Turkey After the Coup: Three Things to Watch Out For

• Following the attempted coup in Turkey on 15th July, we examine afresh the pressure points in the Turkish economy, and note three themes investors will be watching with interest.

Following an attempted coup on Turkey’s president Erdogan on 15^th July, the spotlight has turned to the government reaction and the effect this will have on Turkey’s politics, society and economics.

Erdogan wasted no time in using the coup (“a gift from God”) as a chance to tighten his grip on power. He has called a “state of emergency”, arrested 18,000 people, sacks education workers and threatened the reintroduction of the death penalty.

There have also been significant market implications, with spikes in government bond yields, and significant movements in equities and the currency in the wake of the attempted coup. The political gyrations have the potential to destabilise an economy with otherwise strong fundamentals: a projected cumulative real GDP per capita growth of 10.27% up to 2020 (according to the IMF), an undervalued currency, and increasing integration with the European Union. So far, markets remain sanguine, with the lira recovering its pre-coup levels. But how could this be destabilised? And where are the biggest economic threats?

1. Threats to Central Bank Independence

Although Turkey is a long way from the dark days of the early 2000s, it would be premature to say that inflation is fully under control. A significant risk in this department is potential interference of Erdogan in the making of central bank policy: as a long time enemy of high interest rates (advancing the theory that high interest rates lead to higher inflation) Erdogan has attempted to influence the central bank in a dovish direction before (this may have been behind the appointment of current Central Bank of Turkey (CBT) governor Cetinkaya). Needless to say, with inflation still consistently above target, the potential risk of economic instability is significant. An effective interest rate cut in the wake of the coup has been followed by further pressure from Erdogan for interest rate cuts. Investors will be watching CBT policy closely going forward.

2. The current account

A long-standing weakness of the Turkish economy is its reliance on the “kindness of strangers” to fund its current account deficit (to the extent that European remittances cannot). Turkey was helped significantly by the recent collapse in oil price, which has facilitated a rapid improvement in the current account in 2015. However, subsequent recovery of oil prices (and increases in machinery imports) has nearly reversed this. Turkey’s external position means it remains vulnerable. A reassessment of Turkey’s attractiveness to international investors could see a rapid correction, resulting in currency depreciation and a rapid fall in imports.

3. Dollar-denominated debt

If either of these come to pass, Turkey could see significant currency depreciation. The big risk for Turkey is that it has relatively high levels of dollar-denominated debt; if the lira depreciates rapidly against the dollar, this will have a highly adverse effect on Turkish corporates and the government’s fiscal position.

For now, these remain known unknowns and Turkey’s vulnerabilities need to be set beside strong long-term growth prospects, a cheap currency and enhanced prospects for carry in the wake of the coup. It is a known known, however, that any future developments in these areas will be of great interest to investors…