The old city of Istanbul is a fascinating place. It is easy to be transfixed with the narrow, cobblestone streets. The majestic Hagia Sophia and the iconic Blue Mosque are breathtaking. The city’s history is ancient, and I have loved learning more about its interesting history. Istanbul is a remarkable combination of ancient and modern.
Ali Koc, managing director of Kocunix, met me at my hotel in the old city. We drove all over the city, over to the Asian side of Istanbul, and then back to the financial center on the European side. It is a vibrant, modern city. The restaurants, malls, and offices could just as easily been found in a major city in Europe or the U.S.
While in the Asian section of Istanbul, Ali and I had the chance to meet with Selim Cakir, chief economist at Turkish Economy Bank. Selim’s background is impressive—he spent several years as a senior economist at the International Monetary Fund in Washington, D.C. The previous day, he had been in Turkey’s capital Ankara in a meeting with Turkey’s finance minister.
Turkey has made great progress since the banking crisis of 2001. Turkish officials learned several lessons, and they have put their fiscal house in order. They also create strong supervision of the banking sector. Other reforms have taken place, including the independence of the central bank.
In practice, markets have some question about the bank’s independence. (It doesn’t help when the Turkey’s president suggested that defending interest rates at current levels is tantamount to treason). The concern about political pressure on the Bank of Turkey undermines the confidence of financial markets. While the central bank targets 5% inflation (still too high), the actual inflation rate has remained around 8% or higher. High inflation undermines competitiveness, confidence and real returns.
Although growth is projected to be around 3% in the coming years, the current account has doubled since 2009. This makes Turkey more vulnerable to changes in risk sentiment and to the Federal Reserve’s rate moves.
There has been a clear sense that Turkey had taken some steps back in reforms, monetary independence, and in legal protection. It is almost as if the country was headed for a slow motion crash, and many investors thought that they could simply jump off before the crash.
Turkey had elections on June 6th, and President Recep Tayyip Erdogan’s ruling AKP party lost the majority it had held for more than 12 years. While uncertainty reigns as coalition talks continue, the consensus view is that Turkey is better off than it was on June 6th prior to the election. If a coalition government is formed, there is likely to be more accountability and more transparency. A coalition government would likely give a freer hand to the central bank. Selim felt that there are good economists in both parties, and he is cautiously optimistic about a grand coalition.
It is worrisome that while leaders in both parties seem to want a coalition, Turkey’s President seems to be fighting against an agreement. The chances of a failure are not small, as Selim put the chances of a new election at 35%-40%. However, it is unclear that a new election would bring about a different result. Also, Moody’s country credit rating review will happen in August, and it is likely that the Federal Reserve will raise rates in September. If there is no government in place, the risks of an “accident” increase. While there are the known unknowns, political uncertainty increases the risk of “unknown unknowns” (Syria?).
While the Turkish Lira has devalued over the past year (10% in 2015), it has done little to improve Turkey’s global competitiveness because inflation has remained high (real depreciation is not that great). Lower oil prices are hurting countries that import from Turkey (Iraq used to be #2, and Russia was high on the list).
We talked about the importance of price stability, and referred to the recent example of India. Increased “inflation-fighting” credibility has been welcomed by the Indian economy and by financial markets. The same would be true in Turkey if the central bank was allowed this freedom.
Long-term, Selim was very positive about Turkey’s prospects. Strategic geography, a less indebted government, favorable demographics, and an emerging middle class are fuel for long-term growth. For example, if sanctions were reduced or eliminated in Iran, Turkey is positioned to benefit. While financial risks are real in the short-term, favorable resolution will position financial markets for long-term growth.
Special thanks to Brennan Staheli, Kailey Battaglia, and the Lunt Capital team for their contributions to this report.