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Summary
- Turkey’s improved policy coordination and commitment to continuity are allowing continued rebalancing to a more sustainable growth dynamic.
- Cooling domestic demand alongside favourable base effects should foster disinflation in Q2, while expectations should also decline.
- C/A adjustment is ongoing, reserves are rising, and the CBRT is simplifying its policy toolkit.
- And with fiscal policy now contractionary, the much-improved macro backdrop is attracting significant capital inflows.
Market Implications
- With the policy rate at 50% and TRY stable through Q2, long lira is becoming popular.
- For bonds, with non-resident holdings still only 15% of the 2013 high, we see scope for continued inflows.
- External financing needs have reduced but remain elevated. So while Turkey’s macro story has improved, risks remain.
- TRADE UPDATE: We take profit on our EUR/TRY digi put, realizing a gain of 1.5X the initial premium paid, and would re-engage on material cheapening.
Economics, Not Politics, Now Driving Turkey’s Policy Mix
The Turkish economy is gradually stabilizing thanks to a turnaround in President Erdogan’s economic thinking and an election calendar now largely empty until 2028. Erdogan’s earlier predilection for low interest rates amid rising inflation – and limited patience for central bank governors who dared tighten policy – meant lingering uncertainty over how long the shift to conventional policy would last.
But with local elections over, and Erdogan pledging commitment to reform while conceding the AKP’s unprecedented defeat, incentive to return to the ever-changing and highly stimulatory policies of the past has decreased. Disinflation is about to take hold, de-dollarization has resumed, and investor confidence is returning.
Policy and currency stability are rare in Turkey. And the currency macro adjustment is far from complete. But with ongoing dismantling of the artificial support for TRY and Erdogan’s ongoing support of the new policy framework, we remain bullish on Turkey.
Gradual Growth Cooldown
Turkey’s demand-led expansion is gradually subsiding. After three years of solid growth driven by pre-election stimulus and earlier ultra-loose monetary policy, the economy is slowly rebalancing. Tighter financial conditions are slowing credit card spending and loan growth, the C/A correction is ongoing with slower domestic demand and improved terms of trade, and disinflation should kick in for H2.
Policy continuity – and coordination across monetary, fiscal and incomes policies – are key to sustaining the economic rebalancing and to entrenching disinflation. With elections over, we expect continued macro adjustment and improved investor confidence.
Tighter Financial Conditions Just One Part of the Adjustment
41.50pp in rate hikes over nine months only partly slowed Turkey’s robust growth. Last year’s 4.5% GDP growth was the slowest since 2020. But sequential momentum accelerated through Q4 2023 and Q1 2024, with still-expansionary fiscal and incomes policies the main offset to tighter monetary policy. Presidential (May 2023) and local (March 2024) elections meant significant pre-election spending and wage/pension hikes. Dismantling the myriad earlier tools to stabilise the exchange rate and prevent rising dollarization is also a gradual process.
Q1 GDP at 2.4% QoQ was an acceleration from the 1.0% in Q4, reflecting the still-strong growth impulse from fiscal policy despite several quarters of rate hikes. The growth composition is nevertheless improving. Net trade contributed positively to growth for the first time since Q3 2022, while the YoY growth rate in private consumption has been in single digits for the last two quarters (Chart 1).
Turkey’s late March local election also impacted growth through Q1. Worries over a repeat of the sharp lira depreciation after last year’s presidential election triggered renewed dollarization and kept inflation expectations elevated. Consumption was brought forward in fear of yet further price acceleration, while January’s 49% minimum wage hike boosted spending.
Chart 1: blue bars = contribution to YoY GDP from domestic demand in pp, orange bars = contribution from net trade. Chart 2: blue line = credit impulse in % GDP, orange line = consumption expenditure YoY.
Moderation in credit dynamics is key for a shift to more sustainable consumption. Reflecting the incomplete nature of the recovery, 13-week, FX-adjusted, annualised loan growth accelerated again in Q1, while our measure of the credit impulse remained elevated (Charts 2 and 3). Growth in retail loans dropped slightly as credit card balances declined. Meanwhile, credit card spending also fell in real terms in April.
