Turkey

Chart 1Turkey: The Central Bank Is Providing Ample Liquidity To Commercial Banks Turkey: The Central Bank Is Providing Ample Liquidity To Commercial Banks Turkey: The Central Bank Is Providing Ample Liquidity To Commercial Banks Turkey’s unorthodox macroeconomic policies are backfiring again. The Turkish lira plunged 15% against the US dollar after the Central Bank of Turkey (CBTR) cut interest rates by 100 basis points in their latest meeting in November. Not only has the central bank cut interest rates when inflation has been surging, but it has also continued injecting ample liquidity into the financial system. Chart 1 shows that the central bank has been increasing its net funding provisions to commercial banks. This has facilitated commercial bank lending and their purchases of government bonds. Further, state-run banks have slashed their lending rates on household and business loans to the central bank’s funding rate of 15%. Similarly, private commercial banks’ lending rates are also falling, which should stimulate consumption of consumer goods and imports (Chart 2). Altogether, local currency credit and broad money annual growth rates have accelerated to 30% and 15%, respectively (Chart 3). Chart 2Turkey: Lower Rates Will Boost Demand Turkey: Lower Rates Will Boost Demand Turkey: Lower Rates Will Boost Demand Chart 3Turkey: Money and Credit Growth Are Strong Turkey: Money and Credit Growth Are Strong Turkey: Money and Credit Growth Are Strong Lastly, primary government spending is also picking up (Chart 4). The government is planning to boost both public and minimum wages by 30-40%. This is happening when wages have already risen by 30% from a year ago (Chart 5). A wage inflation spiral is already underway, and a massive government wage hike will fuel more inflation. Chart 4Turkey: Higher Fiscal Spending Will Support... Turkey: Higher Fiscal Spending Will Support... Turkey: Higher Fiscal Spending Will Support... Chart 5...Wage Growth and Higher Inflation ...Wage Growth and Higher Inflation ...Wage Growth and Higher Inflation All this points to authorities defying the reality of surging inflation. Not surprisingly, the nation’s exchange rate recently crashed. Considering the plunge in the lira, should investors remain short and underweight Turkish financial assets? We recommend the following: Currency traders who have been shorting the lira should take profits on this position due to tactical considerations; Medium- and long-term investors should remain underweight Turkish equities and local currency bonds relative to their respective EM benchmarks; Dedicated EM credit investors should stay neutral on the nation’s US dollar sovereign credit. The rationale for us to book profits on our short position in TRY versus the US dollar is as follows: Chart 6The Lira Has Cheapened The Lira Has Cheapened The Lira Has Cheapened First, the lira’s real effective exchange rate – based on consumer and producer price indexes – has dropped two standard deviations below its historical mean (Chart 6). Hence, one might argue that the lira has become reasonably cheap for time being. While the currency is unlikely to appreciate in nominal terms versus the US dollar, it might appreciate in real terms given inflation will remain persistently elevated for some time and authorities will undertake draconian measures to control the exchange rate. Second, President Erdogan is faced with falling popularity and growing opposition as currency devaluation and high inflation have eroded household purchasing power. Last week, street protests erupted in several cities. Social and political protests will likely get larger and violent over the coming weeks and months. President Erdogan’s tolerance for further lira depreciation has probably diminished. While it is not clear what authorities will use to stem the currency decline, odds of political intervention to halt the lira’s depreciation have grown substantially. We have been shorting the lira versus the USD since March 2021 and this position has generated a 19.8% gain. We are booking profits as odds of government interventions have risen. The 2018 Redux? Back in 2018, Turkey experienced a currency crisis and authorities responded by tightening policy substantially. Subsequently, the lira experienced a period of stability. Can similar dynamics transpire now? Back then, the CBTR hiked its policy rate by a total of 1600 bps after the lira fell 30% over the summer (Chart 7, top panel). This pushed both the policy rate and bond yields in real terms (adjusted for core CPI) into positive territory (Chart 7, bottom panel). In addition, the central bank withdrew liquidity from commercial banks. Liquidity tightening and higher short-term rates forced commercial banks to cut back on lending (Chart 8, top panel). In parallel, government spending slowed in nominal and contracted in real terms. Chart 7In 2018, The Central Bank Raised Rates