Turkey's economy is spiraling — and a new election will make things worse

  • Turkey’s lira fell to a six-month low against the dollar as President Recep Erdogan’s ruling AK Party formally requested new elections for Istanbul, which it appears to have narrowly lost.
  • Unemployment hit 14.7% in January, the highest in a decade.
  • Moody’s expects the Turkish economy to contract by 2% in 2019.

Turkey’s lira fell to a six-month low against the dollar this week as President Recep Erdogan’s ruling AK Party formally requested a new election for the city of Istanbul, where current tallies show it lost by a slim margin in local elections last month.

The move spells more trouble ahead for a massive economy already rocked by volatility, political tensions and diplomatic standoffs and whose currency crash last year set off a run on emerging markets.

“The market will not like months of uncertainty, if indeed the vote is repeated,” Timothy Ash, senior emerging markets strategist at Bluebay Asset Management, said in a note Tuesday.

“At this stage, whatever the result of the re-vote, the impression has been left that the election process in Turkey is not secure,” he added.

At one point on Tuesday the lira was trading as much as 5.82 to the greenback, a level not seen since October, before inching back to 5.74 on Wednesday morning Istanbul time. For perspective, a dollar bought just 3.5 lira in mid-2017.

Efforts by the Turkish central bank to prop up the lira by cutting deep into its reserves aren’t helping. Locals are increasingly doing business in euros and dollars and away from the lira. Moody’s said it expects the Turkish economy to contract by 2% in 2019.

Economic pain ahead for 80 million people

The country of 80 million and home to NATO’s second-largest military fell into recession last year, and the lira tanked 36% against the dollar by the end of 2018.

The causes were many and varied: Investors lost faith in Erdogan’s will to allow central bank independence, Turkey’s current account deficit kept widening and inflation skyrocketed, Turkish businesses struggled under mounting foreign-denominated debt and Washington threatened sanctions over diplomatic crises.

Unemployment hit 14.7% in January, the highest in a decade. That’s expected to rise further as a result of slower economic growth.

Turkey’s March 31 elections, while not a vote for the president, were largely seen as a referendum on Erdogan’s performance — and his right-wing AK Party suffered bruising losses in capital Ankara and commercial hub Istanbul after 25 years in power in both cities.

The party is now alleging “irregularities” in the voting as grounds for a new vote, while critics accuse it of attacking democracy.

Scaring away investors

The prospect of a new election is “of great concern to markets,” according to Shamaila Khan, director of emerging market debt strategies at AllianceBernstein.

    It’s “a source of pressure on the currency as it raises the risk that the government continues to be distracted by the elections” at a time when Ankara should be providing “more details around the fiscal program, plans to boost net (foreign exchange) reserves, transparency around the recap of the banking sector and inflation numbers needed to stabilize sentiment around Turkey,” she told CNBC on Wednesday.

    Erdogan has espoused keeping interest rates down despite rising inflation, currently at more than 19 percent. Investors fear he will continue to pursue populist monetary policy after his party’s unprecedented defeat in the local elections.

    But more than the election results themselves, it is the substance of an economic reform package that is needed to calm markets, experts say. That effort has so far not gone well.

    Of note, an investor discussion with Turkish Finance Minister Berat Albayrak during the IMF Spring Meetings in Washington DC last week received decidedly negative reviews.

    Investors described Turkish officials as unprepared and lacking details, and a J.P. Morgan survey carried out during the event revealed that more than 80% of investors did not have confidence in Ankara’s ability to turn things around.

      “The government is still lacking a viable strategy to promote financial stabilization,” Larry Brainard, chief emerging markets economist at TS Lombard, wrote in a note this week.

      “(Its) new plan … is unlikely to make progress in cleaning up banks’ balance sheets. This suggests a prolonged financial and economic squeeze lies ahead,” he added.

      Many economists points to an IMF program as the best way out for Turkey at this point. The international lender, however, has said nothing has yet been discussed on the matter.

      Standoff with Washington threatens sanctions

      Financial market jitters are only increasing amid Turkey’s standoff with the U.S. over weapons system purchases.

      Albayrak has gone directly to Trump to make his case for Ankara’s need for a Russian-made missile defense system, the S-400, the purchase of which many in Washington say threatens its status as a NATO ally.

      In choosing between the S-400 and the U.S.-made F-35 fighter jet — systems the Pentagon says cannot operate side by side for operational security reasons — Erdogan’s government is essentially choosing between Moscow and the U.S.

      Tensions with the U.S., now at recent highs, are being compounded by the election uncertainty to further pressure Turkish assets, analysts say.

      “Turkey needs another election campaign like a hole in the head,” Bluebay’s Ash said, adding that completing the S-400 purchase would almost certainly trigger U.S. sanctions. “In my twenty years covering Turkey, I have not felt this concerned.”

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