2021: A very rough year for the Turkish economy

Turkey is entering 2021 with the burden of 15 percent year-on-year inflation, according to official data. But the results of a latest survey by research company Metropoll reveal that 80 percent of Turkish voters do not believe that the data is accurate. In fact, 51 percent think real inflation in Turkey is at around 30 percent.

The level of inflation and perceived price rises mean that the intense efforts of new central bank governor Naci Ağbal to reverse key policy mistakes made until recently by Turkey’s economy team have not been enough to restore public trust and confidence.

The Turkish people believe that interest rates, which Ağbal has increased to 17 percent, are not sufficient for them to take the risk of holding liras and they continue to pile up foreign currency deposits. Central bank data published on Dec. 25 showed that foreign currency deposits of Turkish residents hit a record for 10 successive weeks, reaching $234.8 billion. Locals seem to have used the appreciation of the lira in December as an opportunity to increase their foreign exchange holdings, rather than reduce them.

Meanwhile, particularly after a second interest rate hike by the central bank last month, short-term capital flows to Turkey – aka "hot money" – have increased, bolstering the central bank’s foreign exchange reserves. The drop in the dollar index in global markets combined with Turkey being forced to offer positive real interest rates to investors made the country an attractive destination for foreign portfolio inflows ahead of the long Christmas holiday.

If the inflows, which increase the value of the lira in the short term, are not followed up by a switch in local deposit holders’ preferences from foreign currency to lira, it will not be easy for the central bank to increase its foreign currency reserves significantly. They stand at around a negative $50 billion, including liabilities comprised of swap transactions.

FX deposits of Turkish residents

The rapid pace of dollarisation in Turkey, which occurred immediately after the 2018 currency crisis and which has continued strongly, after a lull, since the first COVID-19 shock in March, can be seen in the accompanying graph. In order to conclude that monetary policymakers have regained credibility in the eyes of investors, beyond being able to reverse a recent slump in the lira, at least half of the $60 billion increase in locals’ foreign exchange deposits in the last two years should return to lira, hence paving the way for a similar increase in the foreign exchange reserves of the central bank.

But locals’ lack of confidence in the lira is not totally due to the central bank’s monetary policy. It is rather rooted in general governance in Turkey, with its inevitable repercussions for the economy. The economic management team has long based its day-to-day decisions on short term considerations and lacked clear vision. Especially after the outbreak of COVID-19, the political authorities have spent precious time on policies that polarise society, ignoring much needed reforms that would create productivity gains and improvements in the education system.

Consequently, the central bank will probably have to raise interest rates by another 100-150 basis points at its January meeting. If locals keep adding to their foreign exchange deposits due to the general perception that inflation is hovering around 30 percent, the bank might be forced to increase interest rates even further. In fact, the bank will have to stick to its high interest rate policy longer than anticipated given the institutional incapacity that the administration has created over time that is now failing to tackle the problem areas of the economy.  

The danger is that with elections now on the horizon - they are slated for 2023 - Erdoğan may at some point decide to appoint yet another central bank chief who will be tasked with slashing the interest rates, once Ağbal has been given “reasonable time" to stabilise the economy. Then, all his good work would be truly undone.

Turkey was one of the few countries around the world to achieve positive economic growth in 2020 due to a policy of keeping interest rates below inflation and stimulating credit growth.

The stimulus, engineered during the second and third quarters to secure economic expansion, cannot be repeated in 2021.

The credit bubble, created via cheap lending from state-run banks, continued to support economic growth until the very last weeks of the year. However, in 2021, high interest rates and the secret that everyone already knows – that real levels of problem loans in the banking system amount to about 20 percent of total lending – will combine to reverse the credit impulse. Moreover, the government, which chose to override the COVID-19 economic contraction by stimulating lending rather than granting direct financial support to households, has now reached a brick wall both in terms of inflation and constraints on the budget.

Turkey loan growth banks

2020 was also a year when the tourism industry and its vital foreign currency revenues collapsed. Another important side effect of economic growth, achieved by overstimulating consumption through the credit boom, was undoubtedly the current account deficit.

The gap in the current account reached 4.5 percent of economic output last year and it was not financed by tourism, the private sector, banks' external borrowings or by an increase in direct investments. In fact, just the opposite happened. While direct investments fell to almost zero and hot money fled the country, the private sector including the finance industry continued to pay off external debt rather than take on more. Hence, the central bank’s foreign currency reserves and inflows of hard cash from unknown origins abroad remained the main source of financing for the expanding current account deficit, adding to pressure on the lira.

With the slowdown in economic growth in 2021, the current account deficit will narrow. Yet, excluding the $21 billion in debt coming due for the central bank, 12-month foreign currency debt repayments remain elevated at $160 billion, meaning the private sector will of course continue to pay off its dues.

Despite the incredibly high amount of low-cost liquidity around the world, the debt rollover ratio of Turkey’s private sector will remain below 100 percent. And, with Turkey’s budget deficit at 6 percent of economic output, the public sector will be unable to create growth momentum in the economy.

Returning to inflation, interest rates will need to remain high for a long period considering that annual price increases stand at an official 15 percent. In the 19th year of the Justice and Development Party (AKP) government, the fact that the locals are neither buying its economic reform story nor switching back to the lira creates another obstacle to growth. Recent portfolio investments into Turkey following the rate hikes are encouraging. Yet, to achieve meaningful growth in GDP, the way Turkey is administered needs to be completely reformatted.

High interest rates, burgeoning foreign exchange demand and the low supply of external funds will be the basic factors limiting growth in Turkey's economy in 2021. Serious policy mistakes over the past two and a half years will make 2021 a very rough year. Major macroeconomic imbalances created in 2020, 2019 and 2018, caused by the government’s high economic growth ambitions, will be paid for in 2021.

Thanks to its large population, Turkey can still post growth of about 3 percent in 2021. Yet, in Turkish terms, growth of 3 percent means that a spike in unemployment and bad loans, along with the structural wounds caused by the COVID-19 economic crisis, cannot be reversed.