Investors warn Turkish economy in for ‘tough period’ regardless of who wins election

Fund managers warn it will be a “grotesquely difficult” task to rebuild Turkey’s economy and regain credibility among foreign investors regardless of which party wins this month’s hotly contested election.

Kemal Kılıçdaroğlu, who is leading a coalition of six opposition parties, has vowed to undertake sweeping reforms to lure back foreign capital that has fled over the past decade if he unseats Turkey’s longtime leader Recep Tayyip Erdoğan in the presidential election on May 14.

But while fund managers say change is needed, some caution that, even if the opposition wins, investors will sit on the sidelines until the coalition shows it can bring about durable change.

Turkey has “a whole bunch of variables that are in the wrong place and getting them in the right place will be grotesquely difficult,” said Paul McNamara, an emerging markets-focused investment director at GAM fund manager in London. “Is the money out there? Absolutely yes. Will people be in a huge hurry to put it in? I don’t think so.”

The cautious sentiment from investors comes as Erdoğan fights his toughest re-election campaign after two decades in power. Polls show Kılıçdaroğlu and Erdoğan are locked in a very tight battle just days before the election, with voters pointing to the economy as central.

Erdoğan’s unconventional economic policies, including a longstanding objection to raising interest rates, helped send inflation soaring above 85 per cent in October, while the lira has tumbled almost 60 per cent over the past two years to a record low against the dollar.

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Concerns over Turkey’s economic trajectory and an ever-rising number of measures to relieve pressure on the lira have caused investors to flee. “This is a market that is almost completely abandoned by foreigners,” said Emre Akcakmak, a senior consultant at East Capital, a specialist emerging-markets fund manager.

Less than 1 per cent of Turkey’s domestic government debt is owned by foreigners, down from around a quarter a decade ago. The banking system, including domestic banks and Turkish affiliates of foreign lenders, now owns nearly 80 per cent of the local sovereign debt stock from less than 50 per cent in 2013, data from the finance ministry shows.

A similar trend has taken hold in the Turkish equities market, where international investors have yanked $7.3bn over the past decade, according to Goldman Sachs.

“Investors’ allocations to Turkey have rarely been lower,” said Kieran Curtis, head of emerging-market local currency debt at UK-based asset manager Abrdn.

Akcakmak said Turkey is nearing a “breaking point” under current policies, particularly since the central bank’s foreign currency reserves have been “nearly depleted”.

The central bank has burnt through reserves, economists say, as policymakers have tried to prop up the lira. Net foreign assets, a proxy for the size of Turkey’s foreign currency war chest, are minus $10bn even after accounting for more than $30bn in funds borrowed from local banks through short-term borrowing known as “swaps”, data from Turkey’s central bank and Goldman Sachs shows.

Some analysts expect Erdoğan could shift towards a more conventional economic policy if he wins the election. This speculation has been bolstered by the president’s recent courting of Mehmet Şimşek, a former deputy prime minister who was well regarded by foreign investors but exited government in 2018 when Erdoğan installed his son-in-law as finance minister.

“If [Erdoğan] was to change his view, and adopt a more conventional policy, it will be very well received,” said a senior EM-focused capital markets banker at a big Wall Street bank, adding that if Erdoğan wins, he may “realise now is the time he can pivot and re-attract foreign funds.”

Curtis added that “to the market, it doesn’t matter a lot who is doing the policy, it’s a matter of them doing the policy.”

Kılıçdaroğlu told the Financial Times last month that one of his priorities would be turning around Turkey’s economy, including establishing an independent central bank rather than the current system in which Erdoğan effectively controls interest rate policy.

Investors worry that a big policy adjustment, while important in the long-run, will be painful in the short-term. Curtis said many investors expect Turkey’s benchmark interest rate will need to be boosted over time from 8.5 per cent today to as high as 40 per cent to show that the country is making a credible effort to tame inflation.

A rise in interest rates of that magnitude would spark a big sell-off in Turkey’s domestic bond market, Curtis said, something that would be “pretty terrible for overseas investment” in the short-run. “You have to be patient,” he said. McNamara said this process would also exert pain on domestic banks since they now own such a big share of local bonds.

The Erdoğan administration has also increasingly relied on other tools to stabilise the lira, including introducing special savings accounts in 2021 that reimburse depositors if the lira weakens against foreign currencies. These accounts have been instrumental in keeping local residents from buying dollars, and many analysts and investors say this is a big reason why the lira has been broadly stable in recent months.

These accounts hold $102bn, according to the Turkish bank regulator, and economists say they could pose a big risk to the government’s budget if the lira rapidly depreciates, since depositors would be reimbursed if the currency were to fail. Similarly, unwinding these accounts could prove difficult because holders could choose to purchase dollars and euros en masse, which would send the lira plummeting.

“All the steps the opposition [would] pursue (to repair the economy) are going to create bumps on the road,” said Akcakmak, who added that investors are “awaiting turning points on the economy and economic management” before they decide to come off the sidelines.

“Whatever happens it’s going to be a tough period for Turkey,” Curtis said.