After The Currency Plunged... In 2018, The Central Bank Raised Rates After The Currency Plunged... In 2018, The Central Bank Raised Rates After The Currency Plunged... Chart 8...Which Allowed For A Macro Adjustment To Occur ...Which Allowed For A Macro Adjustment To Occur ...Which Allowed For A Macro Adjustment To Occur Such material monetary and fiscal tightening supported the lira. On the economic front, Turkey experienced a macroeconomic adjustment whereby household spending, wage growth, imports and credit/money growth all decelerated markedly in nominal and contracted in real terms (Chart 8, bottom panel). This policy tightening led to falling inflation and a current account surplus. All these bolstered the lira by 30% between August 2018 and January 2019. It is hard to know what the government and central bank will do now. By and large, they have two options: (1) to hike interest rates substantially and withdraw liquidity from the banking system, producing an economic slump/recession (this could temporarily stabilize the exchange rate and cap inflation); or (2) to impose some sort of capital control to prevent further currency devaluation. Overall, it is not clear if President Erdogan will allow monetary and fiscal policy tightening at the current juncture so that the exchange rate standardizes at least for a period of time, or if he will become even more unorthodox and resort to some forms of capital controls or other types of government intervention. In our view, odds of the latter option have increased. Investment Strategy Investors should take profits on short positions on the lira against the US dollar to protect gains in case of unorthodox government interventions in the currency market. We have been trading TRY on the short side since January 2011 (Chart 9). This is a tactical call but not a fundamental change in the view. Medium to long-term investors should remain underweight Turkish equities and local currency government bonds relative to their respective EM benchmark. For dedicated EM sovereign credit investors, we continue recommending a neutral allocation to Turkey. The government has low public debt of 41% of GDP and spreads are already reasonably wide. Chart 9Our Trades On TRY In Past 10 Years Our Trades On TRY In Past 10 Years Our Trades On TRY In Past 10 Years   Andrija Vesic Associate Editor andrijav@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com

Highlights Remain neutral on the US dollar. A breakout of the dollar would cause a shift in strategy. Russia’s conflict with the West is heating up now that Germany has delayed the certification of the Nord Stream II pipeline. As long as the focus remains on the pipeline, the crisis will dissipate sometime in the middle of next year. But there is an equal chance of a massive escalation of strategic tensions. Our GeoRisk Indicators will keep rising in Europe, negatively affecting investor risk appetite. Stick with DM Europe over EM Europe stocks. If the dollar does not break out, South Korea and Australia offer cyclical opportunities. Turkish and Brazilian equities will not be able to bounce back sustainably in the midst of chaotic election cycles and deep structural problems. Rallies are to be faded.  Feature We were struck this week by JP Morgan CEO Jamie Dimon’s claim that his business will “not swayed by geopolitical winds.”1  If he had said “political winds” we might have agreed. It is often the case that business executives need to turn up their collars against the ever-changing, noisy, and acrimonious political environment. However, we take issue with his specific formulation. Geopolitical winds cannot shrugged off so easily – or they are not truly geopolitical. Geopolitics is not primarily about individual world leaders or topical issues. It is primarily about things that are very hard and slow to change: geography, demography, economic structure, military and technological capabilities, and national interests. This is the importance of having a geopolitically informed approach to macroeconomics and financial markets: investment is about preserving and growing wealth over the long run despite the whirlwind of changes affecting politicians, parties, and local political tactics.  