With Erdogan ahead in Turkey’s elections, investors should re-evaluate risks

The writer is chief investment officer, emerging market debt, FIM Partners

Debt and currency investors went into the Turkish election pricing in a high probability of an opposition victory in the first round. Such a victory meant a return to economic conservatism, even as it was understood that the macro challenges ahead were immense and opposition unity was anything but guaranteed.

Five-year credit default swaps – a type of insurance instrument to hedge against loan default – were halted for Turkey, falling 70 basis points to 480bp in the run-up to elections last week. And investors were buying foreign bonds ahead of the event. Local currency bonds were pricing in larger rate hikes in anticipation of an opposition-controlled central bank that would be more responsive to inflation challenges.

It’s all gone now: Those trades are being brought back with CDS up to 605bp and rate hike expectations reversing. Not only did the opposition not win outright, but President Recep Tayyip Erdoğan’s chances of winning the second round of the election have increased significantly with the ruling Justice and Development Party (AKP) and its allies on track to win a majority in the Turkish assembly. ,

It would be tempting to think that with Erdoğan more likely to retain control, markets will return to the status quo before the election.

it’s not possible. For investors, keeping Turkey’s risk aversion in check over the past few years has partly been a combination of financial repression – or government capture of domestic dollar savings and controls on financial flows to keep the lira stable – and assets. Sale of such as stores.

And expect a change in the direction of economic policy at some point down the road.

While financial repression will continue under Erdoğan, the room for maneuver is getting narrower by the day, with each measure imposed by the government having an impact on various economic actors. A bank deposit scheme to provide an incentive for locals to keep their savings in lira, for example, creates a large contingent liability for government finances when the lira depreciates against the dollar.

Similarly, the balance sheet of the country and the central bank has gone down to very low levels. The net foreign exchange reserves by the bank are running at insufficient levels to meet the country’s large foreign exchange refinancing requirements.

Of course, economists and market participants have been pointing out the unsustainability of Turkey’s economic model for years, but the balance sheet has never been more damaged than it is today. In other words, the initial conditions have never been so weak compared to previous crises.

The extent of internal and external imbalances is extreme, with both inflation and external deficit running at very high levels. The current account deficit is running at $54bn on a trailing 12-month basis as of the last date point in March, which is close to an all-time high in the past decade. Meanwhile, inflation, despite easing somewhat, remains over 40 percent year-on-year.

Political change meant a change in the direction of economic policy. absent, it will now have to come from within the AKP itself. it is not impossible. Erdogan may have an ideological sermon on the economy. Or maybe, with a more comfortable majority in power, he may come to the more sober realization that the only way out of the current economic predicament is conservative.

Market-friendly appointments to key economic posts have been made in the past, but they have lasted for more or less time than the power of the presidency.

Turkey has had strong financial backing of late, mostly from the Gulf – Saudi Arabia, for example, deposited $5bn in the Turkish central bank in March as the country was dealing with the aftermath of a massive earthquake in February. But Gulf creditors are also becoming more sensitive and more attuned to tough economic realities globally and on the ground.

The reality is that the history of economic management under the AKP has been one of development at all costs, regardless of the imbalance, with a focus on the next election.

What this practically means is that the country will continue to walk on the edge of the abyss, just a step or two closer. Markets will have to reevaluate accordingly, taking a bearish outlook on Turkish credit, and containing the high probability of a financial crash.

The writer is chief investment officer, emerging market debt, FIM Partners

Debt and currency investors went into the Turkish election pricing in a high probability of an opposition victory in the first round. Such a victory meant a return to economic conservatism, even as it was understood that the macro challenges ahead were immense and opposition unity was anything but guaranteed.

Five-year credit default swaps – a type of insurance instrument to hedge against loan default – were halted for Turkey, falling 70 basis points to 480bp in the run-up to elections last week. And investors were buying foreign bonds ahead of the event. Local currency bonds were pricing in larger rate hikes in anticipation of an opposition-controlled central bank that would be more responsive to inflation challenges.

It’s all gone now: Those trades are being brought back with CDS up to 605bp and rate hike expectations reversing. Not only did the opposition not win outright, but President Recep Tayyip Erdoğan’s chances of winning the second round of the election have increased significantly with the ruling Justice and Development Party (AKP) and its allies on track to win a majority in the Turkish assembly. ,

It would be tempting to think that with Erdoğan more likely to retain control, markets will return to the status quo before the election.

it’s not possible. For investors, keeping Turkey’s risk aversion in check over the past few years has partly been a combination of financial repression – or government capture of domestic dollar savings and controls on financial flows to keep the lira stable – and assets. Sale of such as stores.

And expect a change in the direction of economic policy at some point down the road.

While financial repression will continue under Erdoğan, the room for maneuver is getting narrower by the day, with each measure imposed by the government having an impact on various economic actors. A bank deposit scheme to provide an incentive for locals to keep their savings in lira, for example, creates a large contingent liability for government finances when the lira depreciates against the dollar.

Similarly, the balance sheet of the country and the central bank has gone down to very low levels. The net foreign exchange reserves by the bank are running at insufficient levels to meet the country’s large foreign exchange refinancing requirements.

Of course, economists and market participants have been pointing out the unsustainability of Turkey’s economic model for years, but the balance sheet has never been more damaged than it is today. In other words, the initial conditions have never been so weak compared to previous crises.

The extent of internal and external imbalances is extreme, with both inflation and external deficit running at very high levels. The current account deficit is running at $54bn on a trailing 12-month basis as of the last date point in March, which is close to an all-time high in the past decade. Meanwhile, inflation, despite easing somewhat, remains over 40 percent year-on-year.

Political change meant a change in the direction of economic policy. absent, it will now have to come from within the AKP itself. it is not impossible. Erdogan may have an ideological sermon on the economy. Or maybe, with a more comfortable majority in power, he may come to the more sober realization that the only way out of the current economic predicament is conservative.

Market-friendly appointments to key economic posts have been made in the past, but they have lasted for more or less time than the power of the presidency.

Turkey has had strong financial backing of late, mostly from the Gulf – Saudi Arabia, for example, deposited $5bn in the Turkish central bank in March as the country was dealing with the aftermath of a massive earthquake in February. But Gulf creditors are also becoming more sensitive and more attuned to tough economic realities globally and on the ground.

The reality is that the history of economic management under the AKP has been one of development at all costs, regardless of the imbalance, with a focus on the next election.

What this practically means is that the country will continue to walk on the edge of the abyss, just a step or two closer. Markets will have to reevaluate accordingly, taking a bearish outlook on Turkish credit, and containing the high probability of a financial crash.