The interest-rate lobby
Tayyip Erdogan seems to like the concept of “choking” things. At the weekend, Turkey’s prime minister sent riot police into an Istanbul park with tear gas and water cannons to clear out the protesters. A week earlier, he had threatened to “choke” an alleged “high-interest-rate lobby” of speculators who wanted to push interest rates up and suffocate the economy.
Erdogan’s harsh actions against protesters and harsh words against investors could backfire economically. The country depends on foreign investors to fund its big current account deficit. If they turn tail in response to the mounting unrest, interest rates will indeed have to rise.
The protests which began two weeks ago over Tayyip Erdogan’s alleged authoritarianism, triggered by the prime minister’s insistence on bulldozing one of Istanbul’s few public parks, initially alarmed investors. The stock market plunged, the lira fell and government bond yields spiked. Then, after the central bank intervened in the foreign exchange market and Erdogan offered concessions last week, investors calmed down.
But the weekend’s use of riot police has stoked a conflict that seemed like it might be on the point of resolution.
The problem is not so much that speculators have an incentive to jack up interest rates. This would be perverse. Foreign investors own $140 billion of domestic bonds and equities, according to Standard Bank. They will lose money if interest rates rise.
The risk rather is that investors will pull out their money if they lose confidence. The U.S. Federal Reserve’s indication that it may slow down its massive bond-purchasing programme has exacerbated that risk, as some of the money it has been pumping into U.S. bonds has seeped into emerging markets such as Turkey.
What’s more, the Turkish miracle isn’t quite as good as it seems. The economy grew only 2.6 percent last year, down from 8.5 percent the previous year – after the central bank had to hike interest rates because the economy was overheating and inflation reached 8.9 percent last year.
Turkey’s biggest economic weakness is its current account deficit – a sign that consumption has been growing faster than is sustainable. The deficit did fall to 5.9 percent of GDP last year, after a 9.7 percent gap the previous year, as the economy slowed. But it is rising again this year. The April trade deficit was $10.3 billion, up from $6.6 billion last year.
Indeed, the selloff in Turkey’s financial markets began a week or so before the police crackdown on protestors in Istanbul’s Taksim Square on May 31. For example, two-year bond yields rose from 4.8 percent on May 17 to 6 percent at the end of the month; and the stock market fell 8 percent between May 22 and the end of the month.
Until now, international investors have been happy to fund the deficit. Not only were they attracted by the strong economic growth. They also liked Erdogan’s pro-market approach, the political stability they thought he had brought and the prospect that Turkey’s march towards a market democracy would be anchored by negotiations to join the European Union, says Timothy Ash, Standard Bank’s head of emerging markets research.
The “interest-rate lobby” also liked the fact that the government’s debt is only 35 percent of GDP and that banks have strong balance sheets, partly because they were seared by Turkey’s financial crisis at the start of the millennium. Meanwhile, both Moody’s and Fitch recently upgraded the country to investment grade.
The problem is that the unrest is casting doubt on some of these positive factors. For a start, Turkey no longer looks so stable politically. Then there’s the fact that Erdogan’s attack on speculators is sowing doubts about the depth of his commitment to markets. Furthermore, the crackdown on protesters may undermine Turkey’s chances of joining the EU after Germany last week suggested delaying the next round of negotiations. What’s more, the unrest could harm growth if tourists are deterred from visiting and domestic consumers become more cautious.
A particular weakness is that the current account deficit has been largely funded with hot money. The share accounted for by foreign direct investment – long-term money that can’t easily run away – has been falling, according to Morgan Stanley. Meanwhile, the share made up by debt has been on the rise.
One measure of Turkey’s vulnerability to a loss of confidence is that it has an “external financing requirement” of $205 billion – roughly a quarter of GDP – over the next year, according to Standard Bank. This financing requirement is the sum of its current account deficit and the maturing debt it needs to repay or roll over. A more extreme measure of vulnerability would add the $140 billion of foreign held bonds and shares. If this tries to flee, the lira could plunge.
Against this, the central bank has $130 billion of reserves, which it dipped into last week when it helped to stabilise the foreign exchange market. This war chest, though, is low compared to Turkey’s external financing needs. What’s more, the net reserves – after excluding foreign exchange deposited by the banking system – are only $46 billion, according to Standard Bank.
So the central bank couldn’t hold the line if the “interest-rate lobby” really did run for the exits. In that case, Turkey would have to raise interest rates, which would damage growth. And then the economic miracle, which Erdogan has presided over and which is one of the main sources of his popularity, might look like a conjuring trick. Instead of choking protesters, Turkey’s prime minister should try to make a genuine peace with them.