• How effectively are the authorities managing the Turkish economy?

TURKEY/ECONOMIC POLICY

Even as it builds defenses, Turkey is highly vulnerable to further fallout from the eurozone.  
06 Jul 2012 

KEY JUDGEMENTS
  • The Achilles' heel of the economy is a large current-account deficit, financed mainly by short-term capital inflows from a troubled and hence unreliable EU.
  • The deficit has begun to narrow as the authorities rein in a recent credit-fueled boom, a weaker currency boosts exports, and oil prices experience a sharp drop.
  • Rebalancing has some way to go before the government can be sure the economy will avoid a hard landing, triggered by a loss of investor confidence or a lira collapse.
  • Unorthodox monetary policies to tighten liquidity have squeezed lending by the commercial banks, cushioned the currency, and deterred hot money inflows.
  • New investment incentives are designed to add value to Turkey's output and thus reduce imports, while domestic savings will be boosted by pension fund reform.
  • Delivering economic stability is critical to the fortunes of the ruling Islamist party, and to Prime Minister Erdogan who hopes to become president in 2014.
ANALYSIS

Turkey's economic planners face a challenging period. Having engineered robust real GDP growth of 9% in 2010 and 8.5% in 2011, after a deep recession that followed the 2008-09 financial crisis, the task ahead for Prime Minister Recep Tayyip Erdogan's Justice and Development Party (AKP) government and the Central Bank of Turkey is to guide the economy towards a soft landing. A key risk is that the eurozone, a major market for Turkey's exports and a source of capital to cover its large current-account deficit, will head into even greater turbulence, leaving Turkey highly exposed. 

ebb jul 06 2012 chart one real GDP
 
New data points released on July 2 demonstrate that Turkey is having some success in cooling the economy:
  • First-quarter GDP rose 3.2% year over year (y/y), a stronger rate than many analysts had expected but still lower than the 5.2% y/y recorded in the final quarter of 2011 and very significantly down from the record 11.9% in the first quarter of last year.
  • At an annualized 8.87%, June inflation was above the prior month's 8.28% but below economists' forecasts of 9.2% and a considerable improvement on the January outturn of 10.6%, a three-year high.
A sustained disinflationary trend will give the central bank some scope to loosen monetary policy later in the year, if the landing threatens to become a hard one.

How big a liability is the current-account deficit?

One of the most striking consequences of Turkey's recent credit-fueled boom is that its current-account deficit increased dramatically, rising from just 2.2% of GDP in 2009 to 10% of GDP in 2011. Consequently, the Turkish currency and economy are vulnerable to changes in levels of global liquidity and sudden shifts of investor confidence, especially because the deficit is mainly financed by volatile short-term capital inflows. More stable forms of capital such as foreign direct investment (FDI) have been limited.

After declining sharply in 2009 to about $7 billion, compared with $15-20 billion a year in 2007 and 2008, net FDI inflows rebounded to $15.9 billion in 2011. These are still small, covering less than 10% of Turkey's gross external financing requirement (the current-account deficit plus external debt-servicing costs).

ebb jul 06 2012 chart two current account balance
 
The current-account deficit has now begun to narrow, as domestic demand eases and oil prices have come down sharply from the very high levels reached in March, helping to reduce the merchandise trade deficit. At the same time, export growth accelerated in early 2012 as a moderately weaker lira boosted Turkey's export competitiveness, suggesting that the economy is starting to rebalance.

ebb jul 06 2012 exports
Exports searching for an 
alternative to the EU
This has enabled Turkish exporters to increase sales to faster-growing markets outside the sluggish EU. While exports of goods to the EU27 declined by 6% year on year in US dollar terms in January-April, total exports increased by close to 11%. Despite the sanctions-related difficulties of trading with Iran and Syria, exports to the Middle East jumped by 35.5% and to North Africa by 63%. As a result, the EU27 accounted for 41% in the total value of Turkish exports, down from 48.4% a year earlier.

However, the merchandise trade and current-account deficits are still large enough to be a source of concern. The rebalancing process has some way to go before the government can be sure that the economy will avoid a hard landing that could be triggered by a loss of investor confidence and a collapse in the value of the lira.

How effective is monetary policy?

