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  Click to listen highlighted text! A combination of domestic political and policy uncertainty alongside a diplomatic dispute with the US has contributed the latest sell-off in Turkish assets: Politics Turkey has been in a state of emergency since an attempted military coup in July 2016. In April, President Recep Tayyip Erdogan announced parliamentary and presidential elections would be held seventeen months ahead of schedule “to remove uncertainties” on both the “internal and external agenda”. President Erdogan was re-elected in June following the first round of the presidential elections – a surprise outcome given polls indicated a high probability of a second round. His presidency is in its fifteenth year and constitutional changes mean he can serve up to three more terms. The election victory also transitioned the country from a parliamentary system to an executive presidency meaning policy-making is highly centralized with the role of ministers largely confined to implementation. In the parliamentary vote, Erdogan’s Justice and Development (AK) party and its coalition partner, the Nationalist Movement Party (MHP) received a combined 54% share of the vote, enough to secure a majority in the assembly. Concentration of control, a perceived lack of adequate checks-and-balances and Erdogan’s intolerance of opponents and dissent within his own party have unnerved investors. Side-lining of officials who would pursue market-friendly policies and the appointment of officials with unorthodox views has further compounded investor unease about the direction of economic policymaking. Policy Expansionary policies following the 2016 attempted coup and a supportive global macro backdrop helped Turkish GDP growth rebound sharply in 2017, rising from -0.8% year-over-year in the third quarter of 2016 to over 11% a year later. Above-trend growth and a positive output gap have generated domestic price pressures, pushing inflation to above 15%, more than triple its 5% target (Exhibit 1). The central bank has raised rates by 9.75% to 17.75% this year (Exhibit 2) but further monetary tightening is required to temper elevated inflation, reduce inflation expectations and to stem the slide in the currency (Exhibit 3), with Turkish lira depreciation adding further upward inflationary pressures. However, confidence in appropriate monetary actions has been eroded by a lack of central bank independence and opaque forward guidance. It is also unclear whether earlier rate hikes were politically motivated ahead of the June election and therefore unlikely to continue in the near-term. The central bank has committed to provide liquidity to the country’s banks if required but this has done little to support the currency. The government also unveiled a medium-term growth plan last week but this lacked detail, particularly in relation to fiscal policy. Geopolitics The recent deterioration in US-Turkey relations is centered on the US’s disagreement with the continued imprisonment of an American pastor in Turkey and President Erdogan’s unfulfilled request for the extradition of a Turkish preacher living in the US. Erdogan believes both individuals should be prosecuted for their participation in the 2016 attempted coup, though evidence of this is disputed. The US Treasury has frozen the assets of two Turkish ministers due to their involvement in the arrest and continued detention of the pastor–an unprecedented measure against a fellow NATO ally–and last week US President Donald Trump announced that he intends to double the tariff levied on Turkish steel and aluminum imports. These actions have further weighed on Turkish asset performance and highlight the global risk environment’s continued sensitivity to geopolitics. Exhibit 1: turkish inflation - persistently above target Source: Macrobond, GSAM, http://www.tcmb.gov.tr. As of July 2018. Based on annual headline CPI inflation minus central bank target. Exhibit 2: monetary policy - still too accomodative   Source: Macrobond. As of August 13, 2018. Exhibit 3: turkish lira - depreciation amid investor unease   Source: Macrobond. As of August 10, 2018. Investment ImplicationsVolatility in emerging market (EM) assets is not uncommon and—as we noted recently—does not preclude positive performance over the medium- to long-term. We do not think the current situation in Turkey is a bellwether for the broader EM complex; however, the extent of volatility in Turkish assets will likely challenge investor sentiment towards EM complex in the near-term. With respect to Turkish assets, some of the concerns driving recent price moves are not new. Many investors—including us—have been monitoring Turkey’s elevated USD funding needs (which we define as short-term external debt and the current account deficit) for the past several years. To gauge vulnerability to a stop in foreign funding flows we evaluate whether countries have adequate FX reserves to meet this measure of funding needs. Turkey appears vulnerable on this metric; its funding needs resemble Frontier Markets and are not too dissimilar to the needs of Latin American countries in the 1980s or Asia in the 1990s¹. However, it is the addition of concerns around heterodox policy and escalating geopolitical tensions that has resulted in a rapid rise in risk premia across Turkish assets in recent weeks. The Turkish lira has weakened over 40% versus the US dollar this year. The currency is unlikely to gain ground until investors see tangible signs of policy reform and adjustments on both the monetary and fiscal front. Yields on local currency sovereign debt increased around 200 basis points last Friday—one of the weakest days since volatility commenced earlier this summer—though low trading volumes prevented further outsized moves (in contrast to the currency which remains highly sensitive to incoming news flow). External debt has fared better due to Turkey’s strong fiscal position, with credit default swap spreads on USD-denominated debt widening around 80bps on Friday. Turkey runs a fiscal deficit of around 2% of GDP and its debt-to-GDP ratio stands at ~30%. This is low relative to EM peers and pales in comparison to Italy’s 130% ratio. Both fiscal measures are consistent with an investment grade credit rating. We would need to see a significant deterioration in Turkey’s fiscal standing before the sustainability of external debt becomes a significant concern. What we’re watching Current account adjustment. Last year’s expansionary fiscal policies, including a credit scheme underwritten by the Credit Guarantee Fund, resulted in material widening of the current account deficit. The recent adjustment in the currency may cause this deficit to contract as a weaker currency compresses imports but boosts export competitiveness. Geopolitics. We think concerns around further US trade actions and potential sanctions will linger over Turkish asset performance until the diplomatic dispute concerning the US pastor who is still held under house arrest in Turkey is resolved. European banking sector. Sharp moves in the Turkish lira raised concerns about the exposure of European Banks to Turkey. We think this exposure is limited and adequate capital holdings will absorb any losses related to equity stakes in Turkish banks. Furthermore, Turkish banks obtain funding from global sources and so we think any pullback in funding from European banks is likely to be manageable. That said, a continued sell-off in Turkish assets will likely generate volatility in broader risk markets, including European credit and in particular the financial sector. We are also alert to the ability of Turkish banks to obtain USD funding given heightened geopolitical tensions. Capital controls. Over the weekend Turkish leadership reiterated that it would not limit the flow of foreign money out of the country despite ongoing weakness in its currency. If policymakers do seek to stem depreciation of the Turkish lira, President Erdogan also has the option to request an International Monetary Fund (IMF) stand-by agreement rather than impose capital controls. Potential for capital controls is a tail risk scenario, though the probability of this would rise if the Turkish lira experiences pronounced further depreciation and if Turkey is unable to obtain IMF assistance.

