MPC hikes the policy rate to at least 15% in its June 22 meeting and promises to make further hikes to 25% if necessary, then the policy normalization narrative will be more persuasive, at least for the coming months. The most likely scenario though is that the MPC strongly hikes rates in either one meeting or over the next two to three and then reluctantly opens the door for further increases if needed. In this scenario, a currency crisis is unlikely but the lira can be expected to depreciate further. Fiscal measures will be taken into account as well. The medium-term program and the 2024 budget draft, which will be released in October 2023, will be closely examined to see whether spending has slowed. However, neither fiscal contraction nor a rate hike above the inflation rate is likely, owing to Erdoğan’s influence and the rapidly approaching local elections in March 2024.

In conclusion, Turkey’s new economic team may take a more hawkish tone when it comes to tackling inflation and preserving financial stability through fiscal and monetary measures. However, investors and policymakers should not be naïve, as this approach will only be temporary or partial, aimed at winning the upcoming local elections. Less hawkish policies would be more acceptable for Erdoğan, but they may not be sufficient to keep the Turkish economy on track. At the end of the day, much will depend on timing and the magnitude of the moves made. Neither Şimşek nor Erkan nor even Erdoğan knows how this story will end, and external factors, like the deterioration of the global economy, may well have the final word.

 

M. Murat Kubilay is an independent financial advisor on the Turkish economy, a columnist in national media outlets in Turkey, and a Non-Resident Scholar with MEI’s Turkey Program.

Photo by ADEM ALTAN/AFP via Getty Images