The curious case of the Turkish economy

With so much potential as a resourceful, dynamic, young country, it seems curious that the Turkish economy is heading for the wall at full throttle. The keyword that explains the shift from being the darling of the Western world to being the object of distaste must be “maladministration”. Or rephrasing the concept for better clarity, we could just as well say “political ambitions interfering with economic reasoning”.

So it was no surprise when on Monday Japan Credit Rating (JCR) Eurasia’s Turkey chief Orhan Ökmen burst out with the truth and nothing but the truth in a short declaration. What is easy to read might be hard to swallow for those who have experienced the level of prosperity brought on when economic rationale was the name of the game between 2002 and 2008. 

Annual GDP growth and contributions
Annual GDP growth and contributions (source: central bank)

To start with, Ökmen warned that Turkey’s strong economic growth, 5.2 percent in the first half, is not sustainable. Looking at the contributors of that growth, it is hard to miss the role of domestic consumption, and of course “investments”, in overall gross domestic product performance. 

Given the revisions to the GDP series in late 2016, the investments we are talking about mostly consist of a construction-related spending craze, thus lacking the muscle to improve Turkey’s double-digit unemployment rate, which is 11.2 percent, seasonally corrected. Temporary tax cuts employed in the second and third quarters of 2017 have also played their part in pumping up GDP performance. Oh, and count in the recovery across the European Union and its positive impact on Turkey’s exports as well.  

What was pivotal however to the strength of GDP was the “creative” deployment of the government’s Credit Guarantee Fund. It has allowed troubled small and medium-sized companies to restructure their pressing debt repayments to the tune of 180 billion liras ($47 billion), year-to-date. It also eliminated an important economic bottleneck right before and after the presidential referendum back in April. Thus, all in all, it looks very likely that the Turkish economy will be able to post GDP growth of about 6 percent this year. 

Turkish loan growth
Loan growth, adjusted for foreign exchange effect (source: central bank)

But what has helped the government, economically and of course politically in 2017, will very much backfire in 2018. The incentives used to spur growth have pushed fiscal dynamics out of balance. The government had to revise its budget deficit target from to 61.7 billion liras from 47.5 billion liras, a mammoth increase of 30 percent and even breached the fiscal limit of 52.4 billion liras. Such a contravention of the fiscal rule will carry the budget deficit to GDP ratio to 2.4 percent at the end of this year, from 1 percent in 2016.

What is even more curious is the way the Treasury has increased its domestic roll-over ratio to some 140 percent over 2017, amid a spike in off-budget, non-transparent fiscal spending.  

With a strong base effect, economic growth will barely exceed 3.5 percent next year, further pressuring the government ahead of the critical 2019 presidential elections. As everyone well knows, an era of easy money for emerging markets will draw to a close in the coming two years, as both the Federal Reserve and European Central Bank adopt tighter monetary policies. 

Economic confidence index
Economic confidence index, October 2017 (source: Turksat)

This means the government will turn its focus to the Turkish Wealth Fund, created last year, comprising about $200 billion of assets, including cash, property and shares. With zero transparency concerning the fund’s activities, speculation is inevitable that the government would use it to defend the lira in troubled times, support the stock market so that banks remained well capitalised and/or to intervene in domestic borrowing auctions to cap interest rates.

It was recently reported that the government was allegedly preparing to extend loans via the fund at zero rates of interest to bolster indebted companies in the lead up to the 2019 presidential election. The leaks angered investors of all backgrounds and official rejection was swift to come. Yet, more such “creative” solutions might resurface in the year ahead.     

With growth prioritised and pushed to the limit, inflation dynamics and the current account balance have suffered correspondingly.

Turkey’s current account deficit of around $40 billion, or some 4.5 percent of GDP, looks tame at first sight. Yet despite the recovery in tourism revenues this year as President Recep Tayyip Erdoğan and Russian President Vladimir Putin shook hands again, a likely rise in GDP terms to 4.6 percent in 2017 from 3.8 percent a year ago is noticeable. Especially when one knows that Turkey’s deficit is not so much financed by FDI (circa 20 percent), but more by banks borrowing from abroad and what remains of short-term, so-called “hot money”.

In the years ahead, banks are expected to continue rolling over their debts, but with higher costs translating into higher interest rates on loans in Turkey, that will impact investment and, in turn, economic growth.

Financing composition of the current account deficit
Financing composition of the current account deficit (source: central bank)

As such a chain of events unfolds in Turkey, it is worth keeping an eye on Turkey’s net international investment position, which has deteriorated to a deficit of $450 billion as of July 2017 from last year’s $362 billion, mainly on the back of substantial private sector borrowing abroad.      

While supporting the growth rate seems to be the government’s priority at all costs, the inflation rate of course becomes a victim. It is worth noting that compared to the 5 percent official target, consumer price inflation is currently 11.2 percent. What is more frustrating is the Central Bank’s inaction, even as it claims to be employing a “tight” monetary policy when its average funding cost is at 11.9 percent.

In the case of a shake-up in global markets in the months ahead, which looks perfectly possible given the expected Fed and ECB moves, Turkey is open to severe volatility given its rapidly deteriorating economic indicators. Thus, it is increasingly likely that the Central Bank will be forced into an emergency rate hike, perhaps to the tune of 200-300 basis points. Meanwhile, political tension will rise each day as we get closer to Turkey’s most important election ever in 2019, and have negative repercussions for the economy.

While the Turkish economy seems to be heading for a fall, there is a way out of this negative spiral of events. As vocalised many times, bolstering the rule of law would improve the quality of institutions, which are rapidly deteriorating.

Regaining long-lost economic credibility no doubt starts with terminating the “state of emergency” in the country. Similar efforts should be made to harmonise economic management. A good starting point would be to set wishful thinking aside in favour of drawing up comprehensively realistic targets for the government’s medium-term plan.

CPI and core inflation index (source: central bank)
CPI and core inflation (B) index (source: central bank)
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