Monitoring Turkey: More cuts to come

• In July, inflation indicators reflected the effects of government-imposed price increases and automatic tax adjustments. These influences, however, are likely to be short-lived, with the underlying inflation trend set to continue declining over the coming period. The Central Bank of Turkey’s latest Inflation Report projects inflation declining to 24% in 2025 with a forecast range of 19-29% and a further drop to 12% in 2026. The bank will release the new inflation report for this year on 14 August, which will shed more light on the inflation outlook and likely monetary policy moves.
• Looking ahead, we remain cautious on the inflation outlook despite better-than-expected inflation readings, as the Turkish lira has been depreciating. We expect 29.5% at the end of the year with risks to the upside. We now expect the CBT to cut by 300bp at the upcoming MPC meeting in September, followed by two more 250bp cuts to 35.0% by end-25.
• Tight monetary policy, weak external demand and ongoing fiscal consolidation, albeit slower than expected, are leading to a loss of momentum in economic activity. We envisage that real GDP growth will slow to 2.7% this year from 3.2% in 2024 before returning to 3.5% in 2026 on the back of a resumption in monetary easing and expected recovery in external demand.
• Turkey has issued USD$8.8bn year-to-date, including USD$2.0bn in May, USD$2.5bn in June, and USD$1.8bn in July, which keeps it largely on track with its USD$11bn issuance plan for 2025 - despite a relatively high level of debt servicing. Considering the upcoming USD$2bn amortisation scheduled for October and the currently favourable market conditions, the Treasury is expected to pursue additional debt issuance during the autumn period.
• Minister of Finance Mehmet Şimşek stated that the government may not be able to meet this year’s 3.1% budget deficit target because the revenue performance is not as strong as anticipated. Accordingly, we have seen the budgetary considerations come into play through automatic adjustments in lump-sum taxes and the natural gas price hike in July, as well as the rise in the withholding tax rate and adjustments in the special consumption taxes (SCT) on automobiles. But still, the performance at the end of this year will not be as good as anticipated in the Medium-Term Program if we look at the overall budget, with the deficit likely approaching 4% by year-end.
• The Banking Regulation and Supervision Agency (BRSA) has announced expanded support for credit card holders struggling with debt, aiming to ease financial pressure on low-income households impacted by tight monetary policies and who heavily rely on credit card spending. With the BRSA move, individuals can now restructure retail credit card debt and consumer loans over a repayment period of up to 48 months.

The Turkish lira maintained its steady, gradual depreciation against the dollar throughout July, with little in the way of fresh developments. Nonetheless, attractive carry continues to skew market positioning, helping sustain demand. Even a slightly more dovish-than-expected restart of the CBT's cutting cycle did not change much in the USD/TRY trajectory. We do not see much change in direction in the current FX policy in coming months. Therefore, TRY remains our favourite carry currency in the EM space. The central bank has made it clear through its actions and communication that it will not allow any further additional inflationary pressures from FX, and the situation seems to be fully under central bank control again. Having said that, we still prefer the spot market over the forward market since liquidity may be tight again in times of volatility. We expect USD/TRY at 42.23 at the end of 3Q and 45.00 in our year-end forecast.

The OIS market has anchored the priced CBT rate for year-end around 36.2%. In our view, there still seems to be some room for more dovish pricing vs our forecast once we get more guidance from the central bank on what we can expect after the July restart of the cutting cycle. At the same time, July inflation suggests a favourable profile for the rest of the year, and we can expect the OIS curve to continue to rally, especially at the front of the curve, continuing the steepening trend.

Turkish government bonds (TURKGBs) saw a strong rally in late June and early July, and since then, we have seen some bounce or sideways movement depending on the part of the curve. The spread against the OIS curve has tightened significantly, making bonds less attractive looking forward. Also, on the supply side, we saw a significant increase in June and July after a weaker May, when MinFin missed some issuance due to higher yields. On the other hand, according to our calculations, MinFin covered roughly 63% of TURKGB issuance. While a wider fiscal deficit and additional issuance may be a risk, for now, MinFin appears to be in a comfortable position, benefiting from decent market demand.

While EM credit spreads have moved wider recently amid a rally in US rates, Turkey has remained resilient, with the spread differential versus BB-rated peers tightening by 40bp over the last month or so. Moody’s finally upgraded Turkey’s rating to Ba3 in late July, catching up with Fitch and S&P, as well as market pricing of the sovereign at BB-levels. With the FX reserve recovery continuing and central bank easing on track, we expect relative stability in spreads over the summer, with new issuance in September likely to be the next catalyst to watch, absent any further political shocks.

While the compression versus the peer group leaves spread levels for Turkey less attractive in terms of potential further outperformance, we expect investor demand to remain robust, while shorter-dated sukuk paper continues to offer a pickup over the conventional curve after recent new issuance.

