The turmoil on both sides of the Atlantic has shaken Turkey, where the Istanbul stock exchange steadied on Tuesday, a day after recording a 7 per cent slump – the biggest drop in almost three years.

After initial heavy falls during early trading, Istanbul’s benchmark index finished up 1.3 per cent on the previous day’s close.

Still analysts say that beyond the worldwide flight to quality, fears about Turkey’s current account deficit and confusion over its central bank policy have eaten into confidence. Monday’s fall was the biggest in percentage terms since October 2008.

Investors have grown more concerned about the near term prospects of an economy that recorded 11 per cent growth for the first quarter compared with the same period in 2010 – a faster rate than China – and whose fundamentals over the longer run have been widely considered to be strong.

Energy groups were some of the bigger losers on Tuesday, falling by a further 3 per cent on the previous day’s close. By contrast average shares in the financial sector rose slightly.

“The investors’ gut instincts say this economy is overheating and policy should tighten, and yet they cut rates last week, which was a big surprise for everyone,” says Timothy Ash at RBS. He was referring to the central bank’s decision to cut its benchmark rate by 50 basis points, despite a current account deficit of 9 per cent of gross domestic product.

Mr Ash revised his year-end forecasts for the Turkish lira against the dollar from the 1.75-1.80 range – in which the currency is now trading – to 1.90.

The lira edged up against the dollar and the euro on Tuesday after the central bank reduced its lending rates for both currencies, promising to watch foreign exchange markets closely and to respond in a timely fashion. But the currency’s fall since last week’s interest rate cut has exacerbated the impact of the stock market decline for foreign investors.

The central bank’s supporters say it acted proactively ahead of the latest problems in the eurozone and the US. But many analysts argue that Turkey’s biggest economic priority should be to cut its external financing requirement. Mr Ash says Turkey’s foreign exchange reserves of about $90bn cover only 50-60 per cent of Turkey’s external financing needs.

“Turkey’s biggest problem is its dependence on external savings,” says Burcu Unuvar at Is Investment in Istanbul, comparing Turkey’s savings rate of roughly 12 per cent with investment needs of about 22 per cent. “Raising public savings would be the shortest and fastest possible cure to the current account deficit.”

She argues that the country’s fiscal position is particularly dependent on domestic consumption since indirect taxes represent about 65 per cent of total tax revenue compared with about 35 per cent in OECD countries.

“No one should expect Turkey to get rid of its weaknesses in the very short term,” she says.

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