Chart 3: blue line = loan growth, 13-week annualised, FX adjusted.
Conditions for Q2 changed meaningfully. President Erdogan’s commitment to policy continuity – despite the resounding defeat in the March local election – improved both consumer and investor sentiment and stabilized the exchange rate. And combined with the expected start of disinflation in June, consumption should not accelerate further.
Q2 also brought tighter financial conditions. CBRT unexpectedly hiked 500bps just 10 days before the late March local election and widened the interest rate corridor (from +/-150bps to +/-300bps). By shifting liquidity to different facilities, the wider interest rate corridor allowed effective interest rates to exceed the 50% policy rate through May (Chart 4).
CBRT rhetoric has also been consistently hawkish, and the MPC statements have kept the forward guidance on maintaining a tight monetary policy stance for as long as necessary. Karahan has also consistently said the CBRT will tighten policy if the inflation outlook worsens.
Consensus forecasts see growth slowing to 3.0% this year, while the government’s Medium-Term Program sees a more optimistic 4.0%. GDP growth at 3-4% would be the slowest since the pandemic, while a more sustainable and balanced growth rate combined with the expected narrowing of fiscal and C/A deficits would leave Turkey’s overall macro landscape much improved.
Chart 4: blue line = CBRT policy rate, orange line = weighted average cost of CBRT funding.
Fiscal Impulse Expected to Turn Negative in 2024
Monetary and fiscal policy are also now becoming coordinated. Turkey’s central government fiscal deficit increased by over 4pp last year (from 1.0% GDP to 5.4%) – the result of pre-election spending and reconstruction costs of around 3.7% GDP related to the devastating February 2023 earthquake. Strong execution on revenues nevertheless helped the budget stay below the 6.4% deficit in the Medium-Term Program.
The headline deficit will reduce only slowly as earthquake spending continues. But current, and pro-inflationary, spending should slow with commitment to spending restraint. The 49% public sector wage hike in January took the YoY increase to 100%, well above inflation (Chart 6).
This year’s deficit target stands at 6.4% as per the MTP. Revenue growth will slow as the economy cools and tax receipts decline, while overall spending reductions will be modest. A higher interest bill and substantial losses at the CBRT are also factors. Nevertheless, the composition between current and capital spending is favourable, and forecasts from the EC and others see the projections undershot leaving an overall negative fiscal impulse for the first time in three years (Chart 5). Fiscal consolidation will aid Turkey’s rebalancing and support disinflation.
And to the extent that the earlier widening C/A deficit was partly publicly driven, fiscal restraint will also support external rebalancing. Reduced financing needs and improved investor sentiment will also ease financing pressures.
Unwinding of the FX-protected deposit scheme since August also ends the growing fiscal/monetary liability. Outflows have accelerated through Q2 with the current stock now at TRY2.12tn or 21.7% of total deposits, from an August 2023 peak of 45%.
Chart 5: orange bars = fiscal impulse in Czechia, Hungary, Poland and Turkey in 2021, white bars = 2022, blue bars = 2023, grey bars = 2024, black bars = 2025. Chart 6: blue line = CPI (% YoY), organise line = minimum wage growth.
Inflation Expectations Still Misaligned With CBRT Forecasts
Accelerating YoY inflation, wage hikes, lira weakness and earlier pre-election spending all kept inflation expectations stuck above CBRT projections. The Q2 Inflation Report raised the end 2024 CPI forecast 38%, with the 2025 projection unchanged at 14%. But expectations remain well above the forecast: 12- and 24-month expectations sit at 33.2% and 21.37% respectively. Year-end expectations stand near 44% (Chart 7).
May’s YoY CPI print at 75.5% (and 3.37% MoM) was above expectations. Expiration of free gas up to a certain threshold contributed 0.64pp to monthly CPI, while restaurants and hotels added 0.49pp, and clothing and footwear another 0.59pp.
