Ankaras About-Face

Turkey found itself at a crossroads in November as pandemic-related shutdowns threw the country into an economic crisis fueled by negative real interest rates and continued short-term borrowing from abroad.

But in early February, the lira reached a six-month high against the US dollar. Some $15 billion had flowed into Turkish assets over the previous three months. Manufacturing is booming on the back of record exports, which rose 2.5% to over $15 billion in January, while imports, hobbled by low domestic demand and rising prices, fell more than 5.5% to $18 billion. By the end of the month 7 million Turks had been vaccinated, putting Turkey’s vaccination rate on par with Denmark’s, ahead of Germany, France and Spain.

But it had not been an easy journey from November to February. With the lira down by more than 30%, Finance Minister Berat Albayrak, who had spent almost $140 billion unsuccessfully defending the currency, resigned, followed by Murat Uysal, governor of the Central Bank of the Republic of Turkey (CBRT). The new team—Lufti Elvan, finance minister, and Naci Agbal, governor at CBRT—did an about-face, raising interest rates by 675 basis points, followed by a further 200bp hike in December, to 17%. With these moves, they indicated they would follow the orthodox fiscal and monetary policies that markets and international lenders had been calling for—although there was no word on the structural policy changes that the International Monetary Fund (IMF) has been urging.

Despite these shifts, Turkey’s government is still doing plenty to give investors the jitters. President Recep Tayyip Erdoan’s assertive foreign policy has placed Turkish troops on the ground in Libya, Qatar, Syria and Iraq. It provided strong support to Azerbaijan in its November war with Armenia, while a diplomatic standoff in the eastern Mediterranean over territory and energy reserves have strained its relations with Greece, Cyprus and the EU. All this comes at a time of weakening international stability, with Turkey facing sanctions from the US for purchases of Russian military equipment and from the EU over drilling in the eastern Mediterranean.

Domestically, actions taken by Ankara against non-governmental organizations (NGOs) have prompted wider worries about the state of democracy and efforts to monopolize power by the governing Justice and Development Party (AKP), which currently has less than 40% support amid party defections and a worsening economic outlook.

Ian Bremmer, head of Eurasia Group, tags Turkey as one of this year’s Top 10 Global Risks. “Economic setbacks and Turkey’s poor Covid-19 response will leave Erdoan struggling to win back voters disillusioned with his two-decade rule,” Bremmer said in an early-January Zoom meeting with investors and journalists. “These dynamics will stoke social tensions, prompt a crackdown against the opposition and encourage Erdoan in more foreign policy adventures to fuel nationalism and distract supporters.”

Opposition-party leaders put the situation even more starkly: “Turkey is no longer a democratic state. There is no real rule of law or separation of powers here,” says Ahmet Erozan, deputy head of the IYI (Good) party and a member of the Nation Alliance coalition that took control of Istanbul, Ankara and Izmir from the AKP-dominated People’s Alliance in 2019’s municipal elections.

Year of the Reset

So, can 2021 be the Year of the Reset, when the economy—and foreign policy, foreign direct investment (FDI) and social policy—get back on track? In his first major speech of the new year, Erdoan called for restoration of mutual trust between Turkey and the EU, announcing that he “wants to turn a new page with Brussels … with the Customs Union updated and steps taken in membership negotiations.” Close observers also note that a Joe Biden administration might ease sanctions in exchange for Ankara’s adopting a more “mainstream” international profile.

“Turkey might make more congenial noises, but don’t expect any real foreign policy change, because neo-Ottomanism has worked,” says Dimitar Bechev, a visiting scholar at Harvard University’s Center for European Studies who is writing a book about Erdoan. “Turkey is now a real force to be reckoned with in countries where it previously had not much of a profile. Economic policy is another matter; there has been a change, but whether this persists depends on whether Erdoan is happy to continue delegating power.”

