Turkish President Recep Tayyip Erdoğan is short on time to use the government’s fiscal and monetary space to shore up support for his government as a disruptive rebalancing of the economy looms, hence his decision to hold elections earlier than expected.
While advancing the presidential and legislative polling date to May from June is partly politically motivated to limit opposition parties’ ability to capitalise on their lead in opinion polls (Figure 1), increasingly interventionist economic policies are weakening one of the pillars of Turkey’s (B-/Negative) credit ratings – relatively robust public finances.
The country’s post-election economic direction is uncertain, but current policies are increasing the cost of future adjustments, such as the recently announced early retirement plan, which will have a long-term negative impact on the government debt-to-GDP given Turkey’s ageing population from current low levels.
Figure 1: Trailing in the polls: average voting intentions July 2018 to Nov 2022
Growing imbalances complicate task of steadying economy after elections
The next government faces difficult economic and political choices: either the administration aims for an orderly but economically painful adjustment through a return to more orthodox policies to tame inflation and restore foreign investor confidence or it stays the current course and risks a sudden and disorderly one through a balance-of-payment crisis.
The banking sector is where investors should be alert to signs of growing economic stress – before the elections and after.
Ankara’s reliance on domestic banks to provide hard currency to the central bank and absorb government debt has been increasing as foreign investors have cut exposure to the Turkish debt markets.
Turkish banks have managed to secure foreign financing in the past and rolled over most of their external debt even during the 2018 lira crisis. However, banks’ refinancing risks have increased further as macroeconomic imbalances grow as a result of the government’s unorthodox policies.
Banks’ reliance on central bank for FX liquidity increases refinancing risks
About half of banks’ available USD 90bn foreign-currency liquidity is parked at the central bank, mostly through foreign-currency swaps (Figure 2). So, in case banks need to repay significant amounts of foreign-currency debt or deposits in a stress scenario, they would need to access this liquidity. Banks’ ability to do so is uncertain, as it would pressure central-bank reserves. In addition, expansionary economic policies are feeding into Turkey’s current-account deficit, which we estimate at around USD 40bn in 2023. This exposes Turkey to changes in investor sentiment, especially given tighter global financing conditions.
Figure 2: Turkish reserves are near all-time lows when swap liabilities with banks are deducted
Source: Turkish Central Bank, Scope Ratings calculations
The central bank has implemented new regulations requiring banks to buy more government debt to reduce spending costs to the government in the pre-election period, with 10-year benchmark yields now around 10%, not far away from that of EU members in Central and Eastern Europe, where inflation is, however, running at a fraction of Turkey’s 64% in December. The banking sector currently holds 77% of the Turkish government’s USD 100bn domestic debt stock.
Unwinding this closer relationship between sovereign and banking-system creditworthiness will not be easy either. Any monetary normalisation after the elections could generate sizeable losses for banks’ security portfolios. Figure 3 displays the extent to which Turkey’s real policy rate is in negative territory when compared with that of other emerging markets.
Figure 3: Real policy rates*, as of December 2022
Source: Macrobond, national central banks and statistical offices, Scope Ratings calculations; *Nominal policy rate minus annual core inflation.
Should economic policies change following the upcoming elections to centre more on price stability, this would be positive for Turkey’s long-term credit ratings, despite an initial likely slowdown in the economy. But addressing significant macroeconomic imbalances would take time even assuming improved economic policymaking under any new leadership.
Contributing writer: Matthew Curtin