A combination of domestic political and policy uncertainty alongside a diplomatic dispute with the US has contributed the latest sell-off in Turkish assets:

  • Politics Turkey has been in a state of emergency since an attempted military coup in July 2016. In April, President Recep Tayyip Erdogan announced parliamentary and presidential elections would be held seventeen months ahead of schedule “to remove uncertainties” on both the “internal and external agenda”. President Erdogan was re-elected in June following the first round of the presidential elections – a surprise outcome given polls indicated a high probability of a second round. His presidency is in its fifteenth year and constitutional changes mean he can serve up to three more terms. The election victory also transitioned the country from a parliamentary system to an executive presidency meaning policy-making is highly centralized with the role of ministers largely confined to implementation. In the parliamentary vote, Erdogan’s Justice and Development (AK) party and its coalition partner, the Nationalist Movement Party (MHP) received a combined 54% share of the vote, enough to secure a majority in the assembly. Concentration of control, a perceived lack of adequate checks-and-balances and Erdogan’s intolerance of opponents and dissent within his own party have unnerved investors. Side-lining of officials who would pursue market-friendly policies and the appointment of officials with unorthodox views has further compounded investor unease about the direction of economic policymaking.
  • Policy Expansionary policies following the 2016 attempted coup and a supportive global macro backdrop helped Turkish GDP growth rebound sharply in 2017, rising from -0.8% year-over-year in the third quarter of 2016 to over 11% a year later. Above-trend growth and a positive output gap have generated domestic price pressures, pushing inflation to above 15%, more than triple its 5% target (Exhibit 1). The central bank has raised rates by 9.75% to 17.75% this year (Exhibit 2) but further monetary tightening is required to temper elevated inflation, reduce inflation expectations and to stem the slide in the currency (Exhibit 3), with Turkish lira depreciation adding further upward inflationary pressures. However, confidence in appropriate monetary actions has been eroded by a lack of central bank independence and opaque forward guidance. It is also unclear whether earlier rate hikes were politically motivated ahead of the June election and therefore unlikely to continue in the near-term. The central bank has committed to provide liquidity to the country’s banks if required but this has done little to support the currency. The government also unveiled a medium-term growth plan last week but this lacked detail, particularly in relation to fiscal policy.
  • Geopolitics The recent deterioration in US-Turkey relations is centered on the US’s disagreement with the continued imprisonment of an American pastor in Turkey and President Erdogan’s unfulfilled request for the extradition of a Turkish preacher living in the US. Erdogan believes both individuals should be prosecuted for their participation in the 2016 attempted coup, though evidence of this is disputed. The US Treasury has frozen the assets of two Turkish ministers due to their involvement in the arrest and continued detention of the pastor–an unprecedented measure against a fellow NATO ally–and last week US President Donald Trump announced that he intends to double the tariff levied on Turkish steel and aluminum imports. These actions have further weighed on Turkish asset performance and highlight the global risk environment’s continued sensitivity to geopolitics.
Exhibit 1: turkish inflation - persistently above target
goldman sachs asset management market update turkey 1
Source: Macrobond, GSAM, http://www.tcmb.gov.tr. As of July 2018. Based on annual headline CPI inflation minus central bank target.
Exhibit 2: monetary policy - still too accomodative
 goldman sachs asset management market update turkey 2
Source: Macrobond. As of August 13, 2018.
Exhibit 3: turkish lira - depreciation amid investor unease
 goldman sachs asset management market update turkey 3
Source: Macrobond. As of August 10, 2018.