During most of 2011 the central bank sought to limit bank credit growth and attract longer maturity capital inflows. The reserves that the banks were required to deposit with the central bank were hiked aggressively, especially on short-term liabilities. In coordination with the central bank, the Banking Regulation and Supervision Agency (BRSA) also tightened bank lending criteria, which helped to curb the surge in bank credit. Bank lending to the private sector rose at an annual rate of 40-45% throughout most of 2011. As of April 2012, credit expansion had slowed to 27% year on year, only marginally above an official target of 25%.

ebb jul 06 2012 chart three bank credit
 
Since last August the bank, controversially, has decided on a daily basis how to fund the banking system, tightening Turkish lira (TL) liquidity by frequently limiting its lending at the one-week repurchase (repo) rate of 5.75%, the bank’s official benchmark interest rate, which has been kept exceptionally low. This has forced commercial banks to bid for funds at higher rates within the wide corridor between the overnight borrowing rate of 5% and the overnight lending rate of 11.5%. Controlling the tap of TL liquidity has helped the central bank to support the currency, which has recovered some ground after falling sharply in late 2011 and early 2012, without raising its benchmark short-term interest rate.

ebb jul 06 2012 lira
Lira stabilized by unorthodox policies
Frequently described as unorthodox, the central bank’s monetary policy has drawn widespread criticism. Commercial banks have lamented the burden of higher non-interest-bearing reserve requirements and a lack of transparency and predictability in interest rate policy. International organizations, notably the IMF, have warned that the benchmark interest rate has been kept too low, especially in 2010-11 when cheap bank credit risked causing the domestic economy to overheat. However, tightening monetary policy by raising short-term interest rates also has undesirable effects. In particular, it encourages larger inflows of short-term capital, which might, as they have in the past, accelerate credit growth and demand for imports, again leading to a widening of the current-account deficit.

How solid are Turkey's public finances?

In 2011 Turkey achieved a lower-than-expected deficit on the consolidated central government budget, which covers most of the public sector. The outturn was TL17.4 billion ($9.6 billion), or 1.3% of GDP, down from 3.6% of GDP in 2010 and 5.5% of GDP in 2009. The central government gross debt also declined, to just under 40% of GDP. However, most of this improvement was achieved on the back of surging revenue driven by domestic demand and higher indirect tax rates, rather than tighter expenditure controls. In 2012 the government is targeting a deficit of TL21.1 billion, or about 1.5% of projected GDP, but the actual outcome is likely to be moderately higher owing to the impact of weaker economic activity on expenditure and revenue.

What is Turkey doing to promote savings and investment?

ebb jul 06 2012 erdogan
Erdogan’s fortunes are inextricably tied to economic prosperity
Turkey’s large current-account deficit is essentially a savings gap, the equivalent of the difference between domestic public and private savings and investment. In 2011 savings declined to 12% of GDP compared with investment needs of 22% of GDP. Boosting domestic savings in the medium term is now officially a policy goal. After much delay, the government has announced two reforms intended to increase savings, reduce import dependency, and boost competitiveness in the production of imported inputs for Turkey’s manufacturing exports:
  1. Investment incentives. The declared objectives of this reform, promulgated in April, are highly ambitious and unlikely to be achieved in the short term at least. Besides boosting economic development in the country's poorer regions, they aim to increase the value added of Turkey's output and reduce imports, which soar in periods of strong economic growth because of a heavy dependence on imported intermediates and raw materials, especially oil, gas and steel.

    The incentives comprise a mix of tax breaks, exemptions from customs duty, interest subsidies, social security premium subsidies and land allocations for investors. The government also aims to give special treatment to strategic investments in the defense, aerospace, automotive and pharmaceutical sectors, as well as in education and rail and sea transport.

  2. Pension funds. The second reform, announced in May, aims to strengthen the private pension fund industry in Turkey with a view to boosting domestic savings. The measures include a direct state contribution of up to 25% of an individual’s monthly premium in a voluntary private pension scheme and steps to strengthen the finances of the insurance sector. Furthermore, the withholding tax rate will be reduced on longer-term bank deposits (currently 15% on all maturities), and a zero withholding tax rate will be introduced for equity mutual funds (mutual funds with at least 75% of funds invested in listed Turkish stocks) compared with a 10% rate for other mutual funds.
Outlook

Economists and rating agencies are divided on how the Turkish economy will fare in the fallout from the eurozone crisis and a renewed global economic slowdown. In May Standard & Poor’s revised Turkey’s sovereign credit outlook from positive to stable, citing vulnerabilities arising from the current-account deficit. Moody's, though, upgraded Turkey’s sovereign rating in June to just one level below investment grade, and kept the outlook on positive. Moody’s attributed its more positive view to the greater stability and 'resilience' of the Turkish economy, putting faith in the government’s reforms to boost savings and investment.

The perception that the AKP has managed the Turkish economy well has been a key to its electoral success -- victory in three consecutive elections with a higher share of the vote each time. Under AKP stewardship, the economy has grown by an average of 7% a year in the decade to 2011. Moreover, although the global financial crisis in 2008-09 contributed to a sharp recession, it did not bring Turkey to its knees as it did in the case of some EU economies.

Erdogan aspires to ascend to a reformed and more powerful presidency in 2014, when, for the first time, Turkey will directly elect its head of state. Legislative elections will follow in mid-2015. The political future of both the prime minister and his party will depend heavily on how they steer the economy in the next two years.