Turkey’s hard landing, high inflation and the fiscal mystery…

Turkish assets have been rallying this month beyond what was expected from the release of U.S. pastor Andrew Brunson back in October; a step that has now paved the way for the United States to waiver sanctions for Turkey on oil trade with Iran for the next 180 days. The expected sizable fine from the U.S. Treasury on state-owned Halkbank for undisclosed past transactions with Iran also looks set to be shelved for the moment.

Yet, the remaining thorny issues between Turkey and the United States are as tangible as they were before.  These include the two countries’ different approach to relations with the Syrian Kurds, Turkey’s plans to purchase the S-400 advanced missile defense system from Russia and ExxonMobil’s drilling activities near Cyprus.  Nevertheless, the main focus is now on the positive aspects of the relationship, which has allowed the lira to gain ground against the U.S. dollar by more than 2 percent this month.

Political developments and Turkey’s relations with G-20 countries have always been important for sentiment since Turkey has long been a country dependent on external fund flows to keep its growth intact.  With the tightening cycle by the Federal Reserve now dictating a flow of funds away from emerging markets, such notable betterment in Turkey’s relations with a giant economy like that of the United States does of course always matter. 

But given the mounting economic problems at home, the positive impact of international politics on overall sentiment has limited power.  The “real” agenda item is of course the sharp stagflation in Turkey, which places the country in an exceptionally isolated place compared to its peer group countries. Given the cycle of the external monetary background, the trend is expected to last well into 2019.  

Stagflation is defined as a combination of economic contraction with very high inflation. The October inflation print released at the start of the week does reflect how effective the recent bout of lira strength, rapidly sliding domestic demand and the government’s call on the real sector to cut end prices by 10 percent until the end of the year has been in anchoring inflation expectations. But of course, cost-side pressures, with domestic producer price inflation (D-PPI) at 45 percent, high borrowing rates in the 35-40 percent range and banks’ waning appetite to lend to the real sector mean the nation’s firms are in survival mode.  They have no choice but to reflect their rising costs into end prices since they have no room left to absorb shock because high debt obligations are also pressuring them from the financing side.  Yes, temporary tax cuts will help on the inflation front, pulling headline CPI towards 23 percent by year-end, but beyond that remains a mystery for the moment.

The economic contraction in Turkey looks serious. Data points to it reaching 4-5 percent in 2019.

PMI data – a key measure of sentiment in manufacturing -- released at the start of the week shows the overall index at 44.3 in October. Readings below 50 indicate a contraction phase. Moreover, initial Ministry of Trade figures for October point to a trade deficit of just $529 million, which is scary.  Killing the government official “rebalancing” story, the foreign trade figures reveal the degree to which domestic economic activity, with production dependent on imports of finished or semi-finished goods from abroad, is going through a hard-landing.   

In figures, the 13.1 percent year-on-year rise in exports is meaningful of course, reflecting partly the lira’s weakness but mostly the strength of the Eurozone economy, Turkey’s main trading partner.  But the slump in imports of 23.5 percent is drastic and tells the true story of the state of the economy at home -- that is, how manufacturing at all levels in Turkey is suffering. In normal times, supply-side constraints mean both exports and imports are elevated simultaneously. That’s certainly not the case today.

While all this is happening and Turkey’s GDP is swiftly turning negative as of the fourth quarter, Turkish banks are conspicuous by their absence.  Busy with restructuring the debt of a large chunk of their corporate clients, their successful rollovers of syndicated loans since August have so far failed to impact lending activities in a positive way. Thus, it is no surprise that consumer sentiment, business sentiment and general economic sentiment remain negative.  One can provide further details to support this case; namely that motor vehicle sales, sales of white goods and housing demand are all collapsing at an increasing pace.    

With the government is trying to reverse the contraction through various measures, the most recent data on fiscal performance reflects the magnitude of Turkey’s economic difficulties.  On the revenue side, taxes generated from goods and services, which reflect domestic economic activity, have posted a huge year-on-year contraction of 28 percent in September; led by value-added tax revenue, which dropped by 28 percent, and special consumption tax income, which slid by a whopping 33 percent in real terms. 

Thus, it was a surprise, but at the same time no surprise, that Turkey’s pragmatic government, facing local elections in March, decided last week to introduce consumption tax cuts for various sectors to stimulate domestic demand.  While the tax reductions, which will expire by 2019, are set to help reduce inflation to the tune of 150 basis points, they will surely not have such an impact on economic growth. Turkish households, burdened by more than 30 percent food price inflation, have no appetite to run to banks and take out loans at very high rates to purchase more white goods, cars or housing.  It would hardly be a shock should the government continue with efforts to stimulate demand in the lead up to local elections, but such experimental initiatives would of course weigh on the already fragile lira.

If there is one thing that anchors expectations, it is the government’s three-year fiscal plan that promises austerity to fight inflation. Austerity would of course mean that the economic contraction would prove deeper throughout 2019.  But as seen from the September budget data, the government, lacking room to spend as each day passes, has already put the brakes on investment. 

Thus, getting back to inflation, which is at the very core of the deterioration in Turkey’s economy, further rate hikes amidst a sharply contracting economy will prove no use at all.  That is not to say that at the slightest easing in headline CPI the central bank will start cutting policy rates.  Rather, it means that to prevent further spikes on the inflation front, and to pull price increases down from the new plateau of 15-20 percent, the government should get serious on the fiscal front.  The three-year fiscal program was a good start, yet lacked coherence as the government’s currency, inflation and economic growth assumptions were already smashed at the time of its introduction.  And the recent tax cuts, although temporary in nature, still got ratings agencies JCR and Moody’s nervous, leading them to issue warnings of further downgrades should such unorthodox policies intensify. 

Thus, it is now in the hands of the government to come up with a real – I mean a real – and credible fiscal plan to reach its savings target of 70 billion liras ($13 billion) at a time when the economy won’t be posting some 3 percent economic growth, as it has predicted for next year, but rather a 5 percent contraction. 

Fiscal policy with a solid record of performance is the only remaining key to lowering Turkey’s very high inflation rate, which has spiraled the economy out of control throughout 2018.  Thus, scrutiny of the budget throughout 2019 will be the most important task for anyone trying to figure out the direction of the Turkish economy.