Know Your Customer — Erdogan’s Turkey or this time it is different
Political and economic developments and growing uncertainty around Erdogan’s Turkey and why this time the crisis is inevitable.
Turkey’s economy has narrowly avoided another crisis in 2020, following prolonged slump and rollercoaster ride of its national currency. Turkey’s striking ability to bounce back from near crisis situation in the past is nothing new for investors. For more than twenty years, investors demonstrated implausible risk tolerance, pouring resources into Erdogan’s Turkey despite clear indications of deteriorating democracy and governance institution. This note discusses the political and economic developments and growing uncertainty around Erdogan’s Turkey and why, despite renewed confidence for growth and stability, this time the crisis is inevitable.
The pandemic increased the risk tolerance around the world, but the risks and uncertainty around Turkey’s future are growing beyond tolerable limits. Like never before Turkey is dependent on global financial conditions and the behavior of investors financing its current account and fiscal deficits. Turkey’s turbulence in 2020 came on the tail of the 2018 currency crisis and recession. Despite narrow avoidance of the crisis, the corporate and bank balance sheet vulnerabilities are deeper and haven’t had an opportunity for a full recovery. While the official statistics reports small positive growth, the unemployment is on the rise, meaning more fiscal pressures and fiscal expansion. Negative real interest rates and a sizeable current account deficit complemented by ambitious credit stimulus are aggravating external financing risks. The central bank of Turkey- skillfully handicapped by Erdogan’s policies, heightens the risk of delayed and insufficient policy response, putting extra layer of pressures on already low international reserves and exchange rate volatility. Add to this inflation which is expected to remain in double digits.
Uncertainties of the post-COVID-19 era aside, Erdogan’s Turkey crossed too many red lines in governance and economic policies that are compounded by growing unpredictability in domestic and foreign politics. During the two decades of Erdogan ruling, Turkey transformed from a democracy with European aspirations in the Muslim world to an authoritarian country with neo-ottoman ambitions. Erdogan’s heavily centralized presidential system removed the checks and balances. Democratic gains eroded, reforms and economic growth stalled, the quality of public institutions and the rule of law has deteriorated, the EU accession came to standstill.
Take central bank which was a reputable institution with solid expertise able to move towards inflation targeting in 2000s. In Erdogan’s believe interest rate cuts can “lower inflation” and his personal involvement in monetary policy is one of the critical components of his neo-Ottoman doctrine. Slowly but steadily, Erdogan weakened personal, functional and institutional independence of the central bank. Ultimately, to eliminate any chance of central bank financial independence, in 2019, a new law forced the central bank to reduce contingent reserves accumulated in previous years to transfer as non-tax revenue to budget, thus creating an “illusion” of lower fiscal deficit. Central bank is not alone, and the list is long. The result of these autocratic policies, among others is double-digit inflation, regulatory forbearance in state-owned banks, multi-billion debts in health sector, international reserves that can be depleted any time soon, considering the maturity profile of its foreign debt.
Erdogan’s Turkey adroitly used bargaining skills separating foreign investors from the political and diplomatic front. From one side foreign investors continuously invested in constantly deteriorating business environment, from the other side the EU and many of Turkey’s western allies didn’t put enough diplomatic pressure to strengthen checks and balances. They likely thought that Turkey’s membership and active engagement in regional organizations such NATO, Council of Europe and OSCE would help in developing shared trans-Atlantic values. However, today’s Turkey is becoming a heavy burden for these organizations, while their silence and inaction leaves inerasable mark on their mission, on image of states they represent, questioning the value added they were called once to create for collective security, promotion of democracy, and economic benefits.
Collectively, the West has missed the holistic view on politics and economics behind Erdogan’s Turkey, behind his “adventures” in the Mediterranean, Caucasus and Middle East. The West missed the “no return” tipping point — the point from which their ally and the bridge between the Muslim and Western world became one of the largest threats to democracy and world stability. Turkey grew bitter and even hostile with neighbors but also with European countries like Greece, Cyprus, and France. To cover up for the domestic failures , Erdogan shifted the focus onto external politics, ratcheting up neo-ottoman ambitions and explicitly supporting terrorist radical movements that are dangerously reinforcing the EU cross-cutting cleavages, fragilizing common democratic values.
One could ask, so where is the limit of tolerance for Erdogan’s adventurous games? While the calls of “run for your life” may sound premature, the warning signs of imminent crisis are here. As of the end of November , 2020 gross international reserves of the Central Bank of Turkey were at about 83 billion USD. Not only it is well below IMF-developed ARA metric with ratio of 65 percent versus acceptable 100, but a closer look shows that about half of gross international reserves are in gold, including deposits and swaps. This means that in reality, the gross international reserves that can be quickly used to intervene to stabilize the FX market are only half of total reserves. Take from this number central bank investments in foreign government securities and make your math. In fact, this “manipulation” with the level of reserves has been brewing for quite some time. To start with, Turkey allows household to deposit their scrap gold in banks, which are then transferred to gold bullions. And, since 2011 Turkey’s central bank also allowed banks to use their gold holdings for reserve requirements at central bank, freeing them FX and lira liquidity. Currently, the Turkish Treasury and the Istanbul Gold Refinery allowed selected jewelers to collect gold from household and deposit it at state banks. Both moves seem to be fine from macroprudential perspective for country where gold has so much cultural and economic meaning. However, a flip side of a relatively positive story is opaque, as it helps to mask looming liquidity and solvency crisis in state-owned banks and depletion of foreign international reserves.
Ultimately, is there a way to save Turkey from the adverse impact of Erdogan’s neo-ottoman aspirations. There is no crystal ball recipe, but it is obvious that the international community both on diplomatic and business side needs to take bolder stance. Financial and multilateral institutions, international regulators like FATF-GAFI and rating agencies have to enhance their checks and balances before it is too late. For instance, FATF-GAFI could have a closer look into Turkey’s involvement into financing of international terrorism, discussing its blacklisting. Turkey-despite having institutions and instruments in place, is missing critical reporting aspects and suffers from weak enforcement mechanisms creating important loophole for implementation of FATF principles and guidelines. In its 2019 report, FATF notes that Turkey has serious shortcoming “including the need to improve measures for freezing assets linked to terrorism and proliferation of weapons of mass destruction.” However, a year into inaction, FATF is silent allowing Turkey to further engage in activities that finance international terrorism.
As for foreign investors, they should take more holistic view on Erdogan’s Turkey and carefully review their risk tolerance. Some companies like the fashion giant Mango, the automaker Volkswagen already made their choice, because this time around it is different, this time Erdogan’s Turkey has crossed too many red lines and may be unable to bounce back from the edge of the financial crisis abyss.
