Stability is not a word you tend to associate with Turkey.
Back in the mid-18th century, the great European powers often debated 'the eastern question': what to do about the original 'sick man of Europe'.
The reign of current President Recep Tayyip Erdogan has also been characterised by political ailments: democratic backsliding, erosion of civil liberties, increased economic intervention, military skirmishes and a series of high-profile international disputes.
For investors, all of these make Turkey a risky place to do business.
This was made painfully obvious last summer, when the Turkish lira sunk to all-time lows against the US dollar, stockmarkets nosedived and inflation sky-rocketed.
But for a while, capital markets’ main concern has been the president’s penchant for interfering in monetary policy. Strongman Erdogan fancies himself as a monetary theorist – pushing the economic theory that high interest rates cause, rather than contain, inflation.
His influence on central bank decisions has always been clear enough, but in July he surprised markets by firing central bank governor Murat Cetinkaya.
Cetinkaya’s three years at the helm drew criticism from financial commentators – accusing him of politically motivated interest rate cuts – but even his pace of cuts wasn’t fast enough for the president.
His replacement, Murat Uysal, has already slashed rates by 4.25 per cent, and signalled that further cuts are on the way. As well he might, given his predecessor was sacked because he “wouldn’t follow instructions”.
Capital markets tend not to like political interference in monetary policy. But this time, no one seems to have told capital markets that.
The lira fell the day of Cetinkaya’s departure, but since then has rebounded – and then some. After Uysal’s first rate cut, the currency actually rose 3 per cent.
Could it be that investors buy into Erdogan’s theory on monetary policy?
In the past, the president has declared himself the “enemy of interest rates”. Contrary to conventional theory, he argues higher borrowing rates are passed on to consumers because companies raise their prices.
He’s not alone in questioning conventional views.
A number of economic theories have attracted criticism: the Phillips curve (the supposed inverse relationship between unemployment and inflation) seems to have broken down.
The era of stubbornly low inflation, despite historically low interest rates, has led many to reconsider the old ways, most notably at the US Federal Reserve.
Even for developing economies, recent research from the International Monetary Fund has suggested that crushingly high interest rates can be destabilising.
But whether this is behind markets’ show of confidence in Turkey is another issue.
You don’t have to believe in Erdoganomics to believe in Turkey as an investment proposition. The recent fall in inflation has left Turkey with the highest real (inflation-adjusted) interest rate in the world.
With falling rates and a government poised to crank up public spending, the country looks due a growth spurt in the short term.
As with other emerging markets, the carry trade – borrowing cheaply in developed markets and investing in high growth emerging markets – is looking increasingly attractive.
Protecting against the risks
There are, of course, dangers to this approach.
Emerging markets tend to do well when global growth is strong and the dollar is weak, neither of which is true now.
Yield-chasers have been stung by bouts of Turkish instability in the past, last summer being the prime example.
Even now, the threat of US sanctions – in response to the government’s purchase of the Russian S-400 missile defence system – looms.
In typical Erdogan fashion, the president responded to these threats by making some of his own: the country may have to “rethink” their purchases of $10bn worth of Boeing aircraft if the US follows through.
But the dangers could be overcome.
Internationally, Turkey benefits from being a key ally in a tumultuous region. That fact has got them off the hook for questionable behaviour many times in the past. Barring any major incidences, they will likely be let off again.
Even if they aren’t, there are ways of investing in Turkey that protect against such risks.
Governor Uysal has vowed to preserve “a reasonable rate of real return” on government bonds.
Judging by his past comments, what he has in mind is a return comparable to his emerging market peers in South Korea, South Africa and Brazil. The current trading price puts this at around 3.5 per cent for the five-year bond – meaning investors will get a 3.5 per cent return plus whatever the inflation rate is in that time.
This makes the bond a very attractive proposition. The inflation link provides a natural hedge against the biggest risk involved in emerging market assets: currency devaluation.
If the lira falls, inflation should rise through import prices, and bond returns with them. Given the bond is issued in local currency, there is little-to-no default risk: they can always print more money.
If the central bank keeps up its commitment to maintain real interest rates – and it is an ‘if’ – the only real risk is the currency falling but inflation failing to match it.
That would only happen if the internal economy was weak enough to cancel out import inflation. With an erratic strongman as president, that is always a possibility.
But at the moment, it seems unlikely. Against the odds, for the time-being at least, the country has found some investment stability.