In this month’s GeoRisk Update we update our market-based, quantitative geopolitical risk indicators with a special focus on how financial markets are responding to the interplay of near-term and cyclical political risks with structural and tectonic pressures underlying a select group of economies and political systems. Is King Dollar Breaking Out? Chart 1King Dollar Breaking Out? King Dollar Breaking Out? King Dollar Breaking Out? Our first observation is that the US dollar is on the verge of breaking out and rallying (Chart 1). This potential rally is observable in trade-weighted terms and especially relative to the euro, which has slumped sharply since November 5th. Our view on the dollar remains neutral but we are watching this rally closely. This year was supposed to be a year in which global growth recovered from the pandemic on the back of vaccination campaigns, leading the counter-cyclical dollar to drop off. The DXY bounce early in the year peaked on April 2nd but then began anew after hitting a major resistance level at 90. The United States is still the preponderant power within the international system. The USD remains the world’s leading currency by transactions and reserves. The pandemic, social unrest, and contested election of 2020 served as a “stress test” that the American system survived, whether judging by the innovation of vaccines, the restoration of order, or the preservation of the constitutional transfer of power. Meanwhile Europe faces several new hurdles that have weighed on the euro. These include the negative ramifications of the slowdown in Asia, energy supply shortages, a new wave of COVID-19 cases, and the partial reimposition of social restrictions. Moreover the Federal Reserve is likely to hike interest rates faster and higher than the European Central Bank over the coming years. Potential growth is higher in the US than Europe and the US growth is supercharged by fiscal stimulus whereas Europe’s stimulus is more limited. Of course, the US’s orgy of monetary and fiscal stimulus and ballooning trade deficits raise risks for the dollar. Global growth is expected to rotate to other parts of the world over the coming 12 months as vaccination spreads. There is still a chance that the dollar’s bounce is a counter-trend bounce and that the dollar will relapse next year. Hence our neutral view. Yet from a geopolitical perspective, the US population and economy are larger, more dynamic, more innovative, safer, and more secure than those of the European Union. The US still exhibits an ability to avoid the reckoning that is overdue from a macroeconomic perspective.  Russia-West Conflict Resumes In our third quarter outlook we argued that European geopolitical risk had hit a bottom, after coming off the sovereign debt crisis of 2010-15, and that geopolitical risk would begin to rise over the long term for this region. Our reasoning was that the markets had fully priced the Europeans’ decision to band together in the face of risks to the EU’s and EMU’s integrity. What markets would need to price going forward would be greater risks to Europe’s stability from a chaotic external environment that Europe lacked the willingness or ability to control: conflict with Russia, immigration, terrorism, and the slowdown in Asia. In particular we argued that Russia’s secular conflict with the West would resume. US-Russia relations would not improve despite presidential summits. The Nord Stream II pipeline would become a lightning rod for conflict, as its operation was more likely to be halted than the consensus held. (German regulators paused the approval process this week, raising the potential for certification to be delayed past the expected March-May months of 2022.) Most importantly we argued that the Russian strategy of political and military aggression in its near-abroad would continue since Russia would continue to feel threatened by domestic instability at home and Western attempts to improve economic integration and security coordination with former Soviet Union countries.  Chart 2Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further Putin Showdown With West To Escalate Further For this reason we recommended that investors eschew Russian equities despite a major rally in commodity prices. Any rally would be undercut by the slowing economy in Asia or geopolitical conflicts that frightened investors away from Russian companies, or both. Today the market is in the process of pricing the impact on Russian equities from commodity prices coming off the boil. But politics may also have something to do with the selloff in Russian equities (Chart 2). The selloff can continue given still-negative hard economic data from Asia and the escalation of tensions around Russia’s strategically sensitive borders: Ukraine, Belarus, Poland, Lithuania, Moldova, and the Black Sea. The equity risk premium will remain elevated for eastern European markets as a result of the latest materialization of country risk and geopolitical risk – the long running trend of outperformance by developed Europe has been confirmed on a technical resistance level (Chart 3). Our mistake was closing our recommendation to buy European natural gas prices too early this year. Chart 3Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown Favor DM Europe Amid Russia Showdown In early 2021, our market-based geopolitical risk indicator for Russia slumped, implying that global investors expected a positive diplomatic “reset” between the US and Russia. We advised clients to ignore this signal and argued that Russian geopolitical risk would take back off again. We said the same thing when the indicator slumped again in the second half of the year and now it is clear the indicator will move sharply higher (Chart 4). The point is that geopolitics keeps interfering with investors’ desire to resuscitate Russian equities based on macro and fundamental factors: cheap valuations, commodity price rises, some local improvements in competitiveness, and the search for yield.   