Turkish CPI inflation in July stood at 2.06% month-on-month, coming in lower than the consensus estimate and our call of 2.5%. This was largely due to moderate price increases across both food and non-food categories. As a result, annual inflation, which has been on a downward trend for the past year, saw a sharp drop to 33.2%, down from 35.05% in the previous month. While inflation rose by 3.23% in July 2024, the five-year average for July in the 2003-based index was just 3.5%. This suggests a favourable base effect, reinforcing the continued decline in annual inflation. A closer look at the data shows that i) the housing group made the largest contribution to inflation (0.95ppt), driven by adjustments in natural gas prices and persistently high rents ii) the transportation group added 0.45ppt due to car price adjustments following currency depreciation and gasoline prices iii) on the other hand, clothing reduced inflation by 0.36ppt, driven by seasonal price reductions that exceeded the typical July average in recent years.

At its July MPC meeting, the central bank resumed interest rate cuts, reducing the policy rate by 300 basis points to 46%. This move was more aggressive than our expectation and the consensus forecast of a 250bp cut. The bank signalled that easing would continue, although the magnitude of future steps may vary. This decision came on the heels of last month’s adjustment, in which the CBT lowered the effective cost of funding from the upper bound of the interest rate corridor to the policy rate. Despite some improvement in inflation-related risks, the corridor’s asymmetric structure remained unchanged - indicating that the CBT aims to retain flexibility in response to potential shocks that might exert unexpected pressure on foreign exchange and reserves.

Early indicators for Q2 2025 point to a slowdown, driven by softening domestic demand amid tightening financial conditions, and subdued external demand due to the tariff-related drag on global activity. Hard data in April-May confirmed a deterioration across sectors with a sequential contraction vs the first quarter in services and construction production, and almost flat industrial production. The third quarter has also pointed to continued weakness, as the seasonally-adjusted capacity utilisation rate (CUR) in the manufacturing sector declined further, reaching 74.1%. Capacity utilisation has recently shown a marked weakening in sectors such as investment goods and durable consumer products, which are highly sensitive to financial conditions. Meanwhile, the real sector confidence index fell following the monetary tightening implemented after the volatility seen in March earlier this year and has remained below the 100 threshold in July.

The manufacturing sector PMI, which has been in contractionary territory since April 2024, remained so in July this year with another dive to 45.9 from 46.7 a month ago. The lowest reading since last October implies continued pressure on the manufacturing sector due to the significant policy tightening in recent months. In fact, the key driver of the PMI turned out to be a more pronounced slowdown in new orders and output attributable to challenging demand conditions. Accordingly, companies scaled back their employment and purchasing activity and limited efforts to rebuild inventories. On the other hand, the quickening pace of depreciation in recent months contributed to further increases in input costs and output prices. Findings in the sectoral PMIs, on the other hand, released by the Istanbul Chamber of Industry, are in line with what the manufacturing PMI data suggested in July, as all 10 sectors recorded slowdowns in new orders during the month.

In June, seasonally-adjusted employment came in at 32.5 million people and recorded a 0.1% month-on-month decline. The labour force participation rate remained flat in the last three months at 53.5%, while the unemployment rate, which had been in an 8.0-8.6% range in the last eight months, moved up to the upper band of this range. On the other hand, the seasonally-adjusted average weekly actual working hours dropped by 1.1 hours compared to the previous month, standing at 41.5 hours, the lowest in the last four years. One of the broader unemployment indicators, the underutilisation rate - which combines time-related underemployment, the potential labour force, and the unemployed - maintained an uptrend in recent months and reached 32.9%, a historical peak. The data indicates growing strains in the labour market amid an economic slowdown, although headline unemployment remains quite low, in single digits.

In May, Turkey recorded a current account deficit of US$0.7bn, which was narrower than market expectations. A comparison of May’s data with the same month last year reveals a more pronounced shortfall in the goods balance, a stronger surplus in the services balance, and a reduced deficit in the primary income balance. Based on our assessment, the persistent weakness in domestic demand is likely to help contain the current account deficit this year, keeping it around 1.2% of GDP. On the capital account side, we saw a recovery in May at US$12.8bn, following weakness in the previous two months driven by political developments. With a modest net inflow from errors and omissions of US$1.3bn, and considering the current account deficit, official reserves expanded by US$13.5bn.

On the revenue side, tax revenues saw a notable acceleration in June, with a 13.9% YoY increase in real terms. This was driven by tax collection, particularly income tax (up by more than a real 42% rise), while corporate tax collection was weak, plunging 22.3% YoY in real terms. Annual growth in the collection of Value Added Tax (VAT) and Special Consumption Tax (SCT) was also strong, with 17.5% and 8.6% real changes. Non-interest expenditures rose by a mere 5.9% in real terms compared to the same month last year, reflecting a clear deceleration. The primary contributor to this slowdown was a 6.7% annual decline in healthcare, pension, and social assistance spending. Interest expenditures, on the other hand, have remained strong and more than doubled even in real terms in June. Given this backdrop, based on the IMF-defined primary balance (excluding one-off revenues), a deficit of approximately TRY104.0bn was recorded in June, while the 12-month rolling primary deficit has decreased to TRY890bn, representing 1.7% of GDP. In the most recent Medium-Term Program, the defined primary deficit is projected to reach TRY294.0 bn, corresponding to 0.5% of GDP.