USD/TRY sets all-time highs, but Erdogan's re-election might push the lira even lower (Daily analysis 29.05.2023)

No miracle on the Bosporus. Recep Erdogan, who has remained in power for two decades, triumphed over opposition candidate Kemal Kilicdaroglu in the second round of the presidential election by a considerable margin. It means that hopes for a rapprochement between Turkey and the West, an abandonment of the crazy, unconventional economic model and a return to the favour of international investors are finally being dashed.

The results of Sunday's vote have not come as a financial shock to the markets. Before the first round of voting on 14 May, there was great optimism that Turkey would embark on a path of reform. When Recep Erdogan came within a hair's breadth of victory and then received the support of a third candidate, hopes of an opposition triumph burst like a soap bubble.

The USD/TRY exchange rate has, in fact, continued its upward trajectory uninterruptedly. Since the beginning of the month, it has risen by around 3%, being at record highs and above 20.00. However, it should be noted that this state of affairs does not fully reflect the seriousness of the situation. For a long time, the Turkish currency's exchange rate can hardly be seen as a result of market forces. The sell-off of the lira has been artificially tamed and limited by interventions and numerous restrictions on capital flows. Without such support, the Turkish currency would be considerably weaker. The real demand for US dollars and euros, the so-called hard currencies, remains chronically unsatisfied, and the fragile, artificial and forced equilibrium is under constant threat. At some point, it could again turn into a deep collapse, the sharpest of which occurred in 2021. We expect that the lira should lose around 15% later in the year.

In such a situation, a better litmus test for perceptions of the political scene than the strength of the currency is the performance of the Istanbul Stock Exchange, especially the banking sector. When, in the first part of May, hopes were raised that the opposition would win, the banking index shot up by more than 25 per cent, with the most relevant stock market average, the BIST 100, rising by around 15 per cent. Nothing was left of that rally by the second round of voting. At the start of Monday's session, the banks on the Turkish trading floor were up around 1.5%, and the main index was up 2.5%. This shows that the markets were already at peace with the outcome of the vote.

The balance sheet so far of Recep Erdogan's two decades in power has been the progressive destabilisation of the economy, the spiralling sell-off of the lira and the pushing of Turkish stocks and bonds further and further out of investors' reach. Foreign equity exposure to Turkish bonds is estimated to have declined by around 85% since 2013, during which time the lira has lost around 90% against the US dollar. The composition of the new cabinet will indicate whether reformist factions have any strength in the power camp. However, it seems unrealistic to abandon the hitherto unorthodox course. In a model where low interest rates are supposed to be the remedy for the inflation of several dozen percent and the state interferes in market processes at every turn, a crisis will always hang in the air. This is particularly the case given that, with its melting foreign exchange reserves, Turkey's dependence on foreign capital and complicated balance of payments situation make the economy and financial system particularly vulnerable to any external shocks.