Services at 95.93% YoY gained another 4.03% MoM, with rents still the highest components YoY at 125.14%. Goods prices rose by a slower 3.08% MoM, taking the YoY rate to 67.58%. Energy, fresh fruit and alcoholic beverages and tobacco remain the highest components YoY (Chart 8).
Backward indexation of prices is one factor keeping inflation expectations high and services inflation sticky. But the expected onset of disinflation from June combined with recent lira stability should ensure inflation expectations fall in tandem with headline CPI.
Base effects in July/August are exceptionally favourable, with 9% MoM readings a year ago. Meanwhile, the base for June and the rest of the year is helpful. So while inflation momentum remains elevated, YoY CPI will drop sharply. And with a cooling in overall consumption, Turkey’s disinflation will be pronounced, assuming exchange rate stability is maintained.
Chart 7: orange line = year end inflation expectations, blue line = CBRT year-end inflation forecasts. Chart 8: blue bars = pp contribution to YoY CPI by individual component.
Turkey’s 50% policy rate is attracting foreign inflows and helping the switch out of FX-protected deposits. But as disinflation takes hold, the CBRT will ease policy. Governor Karahan has adopted a very hawkish tone as inflation keeps rising, and Erdogan has so far stayed in the background. But tolerance for high rates as inflation falls is unprecedented.
Whether the CBRT remains hawkish once Turkey shifts to positive ex-post real rates (expected later this year) will be one gauge of the bank’s stance. The size and frequency of cuts will also matter. Anything other than a cautious cutting cycle could break the newfound confidence in Turkish policy.
Current Account Improvement Underway
Projected sharp improvement in Turkey’s C/A deficit over the coming months should also boost sentiment. High deficits from the pre-election Q1 2023 have now dopped out of 12m rolling comparisons, and the March and April readings of 2.8% of GDP are near a two-year low (and a 3pp improvement from a year ago).
Declining fuel prices have helped the trade deficit to fall from over 10% GDP a year ago to 6.4%. Gold imports at 1.7% for the past three months are also much reduced from the 3% GDP through last summer. Continued decline in oil imports will help the C/A correction (the energy balance is down 3.4pp versus the same month last year). Strong tourism inflows have also narrowed the C/A deficit (Chart 9).
Non-oil imports must keep decelerating to sustain the C/A correction. Progress has been slower due to still-elevated domestic demand. Overall imports have fallen faster than exports over the past year. But looking at only non-oil imports, the correction came later (i.e., after May 2023’s presidential election) (Chart 10).
Currency weakness likely also played a role. The breakdown of imports shows consumer goods imports remaining elevated, particularly durable goods (Chart 11). Lira stability in recent months combined with a cooling domestic economy and expected fall in inflation expectations should all support a continued normalization in growth of non-oil imports. Without it, the improvement could be short lived.
Chart 9: orange bars = goods balance ($bn, 12m rolling), blue bars = services, grey bars = income, white bars = transfers, black line = CA. Chart 10: orange line = imports (% YoY 3mma), blue line = non-oil imports. Chart 11: orange line = total imports (% YoY), blue line = capital goods imports, black line = consumer goods imports, grey line = intermediate goods imports.
Tourism inflows will be an important driver of the C/A in coming months, with July usually the peak month for foreign arrivals. Visitor arrivals are 122% of the pre-pandemic peak as of April, and last year’s 49mn foreign visitors was an all-time high. A return to the peak services balance of +6.0% (versus 4.6% currently) would largely neutralise the trade deficit and should mean some months of current account surplus. For the year, expectations are for a deficit of around 2.4%, after last year’s 4.1%.
A savings-investment approach to the C/A also highlights the role of excess consumption, or dissaving, in the earlier widening of the deficit. Savings dropped through much of last year while investment was broadly holding up, leaving a widening gap. The past several months have seen a notable shift with savings now rising.
Chart 12: orange line = savings (% GDP), blue line = investment, grey bars = C/A.
