Turkey: An Open-Ended “Polinomic” Story

Written for Business Today Egypt - August 2016 Issue

Photo by Meg Jerrard on Unsplash

Undoubtedly, Turkey has long been eyed by global investors for at least the last decade as a role model of how an Islamic country can become in terms of its economic development. Investors have been profiling other Islamic countries within a continuum with Turkey on the positive end and Pakistan on the negative end, where the military in both countries have been involved in politics somehow. This underlines the vital role politics play in steering the economic reality of any country, whether Islamic or non-Islamic. More recently, Turkey’s economy has become prey to internal—let alone external—issues, which eventually culminated in a coup attempt that failed mid-July.

The Turkish Experience

It’s nothing new in Turkey’s history to suffer from yet another coup. Indeed, the country has already had three coups d’état since 1960s. Add the last one on the night of July 15 and we have four coups! Historically, the Turkish military has intervened directly and indirectly in the country’s politics several times.

The first coup was in 1960 when the army stepped in and arrested the president, prime minister and several cabinet members then quickly tried them for treason and other offences, ending with the execution of Prime Minister Adnan Menderes. The second coup was in 1971 after the government in office at the time failed to prop the economy off its recession which led inflation to skyrocket to nearly 80 percent. This eventually led to the resignation of Prime Minister Suleyman Demirel, bringing the army back into the political scene, albeit indirectly.

During the 1970s, Turkey had changed its prime ministers 11 times, but the economy remained stagnant and a wave of assassinations kicked in. The third coup, which took place in 1980, had been contemplated by the military for months before it made the move in September 1980, imposing martial law and dissolving the government. A new constitution was put in place after a public referendum in 1982 overwhelmingly approved it. The years after brought stability to Turkey’s economy, with state-owned industries privatized, inflation subdued, and employment flourishing.

In 1990s, while the army did not get involved directly into politics, it did exert some pressure on the Turkish government then. For instance, the 1995 elections resulted in the Islamist Welfare Party (IWP) coming to the forefront and heading a coalition government. However, the military had issued a series of so-called recommendations that the then-current government had to accept. Eventually, Prime Minister Necmettin Erbakan was forced to resign, and the IWP was shut down in 1998.

Later on, some former members of the IWP, including the current 62-year-old President Recep Tayyip Erdogan, founded the Justice & Development Party (AKP). Mr. Erdogan led AKP from 2001 through 2014, during which he was prime minister for more than 11 years (2003-2014) before becoming president in 2014.

The Failed Coup Attempt

On the night of Friday, July 15, 2016, the military seemed to have just staged the fourth coup in the Turkish republic’s history. However, the coup attempt was thwarted in a matter of hours, having failed to arrest heads of the state and having been faced with an otherwise intolerant crowd that took to the streets opposing the coup. It was later reported that this coup attempt was planned by a few factions of the military, suggesting division on the military side with regards to the coup attempt. Also, media channels were hardly blocked by the coup forces, with only the Turkish Radio & Television (TRT) put under control. This left a breathing space for the incumbent government to speak to the Turkish people. Indeed, Mr. Erdogan appeared that same night on CNN Turk via a FaceTime video call where he asked the Turkish people to take to the streets in opposition of the coup. And it did work! Thousands took to the streets protesting the coup and sending a clear message to the world of the coup’s lack of popular support.

The Macroeconomic Picture

Unlike the previous coups, this coup attempt attributed the move to the need to restore “democracy” rather than “economic stability”. On one hand, this is ironic since the democratic process in Turkey has been operating efficiently for the past decade or so. Thus, it was quite unclear of the “real” motives behind the coup attempt. On the other hand, the economic environment in Turkey has been much better when compared to the prior decade. For instance, Turkey’s real GDP growth rate has averaged above 4 percent a year, with the economy surviving the Global Financial Crisis (GFC) after suffering from negative economic growth, high inflation and unemployment rates, and a weak lira (Turkey’s currency).

Turkey’s economy has been on the mend for a few years now and is expected to strengthen further in 2016 and beyond. According to the International Monetary Fund (IMF), real GDP growth rate is expected to approach 4 percent in 2016 and still grow by an annual rate of 3.5 percent thereafter. The government’s finances are in check with a budget deficit of only 1-2 percent of GDP, government debt of only 30 percent of GDP and declining, and the Turkish lira just starting to recover in 2016 (up 1 percent in 2016 through July 14, a day before the coup attempt) after losing around 20 percent of its value in 2015 alone.

Turkey’s GDP annual growth rate (quarterly)

Source: TradingEconomics.com

Perhaps the only macroeconomic issue that Turkey may have today, which needs to be addressed, is its relatively high current account deficit. Historically, the current account deficit has averaged in the high single digits as a percentage of GDP. Yet, the macroeconomic indicator fell more recently to around 4-5 percent of GDP and is expected to remain within the same range for the coming five years. Turkey’s current account deficit has been impacted by a trade deficit, a slowing tourism sector, and low to negative investment income, indicating net outflows.