Chart 4Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russian GeoRisk Indicator - Risks Not Yet Priced Russia may or may not stage a new military incursion into Ukraine – the odds are 50/50, given that Russia has invaded already and has the raw capability in place on Ukraine’s borders. The intention of an incursion would be to push Russian control across the entire southern border of Ukraine to Odessa, bringing a larger swathe of the Black Sea coast under Moscow’s control in pursuit of Russia’s historic quest for warm water ports. The limitations on Russia are obvious. It would undertake new military and fiscal burdens of occupation, push the US and EU closer together, provoke a stronger NATO defense alliance, and invite further economic sanctions. Yet similar tradeoffs did not prevent Russia from taking surprise military action in Georgia in 2008 or Ukraine in 2014. After the past 13 years the US and EU are still uncoordinated and indecisive. The US is still internally divided. With energy prices high, domestic political support low, and Russia’s long-term strategic situation bleak, Moscow may believe that the time is right to expand its buffer territory further into Ukraine. We cannot rule out such an outcome, now or over the next few years. If Russia attacks, global risk assets will suffer a meaningful pullback. It will not be a bear market unless the conflict spills out beyond Ukraine to affect major economies. We have not taken a second Ukraine invasion as our base case because Russia is focused primarily on getting the Nord Stream pipeline certified. A broader war would prevent that from happening. Military threats after Nord Stream is certified will be more worrisome.  A less belligerent but still aggressive move would be for Russia to militarize the Belarussian border amid the conflict with the EU over Belarus’s funneling of Middle Eastern migrants into the EU via Poland and Lithuania. A closer integration of Russia’s and Belarus’s economies and militaries would fit with Russia’s grand strategy, improve Russia’s military posture in eastern Europe, and escalate fears of eventual war in Poland and the Baltic states. The West would wring its hands and announce more sanctions but may not have a higher caliber response as such a move would not involve hostilities or the violation of mutual defense treaties. This outcome would be negative but also digested fairly quickly by financial markets. Our European GeoRisk Indicators (see Appendix) are likely to respond to the new Russia crisis, in keeping with our view that European geopolitical risk will rise in the 2020s: German risk has dropped off since the election but will now revive at least until Nord Stream II is certified. If Russia re-invades Ukraine it will rise, as it did in 2014.  French risk was already heating up due to the presidential election beginning April 10 (first round) but now may heat up more. Not that Russia poses a direct threat to France but more that broader regional insecurities would hurt sentiment. The election itself is not a major risk to investors, though terrorist attacks could tick up. President Macron has an incentive to be hawkish on a range of issues over the next half year. The UK is in the midst of the Russia conflict. Its defense cooperation with Ukraine and naval activity in the Black Sea, such as port calls in Georgia, have prompted Russia’s military threats – including a threat to bomb a Royal Navy vessel earlier this year. Not to mention ongoing complications around Brexit. The Russian situation is by far the most significant factor. Spain is at a further remove from Russia but its risks are rising due to domestic political polarization and the rising likelihood of a breakdown in the ruling government. Bottom Line: We still favor these countries’ equities to those of eastern Europe but our risk indicators will rise, suggesting that geopolitical incidents could cause a setback for some or all of these markets in absolute terms. A pickup in Asian growth would be beneficial for developed European assets so we are cyclically constructive. We remain neutral on the USD-EUR though a buying opportunity may present itself if and when the Nord Stream II pipeline is certified.  