On the financing side, positives include an end to the significant E&O outflows – which accelerated again to $9bn ahead of local elections in March – alongside rising foreign inflows. Uncertainty ahead of the March local elections saw non-resident outflows, renewed dollarization and a decline in FX reserves. But during April and May, non-resident bond holdings increased $7.4bn. This looks to have continued in June, with Governor Karahan saying recently that portfolio inflows had exceeded $10bn since April.
De-dollarization (and reduced pressure on banking sector flows) is another positive. And on a medium-term outlook, a better investment climate should see FDI improve from the 0.8% GDP through the past two years.
Chart 13: blue line = non-resident bond holdings. Chart 14: orange line = share of FX deposits.
Net Reserves Now Positive
Gross FX reserves are rising, and net reserves excluding swaps are already positive as of end May, according to Finance Minister Simsek. Our measure using central bank net foreign assets (NFA) excluding all swaps has now been positive for three weeks – the first positive readings since 2000. Since the late March local election, this measure is up by a very significant $72bn (Chart 15).
All three components (foreign assets, foreign liabilities and FX swaps) drove the improvement. The largest shift came from swaps, with a $40bn improvement due to the reduced need to match currency liabilities from FX-protected deposits. This is a sharp turnaround from Q1 when NFA dropped by around $20bn.
Also helping were rising foreign assets (up $22bn), the result of higher gross reserves (CBRT intervention to offset capital inflows), and, to a lesser extent, revaluation of gold reserves. Meanwhile, on the liabilities side, foreign liabilities are down $11bn due to declining FX deposits.
Chart 15: blue line = CBRT net fx reserves excluding swaps ($bn). Chart 16: orange bars = aggregate swaps outstanding ($bn), blue bars = foreign liabilities of the CBRT, grey bars = foreign assets, black line = net fx reserves ex swaps.
FX-protected deposits have been gradually declining since August 2023 following the CBRT announcement of targets for banks to convert the accounts into local currency. A combination of attractive local interest rates, lira stability and a ban on new accounts from TRY deposits are all components. And the overall stock has dropped from a peak of $126bn equivalent in mid-2023 to $65bn (the YTD decline is $25bn equivalent).
The recent reduction in the export surrender requirement from 40% to 30% highlights the now reduced pressure on FX reserves. FX reserve requirements have also been raised in several steps to manage excess liquidity, while the securities maintenance periods relating to loan growth have mostly been abolished. Overall, the CBRT has conducted macroprudential tightening while simplifying its policy framework. Increased transmission of the policy rate should help lower inflation assuming the CBRT do not quickly shift to loosening.
What Does It Mean for TRY?
We have been bullish on TRY since December. But only more recently has this been profitable with high carry and nominal stability. TRY has been largely flat through Q2 – after an 8.8% drop in Q1 – as the CBRT accumulates reserves rather than allowing the currency to strengthen.
The currency remains undervalued, although the run-up in inflation has offset gains from nominal depreciation with TRY currently screening 15% cheap versus over 30% last summer. H2 disinflation will, however, see competitiveness improve.
An ongoing, albeit smaller, C/A deficit alongside refinancing needs on debt will mean Turkey’s external financing requirement remains elevated. Lingering uncertainty over Erdogan’s tolerance for a tight policy stance – particularly once inflation starts to fall – could also mean capital inflows cool from the current highs.
But the CBRT have put the building blocks in place over the past year to encourage de-dollarization and lower inflation; we are cautiously optimistic the gains will stay. Rebuilding reserves should ensure lira stability can be maintained, leaving TRY still attractive even when carry starts to fall from the currently very high levels.
Our trade – originally EUR/TRY 6mth 40 strike digi put for which we paid 24% – has rolled down to 4mth and is worth 60%. While we expect TRY carry trade to continue performing, we lock in the sizable gains. We look to re-engage a variation of this if the levels improve. As such, we close this trade and lock in a gain of 150% of the initial premium paid.
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Caroline Grady is Head of Emerging Markets Research at Macro Hive. Formerly, she was a Senior EM Economist at Deutsche Bank and a Leader Writer at the Financial Times.
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