Turkish assets rally in best run in two months ahead of referendum

Turkey’s lira is enjoying its best run in nearly two months as the country heads for a key referendum that could change the course of its parliamentary democracy this weekend.

Despite holding the title of the world’s worst performing emerging market currency of the year, the lira is up nearly two per cent this week – its best winning streak since February -with analysts noting that investors are pricing in a victory for a ‘Yes’ vote on Sunday.

The battered currency has become a barometer for investor nerves about the country’s febrile political and security situation following a failed military coup attempt in July. The government of president Recep Tayyip Erdogan has responded by purging the civil service and military and is now seeking to consolidate his position as head of state by re-writing Turkey’s republican constitution.

Turks will head to the ballot box Sunday on whether to transform the country into a presidential democracy and hand sweeping executive powers to Mr Erdogan.

Despite polls showing the vote is too close to call, with the Yes camp slightly ahead on some measures at 53 per cent, Turkish assets have rallied this week on the hopes of a win for the ruling AKP government.

Investors are hoping a constitutional triumph will help shore up the country’s political stability and avoid a round of early elections.

The lira is volatile today, dropping 0.7 per cent but remains above its 50-day moving average against the dollar at TRY3.6580.

Having slumped to fresh record lows against the dollar this year, the lira’s appreciation has more left to run should the Yes campaign triumph, according to Gyorgy Kovacs, economist at UBS. He expects up to a 3 per cent lira bounce should Mr Erdogan’s ruling AKP win the vote.

“A Yes vote may help to create the conditions for higher-quality capital account flows, and could support domestic demand by reducing domestic uncertainties”, said Mr Kovacs.

Still he warns country’s long-run economic fundamentals – including its deteriorating current account deficit and rising debt levels – will be unchanged without a major government structural reform effort.

“Markets will look for structural economic reforms to be prioritised and early elections to be avoided”, he added.

“Over the longer term, we would be cautious on the lira in the context of a structurally weakening balance of payments and limited competitiveness gains despite a weaker lira”.

Nafez Zouk, economist at Oxford Economics, is more bullish on Turkish assets, estimating the lira has been “oversold” this year. A victory for Mr Erdogan would also offer up a chance for the ruling AKP government redouble its efforts to revamp the economy.

“A ‘No’ vote would lengthen the period of political uncertainty and lead to a selloff in Turkish assets,” said Mr Zouk.

After a wobbly start to the year, the exchange rate has gained a semblance of stability after the Turkish central bank has stepped up its effort to tighten credit conditions

Mr Zouk thinks monetary policymakers have managed to “claw back some of the credibility dented over the past years” and now expects lira to climb to TRY 3.5 by the end of the year.

Foreign investors have also piled back into the country’s assets this year (see chart below), taking advantage of cheap equity valuations.

Turkey’s benchmark BIST stock index has climbed 16 per cent in 2017 and touched two-month highs again this week. In the event of a Yes vote, analysts at UBS recommend buying banking sector stocks as political stability may lead the central bank to lower average bank funding costs.

Still for all the upsides in a referendum victory, even a rejection of the constitutional reforms could lead to a “knee-jerk rally”in Turkish assets, according to Lee Hardman, currency analyst at MUFG.

“However, it could create even more political uncertainty in the near-term and thereby dampen scope for the lira to sustain gains. It is unclear how President Erdogan would react if the constitutional reforms are rejected”, he adds.