Korea: Nobody’s Heard From Kim In A While Chart 5Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Korea GeoRisk Indicator Still Elevated Geopolitical risk has risen in South Korea due to COVID-19 and its aftershocks, including supply kinks, shortages, and policy tightening by the giant to the West (Chart 5). South Korea’s geopolitical risk indicator is still very high but not because of North Korea. Our Dear Leader Kim Jong Un has not been overly provocative, although he has restarted the cycle of provocations during the Biden administration. Yet South Korean geopolitical risk has skyrocketed. The problem is that investors have lost a lot of appetite for South Korea in a global environment in which demographics are languishing, globalization is retreating, a regional cold war is developing, and debt levels are high. Domestic politics have become more redistributive without accompanying reforms to improve competitiveness or reform corporate conglomerates. The revival of the South Korean conservatives ahead of elections in 2022 suggests political risk will remain elevated. Of course, North Korea could still move the dial. A massive provocation, say something on the scale of the surprise naval attack on the Chonan in the wake of the global financial crisis in spring of 2010, could push up the risk indicator higher and increase volatility for the Korean won and equities. Kim could take such an action to insist that President Biden pay heed to him, like President Trump did, or at least not ignore him, in a context in which Biden is doing just that due to far more pressing concerns. Biden would be forced to reestablish a credible threat.  Still, North Korea is not the major factor today. Not compared to the economic and financial instability in the region. At the same time, if global growth surprises pick up and the dollar does not break out, Korea will be a beneficiary. We have taken a constructive cyclical view, although our specific long Korea trade has not worked out this year. Korean equities depreciated by 11.2% in USD terms year-to-date, compared to 0.3% for the rest of EM. Structurally, Korea cannot overcome the negative demographic and economic factors mentioned above. Geopolitically it remains a “shrimp between two whales” and will fail to reconcile its economic interests with its defense alliance with the United States.   Australia: Wait On The Dollar Chart 6Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian GeoRisk Indicator Still Elevated Australian geopolitical risk has not fallen back much from this year’s highs, according to our quant indicator (Chart 6). Global shortages and a miniature trade war were the culprits of this year’s spike. The advantage for Australia is that commodity prices and metals look to remain in high demand as the world economy fully mends. Various nations are implementing large public investment programs, especially re-gearing their energy sectors to focus more on renewables. The reassertion of the US security alliance is positive for Australia but geopolitical risk is rising on a secular basis regardless.   Cyclically we would look positively toward Australian stocks. Yet they have risen by 4.3% in common currency terms this year so far, compared to the developed market-ex-US average of 11.0%. Moreover the Aussie’s latest moves confirm that the US dollar is on the verge of breaking out which would be negative for this bourse. Structurally Australia will go through a painful economic transition but it will be motivated to do so by the new regional cold war and threats to national security. The US alliance is a geopolitical positive.   Turkey And Brazil The greenback’s rally could be sustainable not only because of the divergence of US from Asian and global growth but also because of the humiliating domestic political environment of most prominent emerging markets. Chart 7Emerging Market Bull Trap Emerging Market Bull Trap Emerging Market Bull Trap We booked gains our “short” trade of the currencies of EM “strongmen,” such as Brazil’s Jair Bolsonaro and Turkey’s Recep Erdogan, earlier this year. But we noted that we still hold a negative view on these economies and currencies. This is especially true today as contentious elections approach in both countries in 2022 and 2023 respectively (Chart 7). Turkey is trapped into an inflation spiral of its own design, which enervates the economy, as our Emerging Markets Strategy has shown. It is also trapped in a geopolitical stance in which it has repeatedly raised the stakes in simultaneous clashes with Russia, the US, Europe, Israel, the Arab states, Libya, and Iran. Russia’s maneuvers in the Black Sea are fundamentally threatening to Turkey, so while Erdogan has maintained a balance with Russia for several years, Russian aggression could upset that balance. Turkey has backed off from some recent confrontations with the West lately but there is not yet a trend of improvement. The COVID-19 crisis gave Erdogan a badly needed bump in polls, unlike other EM peers. But this simply reinforces the market’s overrating of his odds of being re-elected. In reality the odds of a contested election or an election upset are fairly high. New lows in the lira show that the market is reacting to the