Despite a slumping economy and a worsening of the Covid-19 pandemic in the early months of this year, the CBRT insists that monetary policy will remain tight until 2023, pointing to the need to reduce inflation—officially 15%, though some say this understates it—to below 10% by year end.

“For now at least, we remain comfortable that [the shift to orthodoxy] will stick,” says Jason Tuvey, Turkey analyst at Capital Economics. He expects a further strengthening of the lira to 7.0 against the US dollar, from 7.4 in early February.

But with Turkey keen to kick-start growth, even the IMF is calling for an easing of fiscal policy. In its latest annual review, the fund suggested Ankara increase spending by around $7.5 billion, equal to 1% of GDP, to help households battered by the pandemic. This would boost growth, which the IMF expects to hit 6% this year—well above the 3% to 4% consensus of other forecasters—and 3.5% in 2022.

The IMF’s positive outlook is echoed in its revised forecast for 2020, which find 1.2% growth against an earlier forecast of a 5% contraction, thanks to an unexpectedly strong, credit-fueled third quarter.  

“The government’s strategy of using stimulus to generate a strong recovery from the pandemic does seem to have paid off,” says Roger Kelly, lead regional economist for the European Bank for Reconstruction and Development (EBRD) in Istanbul. He is revising his 2020 forecast upward, “although it came at a heavy price in terms of macroeconomic stability and reserves.”

Thanks to market pressure and resistance within the AKP, which had been unhappy with the previous policy approach, “there has definitely been a reset,” Kelly says, “as well as better communication by the CBRT.”

But given Erdoan’s track record of interfering in economic policymaking, Douglas Winslow, a director of Fitch Ratings’ sovereigns team, says it will take time to rebuild credibility, not to mention the CBRT’s battered reserves. “The CBRT has limited independence,” he says, “and the combination of the government’s current targets for GDP growth (5% in 2022-2023), inflation (4.9% by 2023) and the current account (in balance by 2023) lacks credibility. How policymakers will resolve the trade-offs over time between boosting economic growth and reducing external and domestic imbalances remains unclear.”  

The impact of Covid-19 and concerns about the domestic policy environment triggered a plunge in FDI and portfolio inflows for much of last year, the former dropping to an unprecedentedly low 0.55% of GDP, while the first 11 months witnessed portfolio outflows of $10.6 billion. The proportion of nonresident investment in lira government bonds fell to 3.5% in October against 10.5% at the beginning of 2019 before picking up again to 5.5%.

“Ensuring macro stability is key to encouraging capital inflows, including FDI,” Winslow argues.

Ankara faces pressure to improve the business environment, in particular. The latest World Bank Governance indices, including such factors as the rule of law, control of corruption and government effectiveness, show a marked decline for Turkey. The latest Transparency International Corruption Perceptions Index ranks Turkey 86 out of 180 countries, citing, among other things, Ankara’s ongoing crackdown on NGOs and poor transparency in the granting of state tenders.

On the plus side, the government has been streamlining Turkey’s famously onerous bureaucracy. The World Bank’s latest Doing Business Survey puts Turkey at 33 out of 190 countries, compared to 69 in 2017, and commends the government for improving, among other things, its tax-payment and construction-registration procedures. Ankara has said it wants to reach the Top 20 by 2023.

One of Ankara’s first priorities, assuming it can maintain policy stability, must be boosting FDI and stabilizing net capital inflows to help bolster reserves, close observers say. “I’m generally optimistic about 2021,” says the EBRD’s Kelly. “There have been strong capital inflows since last November. And although as ever, Turkey remains vulnerable to external events, investors and the money markets are less nervous than they were because of the new policy stance.”

Fitch, which revised the outlook on its BB- rating from stable to negative last August, also seems cautiously optimistic. Winslow forecasts real interest rates of 2.5% by the end of this year, close to where they are now, at 2%. “Beyond the near term,” he says, “there is concern about the durability of policy settings. We’ll be looking very closely for any signs they might be changing.”