President Recep Tayyip Erdogan achieved a double victory in the Turkish presidential and parliamentary elections on the weekend, winning 53% of the vote. Following this election result, the lira appreciated more than 3% on Monday. There was renewed optimism brought on by an end to the political uncertainty that has been present in the run-up to the election. However, the gains seen due to a supposedly more stable political landscape were quickly reversed. The question that now remains for investors is whether the lira will see further gains or whether it will continue on the downward trajectory. This year alone, it has seen a 19% depreciation. It is the second worst performing emerging market currency after the Argentinian peso.
There are many reasons for the lira’s disappointing performance this year: double-digit inflation, debilitating external imbalances, general weak sentiment towards emerging markets and capital flight. However, there is one over-riding factor that will be crucial in determining the future performance of the lira; central bank independence.
Erdogan has remained strong in his belief that interest rates must be lowered in order to support growth. However, the Turkish economy is currently incredibly overheated and lowering rates could quickly lead to a vicious cycle of hyperinflation, currency depreciation and foreign investors fleeing from the country’s assets. Prior to the election, the central bank has managed to parry Erdogan’s attempts to impose an inflationary monetary policy. Now, though, after his recent win, these attempts may be much less effective. Due to Erdogan’s victory in both elections, and the constitutional reforms he previously introduced, he will now sit in a ruling position where he holds immense powers. It would be naive to believe that a man who has so fervently campaigned for looser monetary policy would not seek to pursue this goal when he has recently been endowed with powers that could potentially strip the central bank of its independence. There are no indications from the election that suggest there will be a new macroeconomic policy framework position from Erdogan.
So what will be the impact on Turkish assets? Firstly, the lira will most likely continue to aggressively depreciate due to the threat of lower interest rates. Even if Erdogan does not overtly commit to lower rates the lurking threat of such a policy will keep the foreign exchange market in a state of uncertainty which will not be supportive to price stability. Furthermore, due to the weak sentiment in emerging markets, in general, it is likely that any sell-offs will be accentuated for Turkish assets due to the domestic situation. Moreover, there will be a substantial amount of Turkish companies that will have borrowed heavily in dollars and euros which means that if the lira does depreciate then these debts will become much more burdensome and therefore there could cause contagion in equity and corporate debt markets.
Overall, the previously stated factors coupled with a strengthening dollar seem to corroborate the notion that a long USD/TRY position is perhaps a trade that may start to recover some of the losses that emerging markets have caused so far this year. However, for those that prefer high-risk strategies; Turkish external credit is now very attractively priced relative to other emerging market peers.
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