whole negative complex of issues around Turkey. But the full weight of the government’s mismanaging of economic policy to stay in power and stay geopolitically relevant has not yet been felt. The election is still 19 months away. A narrow outcome, for or against Erdogan and his party, would make things worse, not better. Brazil’s domestic political and geopolitical risks are more manageable than Turkey’s. But it faces a tumultuous election in which institutional flaws and failures will be on full display. Investors will try to front-run the election believing that former President Luiz Inácio Lula da Silva will restore the good old days. But we discourage that approach. We see at least two massive hurdles for the market: first, Brazil has to pass its constitutional stress test; second, the next administration needs to be forced into difficult decisions to preserve growth and debt management. These will come at the expense of either growth or the currency, according to our Emerging Markets Strategy. We still prefer Mexican stocks. Geopolitically, Turkey will struggle with Russia’s insecurity and aggression, Europe’s use of economic coercion, and Middle Eastern instability. Brazil does not have these external problems, although social stability will always be fragile. Investment Takeaways The dollar is acting as if it may break out in a major rally. Our view has been neutral but our generally reflationary perspective on the global economy is being challenged. Russia’s conflict with the West will escalate, not de-escalate, in the wake of Germany’s decision to delay the certification of the Nord Stream II pipeline. Russia has greater leverage now than usual because of energy shortages. A re-invasion of Ukraine cannot be ruled out. But the pipeline is Russia’s immediate focus. Investors have seen conflict in Ukraine so they will be desensitized quickly unless the conflict spreads into new geographies or spills out to affect major economies. The same goes for trouble on Belarus’s borders. Stick with long DM Europe / short EM Europe. Opportunities may emerge to become more bullish on the euro and European equities if and when the Nord Stream II situation looks to be resolved and Asian risks to global growth are allayed. If the dollar does not break out, South Korea and Australia are cyclical beneficiaries. Whereas “strongman” regimes will remain volatile and the source of bull traps, especially Turkey.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com Footnotes 1  “JP Morgan chief becomes first Wall Street boss to visit during pandemic,” Financial Times, November 15, 2021, ft.com. Strategic View Open Tactical Positions (0-6 Months) Open Cyclical Recommendations (6-18 Months) Open Trades & Positions Image Section II: Appendix: GeoRisk Indicator Russia Russia: GeoRisk Indicator Russia: GeoRisk Indicator United Kingdom UK: GeoRisk Indicator UK: GeoRisk Indicator Germany Germany: GeoRisk Indicator Germany: GeoRisk Indicator France France: GeoRisk Indicator France: GeoRisk Indicator Italy Italy: GeoRisk Indicator Italy: GeoRisk Indicator Canada Canada: GeoRisk Indicator Canada: GeoRisk Indicator Spain Spain: GeoRisk Indicator Spain: GeoRisk Indicator Korea Korea: GeoRisk Indicator Korea: GeoRisk Indicator Turkey Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Australia Australia: GeoRisk Indicator Australia: GeoRisk Indicator South Africa South Africa: GeoRisk Indicator South Africa: GeoRisk Indicator Section III: Geopolitical Calendar

Feature Chart 1Turkish Markets: A Budding Breakout Or A False Start? Turkey: Is It Different This Time? Turkey: Is It Different This Time? Even though the Turkish lira and financial markets might be set for a short-term bout of outperformance versus their EM peers, investors should fade it (Chart 1). A sustainable medium and long-term rally and outperformance in Turkish financial assets relative to the rest of EM are not in the cards. Any lasting bottom in the currency will need to be predicated on profound disinflationary forces instigated by higher real interest rates/tighter monetary policy. For now, there is little evidence that monetary authorities are willing to embark on an enduring monetary tightening cycle. Will Growth Weakness Prompt Lower Inflation? Turkey’s business cycle has peaked and growth will decelerate in the coming months: The previous rise in consumer and business lending rates – shown inverted in Chart 2 – heralds a slowdown in retail sales volume, vehicle purchases and capital goods imports, i.e., domestic demand, in the coming months (Chart 2). The soaring cost of living is becoming a restraining force. High food and energy prices as well as escalating housing rent in major urban areas are reducing the amount of income left for household discretionary spending. Notably, recent polls from April 2021 suggest that 27% of respondents cannot meet their basic needs like food and shelter, while 54% can barely do so.1 Besides, government spending in real terms is tame (Chart 3). Chart 2Turkey: Previous Rate Hikes Will Stall Domestic Demand Turkey: Is It Different This Time? Turkey: Is It Different This Time? Chart 3Turkey: Tame Fiscal Spending Turkey: Is It Different This Time? Turkey: Is It Different This Time?   