Investment Implications
Volatility in emerging market (EM) assets is not uncommon and—as we noted recently—does not preclude positive performance over the medium- to long-term. We do not think the current situation in Turkey is a bellwether for the broader EM complex; however, the extent of volatility in Turkish assets will likely challenge investor sentiment towards EM complex in the near-term.

With respect to Turkish assets, some of the concerns driving recent price moves are not new. Many investors—including us—have been monitoring Turkey’s elevated USD funding needs (which we define as short-term external debt and the current account deficit) for the past several years. To gauge vulnerability to a stop in foreign funding flows we evaluate whether countries have adequate FX reserves to meet this measure of funding needs. Turkey appears vulnerable on this metric; its funding needs resemble Frontier Markets and are not too dissimilar to the needs of Latin American countries in the 1980s or Asia in the 1990s¹. However, it is the addition of concerns around heterodox policy and escalating geopolitical tensions that has resulted in a rapid rise in risk premia across Turkish assets in recent weeks.

  • The Turkish lira has weakened over 40% versus the US dollar this year. The currency is unlikely to gain ground until investors see tangible signs of policy reform and adjustments on both the monetary and fiscal front.
  • Yields on local currency sovereign debt increased around 200 basis points last Friday—one of the weakest days since volatility commenced earlier this summer—though low trading volumes prevented further outsized moves (in contrast to the currency which remains highly sensitive to incoming news flow).
  • External debt has fared better due to Turkey’s strong fiscal position, with credit default swap spreads on USD-denominated debt widening around 80bps on Friday. Turkey runs a fiscal deficit of around 2% of GDP and its debt-to-GDP ratio stands at ~30%. This is low relative to EM peers and pales in comparison to Italy’s 130% ratio. Both fiscal measures are consistent with an investment grade credit rating. We would need to see a significant deterioration in Turkey’s fiscal standing before the sustainability of external debt becomes a significant concern.

What we’re watching

  1. Current account adjustment. Last year’s expansionary fiscal policies, including a credit scheme underwritten by the Credit Guarantee Fund, resulted in material widening of the current account deficit. The recent adjustment in the currency may cause this deficit to contract as a weaker currency compresses imports but boosts export competitiveness.
  2. Geopolitics. We think concerns around further US trade actions and potential sanctions will linger over Turkish asset performance until the diplomatic dispute concerning the US pastor who is still held under house arrest in Turkey is resolved.
  3. European banking sector. Sharp moves in the Turkish lira raised concerns about the exposure of European Banks to Turkey. We think this exposure is limited and adequate capital holdings will absorb any losses related to equity stakes in Turkish banks. Furthermore, Turkish banks obtain funding from global sources and so we think any pullback in funding from European banks is likely to be manageable. That said, a continued sell-off in Turkish assets will likely generate volatility in broader risk markets, including European credit and in particular the financial sector. We are also alert to the ability of Turkish banks to obtain USD funding given heightened geopolitical tensions.
  4. Capital controls. Over the weekend Turkish leadership reiterated that it would not limit the flow of foreign money out of the country despite ongoing weakness in its currency. If policymakers do seek to stem depreciation of the Turkish lira, President Erdogan also has the option to request an International Monetary Fund (IMF) stand-by agreement rather than impose capital controls. Potential for capital controls is a tail risk scenario, though the probability of this would rise if the Turkish lira experiences pronounced further depreciation and if Turkey is unable to obtain IMF assistance.
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