Turkey’s budget set to shoulder growth

Following a tumultuous period, Turkey seems relatively calmer in terms of news flow this week. Nevertheless, the central bank’s virtual inaction on interest rates last week is still reverberating through financial circles. 

With November’s 13 percent year-on-year consumer price inflation and the announcement of 11.1 percent annual growth in the third quarter, the central bank’s decision to hike rates in its unorthodox “late liquidity window” by a mere 50 basis points to 12.75 percent seems almost ludicrous. 

The argument put forward by some analysts that the bank could continue with small, incremental rate hikes in January and February also appears surreal. A central bank that has refrained from hiking rates meaningfully even when inflation accelerated to the highest level in 14 years is hardly likely to act when the base-year effect means that inflation is likely to slow marginally in the first quarter. That’s not withstanding political pressure on the bank to keep real interest rates low to support growth ahead of Turkey’s critical presidential and parliamentary elections in 2019. 

Hence with the prospect of further negative news flow in the months ahead, the central bank’s almost glacial rate hike leaves the economy exposed to further lira weakness and volatility, especially considering the high foreign debt levels of the private sector. So long as the ruling Justice and Development Party continues to consider lower inflation as an inferior goal to strong economic growth, the rate of price increases appears set to remain in double digits next year as well.  

Unsurprisingly, inflation expectations keep deteriorating rapidly, potentially feeding the vicious circle in the months ahead.     

Inflation expectations

The course of inflation seems more or less predictable, as does the persistent nature of Turkey’s current account deficit, currently standing at about 5 percent of gross domestic product. That leaves the fiscal balance, or budget, as the economy’s remaining anchor.

As American economist Joseph Stiglitz recently put forth, fiscal deficits and trade deficits normally move in relative tandem. Given Turkey’s high external borrowing requirement, one has to consider the degree to which Turkey’s fiscal stability is at risk. Such an assessment will define the country’s risk premium to a large degree as the world’s largest central banks roll back some $6.2 trillion in excess liquidity in the months and years ahead.    

Public sector primary balance
Public debt dynamics

Turkey recovered from a self-made economic crisis in 2001 thanks to a rule-based rationalization of the fiscal accounts that more than halved the government debt to GDP ratio from a peak of 75 percent. Similarly, the government managed to reduce the budget deficit to GDP ratio to below one percent from around 11.6 percent. 

After Turkey’s IMF-backed economic program was phased out in 2008, the government went on lowering Turkey’s public debt stock thanks to robust GDP growth. Such growth was a byproduct of heavy foreign borrowing by Turkish companies and banks, which took advantage of ample, low-cost liquidity in global markets. 

But come December 2015, Fed rate hikes had begun and volatility returned to Turkish markets because of the country’s increased external vulnerabilities. As the period of easy foreign money drew to a close, the large external debts of Turkish corporates and banks, coupled with high inflation – which prevented an easing in monetary policy – meant that Turkey’s growth became more dependent on fiscal policy. 

The public-sector balance sheet is now the main revenue source to support growth as global liquidity begins to dry out. In fact, fiscal data for 2017 is already showing how growth will become more and more a function of fiscal policy in the years ahead. 

primary balance
budget deficit

The central government budget deficit has widened to 26.5 billion liras in January-November 2017 compared to 2.1 billion liras last year. The surplus in the primary budget balance almost halved to 28.8 billion liras from last year’s 46.3 billion liras. In the first eleven months of this year, a 1.3 percent real decline in central budget revenues was coupled with a 1.8 percent real increase in expenditures. The government’s own revised forecast is for a budget deficit of 2 percent of GDP for end-2017 compared to a deficit of 1.1 percent of GDP a year ago. 

budget balance

The most recent GDP data for the third quarter shows growth slowing on a quarterly basis to 1.2 percent from 2.2 percent in the second quarter. The economic slowdown is also evident from the pace of indirect tax collection, a function of economic activity. There was a sizeable 13.1 percent real contraction in indirect tax revenue in November, far greater than the year-to-date average of 2.9 percent.

Looking ahead, such a trend on the fiscal side combined with the enhanced impact of fiscal policy on growth probably translates to the following:

  1. Public investments and transfers will remain strong in the years ahead, as GDP growth becomes more and more dependent on state-sponsored schemes. In fact, the government just recently announced that its “credit guarantee fund”, which has grown to $60 billion, will continue in 2018 as well. An extra $36 billion will include $13 billion of fresh loans, with the remainder constituting rollovers.  
  2. Higher nominal interest rates and the weaker lira will also translate into additional budget expenditure. 
  3. Slower economic growth will hurt tax generation. Such a trend combined with higher inflation will mean a slower real increase in tax revenue during 2018-20, especially in indirect taxes such as VAT, if not a real decline in tax revenue.
  4. The government could also be tempted to cut taxes on consumption selectively in an effort to boost domestic demand, hence widening the budget deficit still further.    
  5. The upcoming and very critical parliamentary and presidential elections in 2019 will surely motivate the AKP to spend more on current transfers and investments. Such an escalated level of spending would keep the voter base distracted economically and support growth.
  6. As has been the case for domestic borrowing, a higher rollover ratio on external borrowing could increase Turkey’s public debt to GDP ratio.
  7. Last but not least, the extended “state of emergency” will go on distorting daily economic activity and keep investors away.      

Given the global picture of higher fiscal deficits in many countries, a budget deficit of 2-3 percent in Turkey seems very optimistic. 

Caution is indeed required when considering that the budget deficit may double or even triple in the 2018-2020 period compared to last year’s 1 percent. This will come at a time when economic growth is set to slow, the inflation rate is in double digits and the current account deficit persists.

Turkey, in theory, has room to cyclically elevate its budget deficit in an effort to support growth. However, the absence of a convincing economic program that would keep risk perceptions in check, the continuing polarization in politics and problems associated with the rule of law mean things could spin out of control quite easily.