Nevertheless, it is not clear if such a growth slump will dent and bring down core inflation (Chart 4). The basis is that high inflation expectations in Turkey are structural and very entrenched. Hence, it will require lasting and severe monetary tightening and a major economic recession to engineer meaningful disinflation. Chart 4Turkey: Entrenched Structural Inflation Turkey: Is It Different This Time? Turkey: Is It Different This Time? No Regime Shift In Inflation Despite a possible temporary reprieve in core CPI measures, the medium- to long-term inflation outlook in Turkey is troublesome. Turkey is caught in a vicious inflation-wage spiral that will be hard to break. Not only private loan growth has been rampant, but also commercial banks as well as the central bank have been monetizing government debt. As foreign investors have been selling out of domestic government bonds, commercial banks have been accumulating them since 2018. Chart 5 demonstrates that commercial banks’ ownership of local currency government bonds has risen from 45% to 68% in past 3 years. In this process, commercial banks have been creating new money supply out of thin air which has supercharged inflation. Importantly, consumers perceive inflation to be much higher than official inflation data suggests. Close to 50% of consumers polled in March2 this year believe that food inflation is higher than 40%, while the overwhelming majority believe overall inflation is well above official figures. As a result, the mistrust in the lira and fear of rising prices have forced residents to accumulate large sums of foreign currency deposits to protect their savings (Chart 6, top panel). With local currency money supply mushrooming (Chart 6, bottom panel), this lack of confidence in the lira will not go away. Chart 5Turkey: Domestic Banks Have Been Dominant Buyers Of Domestic Government Bonds Turkey: Is It Different This Time? Turkey: Is It Different This Time? Chart 6Turkey: Ballooning Money Supply And Residents' FX Deposits Turkey: Is It Different This Time? Turkey: Is It Different This Time? Breaking this persistent inflation trend will require authorities to implement very tight monetary policy for an extended period of time. In such a scenario, the central bank will have to raise interest rates and commercial banks will have to curtail the pace of credit creation. An extended period of subdued credit growth and higher domestic interest rates would engender severe retrenchment in domestic demand and disinflation. This would help anchor the currency. Table 1Turkey: AKP Is Trailing In Voters Preferences Turkey: Is It Different This Time? Turkey: Is It Different This Time? However, such a macro adjustment is unlikely to transpire anytime soon due to political dynamics. President Erdogan cannot afford a relapse in the economy and employment. He will be reluctant to sustain tight monetary and fiscal policies for an extended period of time with elections looming in less than 24 months. His popularity has been waning and support for the AKP has already been weak. Recent polls continue to show preference for the opposition alliance (Table 1). As in the past, President Erdogan will not shy away from forcing the central bank to cut interest rates and commercial banks to resume cheap lending. His recent speeches have once again been calling for the central bank to ease policy. If and when the central bank starts easing monetary policy, the currency will plummet and financial markets will sell off. Bottom Line: Dismantling inflation in Turkey will require lasting tight monetary policy and tolerating higher unemployment to break the wage-inflation spiral. President Erdogan will not opt for this policy option. Investment Implications Even though Turkish financial markets might outperform their EM peers in the short run, we do not recommend chasing this outperformance. The central bank will remain behind the inflation curve, which is bearish for the exchange rate. Investors should stay short the lira versus the US dollar. Investors should underweight both local government bonds and equities in their EM domestic bonds and equity portfolios, respectively. Credit investors should be neutral on Turkish sovereign credit but underweight its corporate credit within an EM credit portfolio.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1Taken from Metropoll Turkey’s Pulse April edition, http://www.metropoll.com.tr/upload/content/files/1899-themonthin-5numbers--april21.pdf. 2 Taken from Metropoll Turkey’s Pulse March edition, http://www.metropoll.com.tr/upload/content/files/1894-monthin5numbers-march21.pdf.