By far, the tourism sector makes the bulk of the services balance of the current account, hence its importance. Recent clashes associated with the failed coup attempt following a terrorist attack in the country’s airport post headwinds to this very important sector. Also of strategic importance for both Turkey and Europe is the Bosphorus Strait and its impact on global trade. The Bosphorus Strait is a major shipping chokepoint, through which for a sizable amount of the world’s seaborne oil trade passes (over 3 percent of global supply, mainly from Russia and the Caspian Sea). Thus, any disruption of trade passing through this strait would be of international interest.

The Geopolitical Situation

By now, it is crystal clear that terrorism is not a characteristic of any specific country but is rather a phenomenon hitting any country at any time. Just a day before Turkey’s coup attempt, Nice in France has seen a brutal terrorist attack that reverberated strongly across Europe, underscoring the need for cooperation between global intelligence agencies. Thus, it was no surprise for European leaders to denounce Turkey’s coup as an attack on democracy, seeking stability in the world’s most dangerous geopolitical region: the Middle East.

One needs not neglect the strategic role that Turkey plays as the frontline that Syrian refugees must first cross before moving into Europe illegally. In other words, a weaker Turkey would mean higher risk of refugees for Europe. Also, Turkey—as the second largest military force in the North Atlantic Treaty Organization (NATO) behind the U.S. Armed Forces—plays another important role as a launch pad in the fight against Da’esh or the so-called Islamic State in Syria and Iraq (ISIS). Indeed, the air base at Incirlik is a major platform for U.S. operations against ISIS. Losing Turkey’s role would mean a less effective battle with ISIS.

With Turkey’s coup attempt behind us, several political agendas are now at play.

Turkey’s side: The Turkish government wants to ensure stability as well as prosperity by attracting further investments. It is also hopeful that Turkey one day will become a member of the European Union (EU) as it became a NATO member back in 1952. However, recent events led the government to consider some actions that may not resonate well with being a potential EU member. For instance, Turkey is considering reintroducing the death penalty and has recently effected a 3-month state of emergency. Also, the Turkish government has been clamping down on what they saw as coup supporters, arresting thousands of citizens across different sectors, including the judiciary system, education, media, and more recently capital markets! The government has shut dozens of media channels (45 newspapers and 16 television stations) and dismissed more than 1,000 military officers. An emergency decree from the country’s Cabinet of Ministers listed television channels, radio stations, news agencies and newspapers to be closed immediately. Leaving more than 250 people dead, the coup resulted in thousands of government employees being suspended. Around 15,000 people, alleged to be followers of U.S.-based preacher Mr. Fethullah Gulen, whom the Turkish government blames for the coup attempt, have been detained. The list included a third of the highest-ranking military officers. More recently, head of research of the second-largest investment bank in Turkey was stripped of his license by the Capital Markets Board of Turkey over a research report that he published to investors after the July 15 coup.

According to The Wall Street Journal, quoting Anadolu Agency, the total purge numbers exceeded 60,000, including: 21,738 suspended by the Ministry of Education, 21,000 licenses revoked at private educational institutions, 8,777 suspended at the Interior Ministry, 6,319 military personnel arrested, 1,577 university department heads forced to resign, and 1,481 judges and prosecutors arrested.

Europe’s side: Europeans do want to support democracy, but at the same time they are wary that the Turkish government’s crackdown may be overdone in an effort to root out domestic opposition, which would eventually polarize the nation. Citing “national security” as a justification for such extreme measures is not convincing Europe in specific and the world in general. Also, a reintroduction of the death penalty would effectively end Turkey’s EU membership talks, according to a spokesman for German Chancellor Angela Merkel. Not only that, but there is fear across Europe that such post-coup measures may result in more setbacks for Turkey’s economic development.

The Investment Environment

Now, what does this all mean for Turkey’s burgeoning economy and its investment climate?

Always the top priority of every investor is the “rule of law”. Recent measures by the Turkish government have definitely raised red flags about the authoritarian grip that Mr. Erdogan has been tightening throughout his years in office. More recently, Mr. Erdogan’s crackdown on his opponents, whom he claims to be Gulen’s supporters, is putting in question the judicial system altogether. Would it be fair enough with foreign investors, especially amid the crony capitalism system that Turkey has been fostering recently?

Also, currency stability probably comes as the second most important factor that foreign investors consider before investing in Turkish assets, be it through the stock market or through direct investments. Indeed, the Turkish lira has lost 40 percent of its value since the end of 2012 and has lost 50 percent over the last 10 years. Last year alone, the Turkish lira lost 20 percent; it began to recover slightly in 2016 before succumbing to recent turmoil in the aftermath of the failed coup attempt. While a weaker lira makes Turkish assets all the more cheaper, it does pose a risk if it fluctuates widely as it has over the past decade. A weaker Turkish lira eats into an investor’s return on investment in U.S. dollar terms.

