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An improving credit story: Turkey’s turnaround
With the recent focus on global macro data and geopolitical events, some of the positive developments within emerging markets have been easy to miss. Tim Ash, Senior EM Sovereign Strategist, looks at how an improved ratings outlook reflects a turnaround in Turkey's credit story.
The second half of July saw Moody's surprise the market, with a two-notch upgrade of Turkey's credit rating to B1, keeping the outlook on positive. Whilst a one-notch upgrade had been expected, the two-notch move now puts all three ratings agencies on a par at B1/B+. We expect further, and likely, near-term upgrades from Fitch and S&P.
This ratings upgrade reflects a turnaround in Turkey's credit story, which has been evident since the parliamentary elections in May 2023, and something which we have been signalling for a while.
Since that time, we have seen President Erdogan do a remarkable 180 degree – almost handbrake – policy turn from his seemingly entrenched prior unorthodox monetary policy stance, which had seen inflation spiral into high double digits and the lira plunge.
Erdogan re-appointed the respected former minister, Mehmet Şimşek, to his former role as minister of finance. Şimşek proceeded to re-hire a team of trusted orthodox thinkers to the central bank and elsewhere in the economic policy administration. The team has promptly moved to tighten fiscal and monetary policy, with a hike in policy interest rates from 8.5% to 50%1. A complex cobweb of financial alchemy which had sustained Erdogan's low interest rate policy has been removed – simplifying the monetary policy mix and improving the transmission mechanism.
The policy reset has begun to work, with inflation seeming to have peaked (and set to go lower), the lira stabilising and the current account more than halving year-on-year. Investor confidence has improved, with around USD20 billion in portfolio inflows over the past year, while de-dollarisation has begun2. This has enabled the central bank to rebuild foreign exchange reserves, which had reached mission critical levels – net reserves had sunk to minus USD60 billion, but are back up to over USD15 billion, and gross reserves are now close to record highs at over USD150 billion3. Market confidence is returning with Turkey 5-year CDS back at close to 250bps, after pushing over 700bps at the height of concerns over Erdogan's policy unorthodoxy in early 20234.
Indeed, Turkey is now one of the favourite local market trades for 2024, as the market buys into the line that the central bank will hold policy rates higher for longer to finally break the back of inflation, cutting inflation from 75% year-on-year at present, to 35-40% by year end, and the teens by the end of next year.
However, it is important to flag the risks. The largest, perhaps, is that Erdogan could have second thoughts about the new monetary policy orthodoxy and repeat his move to fire the former orthodox central bank governor, Naci Agbal, in March 2021 after less than six months in office. A move by Erdogan to fire Şimşek and his team would be disastrous for markets, and the risks would then be that Turkey would quickly move to a systemic crisis. That very fact will likely deter such a pivot again by Erdogan.
What encourages our view that he will remain with Şimşek is our own interaction with Erdogan's advisers, which suggests that that team has changed and is now staffed by pro-business and pro-market individuals, some in his close family inner circle. They have begun telling truth to power and have made it clear to Erdogan that if he had not changed tack in 2023, the systemic crisis was not long around the corner.
A poor showing by Erdogan's ruling AK party in local elections in March this year sent a clear message, acknowledged by Erdogan, that the number one economic problem in Turkey is inflation. Erdogan has acknowledged that beating inflation is a pre-requisite for a re-election win four years down the line, hence the need to stick with Şimşek and his team.
The latter assumption underlines our continued confidence in the investment case for remaining long Turkey, particularly on the local currency side, where both the Turkish lira and local government bonds look attractive.
1 Turkey raises interest rates to 50% as it seeks to cool runaway inflation (ft.com)
2, 3, 4 Bloomberg
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