Amid the recent troubles of Turkey’s economy, there is one factor sometimes overlooked by investors: the country’s formidable export machine.
In the run-up to the pandemic, export volumes of goods and services by Turkey rose 24 per cent between 2016 and 2019, far above export performance in most other emerging markets. This, combined with a young and entrepreneurial population, suggests Turkey could reap more benefits from a post-Covid-19 world than almost any other emerging market.
What Turkey needs to do now is get on the right path and send a policy signal that it plans to raise interest rates. It is the right time for such a move. There is a lot of goodwill in markets — investors are seeing the appointment of an economic team led by a new finance minister as a potential fresh start. The lira has rallied more than 10 per cent this week. President Recep Tayyip Erdogan also has promised to foster a better environment for local and international investors.
It is needed. The Turkish lira has been depreciating for many years. We estimate that it has fallen about 40 per cent in real terms since 2013, after adjusting for inflation.
Other emerging market currencies have fallen as well — the Brazilian real is down 31 per cent in real terms over the same period, for example. However, the bulk of such depreciations have affected commodity exporters. For them, currency weakness has largely acted as an economic offset to falling commodity demand. While commodity prices drop in dollar terms, the impact is mitigated when export income is translated back into a lower local currency.
Turkey, by contrast, is a commodity and energy importer, and the fall in the lira has been mainly driven by domestic developments and unorthodox policies.
The country is too dependent on credit-driven booms as the principal driver of growth. Recent years have seen periodic credit expansions, starting in 2017 with a sizeable stimulus from the government’s Credit Guarantee Fund which guarantees loans for small and midsized companies. There also was a 2019 expansion in state bank lending and a very large credit boom in early 2020 at the height of the Covid-19 shock.
There are good reasons for this focus of using credit as stimulus. Compared with other emerging markets, Turkey’s outstanding level of credit is not an outlier as a percentage of gross domestic product, so there is room for additional borrowing. And the credit expansion earlier this year came against the economic devastation from Covid-19, when other countries were also undertaking unprecedented stimulus.
However, credit for Turkey has an adverse side effect. By boosting domestic demand, it buoys imports which, in turn, widens the current account deficit. This dynamic has prevailed this year. While the country had a current account surplus of 1.2 per cent of GDP in 2019, we project that this year’s credit push will take the current account back into deficit in excess of 4 per cent.
That deterioration — coupled with big portfolio outflows due to elevated investor concerns globally about risk — has translated into material official foreign exchange reserve losses in 2020, above what other emerging markets have seen. These reserve losses are a sign that it is not sustainable to rely on credit stimulus as a way to boost growth.
In the near term, rate increases would send a powerful signal and turn market sentiment more positive. This would parallel the 2018 experience, when such increases played a critical role in stabilising the lira. In the medium term, a return to structural reforms and monetary policy orthodoxy would provide a more sustainable path to growth. Markets are likely to reward this with looser financial conditions — a stronger lira and lower interest rates.
As US election uncertainty fades, market sentiment is shifting in a favourable direction for emerging markets, given recovering global risk appetite. The news of a possible Covid-19 vaccine may add further momentum to this trend.
That means there is a tailwind that could stabilise and strengthen the lira with a minimum of policy effort. Additional help will come from the fact that the lira is, in our view, undervalued at this point. Thursday’s exchange rate of TL7.71 to the dollar is above our fair value estimate of 7.50.
Currency valuation is an imprecise business, but this week’s rally and outperformance of the lira vis-à-vis other emerging markets is surely a sign that undervaluation exists.