How much one Turkish lira is worth in U.S. dollars

Source: TradingEconomics.com

Cognizant of the negative sentiment such a coup attempt can mean for Turkey’s markets, the Turkish government was quick to arrange for a conference call on Sunday, the day before markets re-opened after the coup, to assure international investors of the situation on the ground. Meanwhile, the Central Bank of the Republic of Turkey (CBRT) vowed to provide banks with unlimited liquidity as needed, setting the commission rate for the intraday liquidity facility to zero, among other promised measures. Overall, the CBRT promised to take all measures “to ensure financial stability, if deemed necessary.” Furthermore, the CBRT moved to cut interest rates on the following Tuesday, July 19. The Monetary Policy Committee (MPC) cut the overnight lending rate by 25 basis points from 9 percent to 8.75 percent, while keeping its benchmark one-week repo rate steady at 7.5 percent and its overnight borrowing rate at 7.25 percent. This decision, it seems, came as the CBRT weighed its odds and favored ensuring more liquidity in the markets as opposed to supporting the lira. Indeed, the lira traded some 0.1 percent lower at 2.9847 per one U.S. dollar after the decision.

As for the stock market, equities were understandably hit after the coup, despite its failing. After all, investors generally prefer to stay on the sidelines at times of chaos, and at that point, no one knew what was going on and who was in power, let alone the risk of similar incidents recurring in the future. Thus, Turkey’s benchmark Borsa Istanbul (BIST 100) stock index fell 7.1 percent on Monday after the market opened and 9.0 percent over the course of the following 10 trading days (July 16-29), i.e. the remaining trading days of July. Daily trading volumes skyrocketed on Monday, July 18 by 90 percent above the preceding 6-month daily average. Throughout the rest of July, average daily trading volumes was still 23 percent higher than the 6-month historical daily average due to selling pressure.

Likewise, valuation of Turkish equities which was already cheap compared to MSCI Emerging Markets (EM) index got crushed further. On July 15 (pre-coup), BIST 100 was traded at a forward price-to-earnings ratio of 9.5 times, meaning investors were willing to pay 9.5 Turkish liras for each lira of expected profits on average. Back then, this was a 26-percent discount to MSCI EM’s 13.0 times. By end of July, BIST 100 was traded at an even higher discount of 34 percent: 8.7 times vs. MSCI EM’s 13.2 times.

In the bond market, Turkey’s 10-year yield jumped on July 18 by 61 basis points from 8.91 percent to 9.52 percent before it settled by end of July at 9.50 percent, still some 59 basis points above July 15 levels. This is due mainly to the now-higher risk premium embedded in owning Turkish bonds, part of which is due to the currency risk and the other part due to the political and potential economic risks. Indeed, rates of Turkey’s 5-year credit default swaps (CDS) – which are contracts that insure against a sovereign bond default – jumped from 2.26 percent on July 15 to 2.485 percent on July 18 before rising further to 2.74 percent by end of July—a full 48 basis point jump.

Higher risk often opens the door for potential downgrades by credit rating agencies, which is exactly what Standard & Poor’s did on Wednesday, July 20, when it cut Turkey’s foreign currency rating by one notch from ‘BB+’ to ‘BB’ with negative outlook, further down the line into the sub-investment (or junk) category. The rating agency said the coup has “undermined the country’s economy and investment environment.” Meanwhile, Moody’s Investors Service and Fitch Ratings still hold Turkey at investment grade, but the former said it was “assessing the impact of the failed coup for a possible downgrade.” Both Moody’s and Fitch rate Turkey one notch above the junk category at ‘Baa3’ and ‘BBB-minus’.

What does the future hold for Turkey?

Investors will definitely be monitoring the developments of Turkey’s both political and economic scenes.

Investors will be trying to understand which path Mr. Erdogan will lead: a total authoritative system with polarization or an inclusive one with participation. Investors will be gauging the potential economic impact of all political moves and whether the “rule of law” will be in jeopardy, thus putting investments at risk.

As for the sectors that may be affected the most, obviously a weaker economy with less interest from foreign investors would be detrimental to all sectors alike. However, recently-heighted risk in the currency and bond markets may render international financing a bit problematic for Turkish banks that rely to a great extent on foreign funding. For instance, Turkish bank Yapi ve Kredi Bankasi delayed plans to sell a $550-million bond issue in international markets, citing market conditions, while Sekerbank – another Turkish bank – postponed its regional roadshow for a potential bond issue. On the other hand, exporters might see a silver lining in a weaker Turkish lira, but their main problem would be the strength of Turkey’s key trading partner, Europe, which is still suffering from weak economic growth rates.

At the end of the day, it’s politics that will set the scene for Turkey’s economic fortunes or what I would call “polinomics”, but only time will tell.