Turkey has enjoyed strong economic growth and equity outperformance during much of President Erdogan’s tenure, but the nation’s credit-fuelled growth model has run out of steam, and is further troubled by geopolitical tension and waning investor confidence. The lira has depreciated significantly, and numerous indicators are flashing red.
Turkey’s economy faces testing times
After more than a decade, when asset returns outperformed the emerging market average, Turkey’s economic outlook has darkened. Its credit-fuelled growth model has run out of steam, leaving behind a large current account deficit and setting the stage for a period of subdued GDP growth. Those secular weaknesses have been compounded by geopolitical risk and waning investor confidence. The lira and stock market have declined in value. Asset prices will remain under pressure at least until the summer referendum on whether to establish an executive presidency. Whatever the result, numerous indicators are already flashing red. Our Financial Vulnerability Indicator ranks Turkey 10th out of 176 countries most likely to suffer from a sovereign crisis.
Economic miracle increasingly reliant on credit
Revised national accounts data show that Turkey’s economy has expanded at an annual average rate of 5.7% since 2003. That remarkable performance in part reflects structural reforms enacted at the turn of the millennium in accordance with an IMF rescue package. But reform momentum has stalled, with economic growth increasingly reliant on credit-fuelled demand. Indeed, the pace of credit expansion has rapidly accelerated over the past decade, and is now in line with that witnessed in the UK and US ahead of the global financial crisis.
Economic growth has been reflected in asset prices, and Turkey’s stock market outperformed the emerging market average by a significant amount for long periods since 2003, when Mr Erdogan became leader. However, that strong run has ended and prior outperformance over that period has been almost entirely eroded.
Secular weaknesses amplified by cyclical swing
Recent events have worsened an economic slowdown that was already in train. The country has suffered several devastating attacks, including one in the heart of Istanbul’s tourist district. Security concerns have led to a sharp drop in foreign arrivals, thus suffocating a traditional source of revenue. Business confidence was further dented by a failed coup last July that prompted a severe crackdown from the authorities and continued state of emergency.
That combination of factors has depressed economic activity, with the economy contracting in the four quarters to 2016 Q3 — the first such decline since 2009. Measures of business confidence have been waning for some time, and suggest that a sharp rebound is unlikely. We forecast GDP growth of 2.4% this year, which is less than half the average rate achieved since 2003, with the risks around that forecast skewed significantly to the downside.
Sharp lira decline poses dilemma
The slowing economy has prompted President Erdogan to call for lower interest rates in a bid to resuscitate the formerly successful credit-fuelled growth model. However, given above-target inflation and a 23% lira depreciation against the US dollar since the end of August 2016, the central bank faces an uncomfortable dilemma. It decreased interest rates steadily in the middle of 2016 but has since been forced to back-pedal by steady currency depreciation.
Following its January meeting, the central bank enacted a 75 basis points hike in the overnight lending rate. But that sort of increase pales in comparison to historical precedent. Interest rates increased by an average of over 450 basis points following periods of significant lira depreciation in 2006, 2011 and 2013. The muted response may partly reflect political pressure, but it is probably also an acknowledgement that the current exchange rate weakness reflects risks that monetary policy cannot directly address.
Risk that current slowdown turns to crisis
Turkey’s economy was already set to slow. The question is whether this dampening turns into a hard landing. Of the five so-called ‘Fragile Five’ emerging economies identified in 2013, Turkey has improved the least. Despite being a net energy importer, the sharp fall in the price of oil since the middle of 2014 has not been sufficient to achieve a more sustainable external position. The aggregate current account deficit of those five economies has more than halved since 2013 to 1.8% of GDP. However, Turkey’s, at 4.4%, remains more than double the average, and improvement largely stalled last year. That deficit is likely to widen this year, despite a slowing economy and lira depreciation. This external vulnerability risks being compounded by debt deleveraging. External corporate debt amounts to 30% of GDP. If capital inflows dry up, adding further downward pressure on the lira, those loans will become difficult to service.
Although Turkey’s downturn risks deepening, the threat of a further sharp currency depreciation appears limited for now, with the central bank ready to act, pledging to tighten policy “if needed”. More importantly, with an upcoming referendum, the political desire for stability should supersede the desire for lower rates. Beyond short term risk control, fundamentals still matter. Our Financial Vulnerability Indicator already ranks Turkey as the 10th most likely out of 176 countries to suffer from a sovereign crisis in the next twelve months.
With entrenched weaknesses, the risk of a major crisis remains just one step away. Our central view is that authorities will manage to muddle through, with weaker growth and elevated price pressures. But events beyond Turkey’s borders could lead to something worse. For example, any further veer towards global isolationism, as outlined in the risk scenario of our most recent global forecast, would leave Turkey exposed. The expected increase in risk premia across emerging market assets would hit Turkey particularly hard, given its existing vulnerability, and could be the catalyst for a severe crisis. In the near term then, decisions abroad may matter more than decisions at home in determining Turkey’s economic prospects.
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