Turkish President Recep Tayyip Erdogan/shutterstock
It had all been going so well. Turkey had bounced back from its financial crisis of 2001, weathered the shock of 2008 and soothed investor nerves following 2016 coup attempt. In fact, on the surface Turkey’s growth has been higher than that of nearly all its peers in the wake of the global financial crisis. Real GDP growth averaged a remarkable 7.4 per cent in 2017. “The Turkish economy rebounded very strongly last year with an estimated growth of around seven per cent, placing Turkey among the top performers among major economies,” said Omer Bayar, Alternate Executive Director on Turkey at the IMF. “Continuing its impressive track record postglobal recession, employment generation was robust again in 2017 as 1.62 million new jobs were added throughout the year.
“Notwithstanding these impressive outcomes, the magnitude and pace of the economy’s response went beyond what the authorities had envisaged as growth targets.” However, onlookers have been jittery about Turkey’s prospects for some time. Rapid growth over the past year has been accompanied by a wider current account deficit, inflation well above target, and soaring debts.
“The economy is showing clear signs of overheating,” the IMF warned. “Monetary policy appears too loose and its credibility is low; and on- and offbudget fiscal policies are expansionary and risk undermining Turkey’s hard-earned fiscal credibility. “As a result, the economy faces internal and external imbalances: a positive output gap, inflation well above target, and a current account deficit of more than five per cent of GDP. Meanwhile, political uncertainty and regional instability remain elevated, and the integration of the many refugees poses challenges.” Despite a strong export performance and a rapid recovery in the tourism sector, the current account deficit has widened from 3.8 per cent in 2016 to an estimated 5.5 per cent of the GDP in 2017, according to the IMF.
The Turkish Statistical Institute suggests that GDP growth in 2017 was about 7.4 per cent, more than double the level of 3.2 per cent in 2016. However, between January and April 2018, the trade deficit also doubled to about $27.4 billion, compared to $17.6 billion in 2016. The current account deficit is expected to widen to 6.1 per cent of GDP this year but should decline to 4.1 per cent next year by the weakening lira, lower oil prices and a growing tourism sector. Fitch said foreign direct investment will remain around one per cent of GDP, meaning that the deficit will be largely debt-financed. Worryingly, this could drive net external debt to 35 per cent of GDP by end of 2018.
Between July 2016 and March 2017, three credit ratings agencies downgraded Turkey’s sovereign credit ratings, citing concerns about the rule of law and the pace of economic reforms. Turkey retaliated by announcing plans to create its own credit rating agency, damning the existing agencies’ analysis of its economy as unfair, politicised and unrealistic. It is a move which illustrates how government interference is threatening Turkey’s reputation. For a number of years, the credibility of Turkey’s policy institutions has been undermined by the ineffectiveness of monetary policy, partly because of political interference in the policy-making process. Now Erdoğan’s new policymaking powers will give him even tighter control over the country’ purse strings. In Fitch’s opinion, economic policy credibility has deteriorated in recent months and initial policy actions following elections in June have heightened uncertainty. This environment will make it challenging to engineer a soft landing for the economy. Investors’ fears were justified when Erdogan signed off on a series of changes to the way the Central Bank’s top leaders are chosen, including scrapping the requirement that deputy governors must have at least a decade of experience.
The government decree also binned the minimum five-year term for central bank governors. Shortly afterwards, Erdogan ushered his son-in-law, Berat Albayrak, into the role of finance minister in a cabinet reshuffle that saw the Turkish lira fall by a further three per cent. Fitch did not waste any time sending Turkey further into junk territory. Just days later, the rating agency downgraded Turkey’s sovereign debt to BB with a negative outlook, citing inflation and the country’s widening current account deficit. “Notwithstanding the simplification of interest rate setting around the one-week repo rate announced in June, monetary policy credibility has been damaged by comments by President Erdogan suggesting a greater role of the presidency in setting monetary policy after the elections,” said Fitch. “Subsequent amendments to the Central Bank’s articles of association appear to strengthen the president’s influence, notably over key appointments. Monetary policy has persistently been unable to bring inflation near its five per cent target and inflation expectations have become unanchored.”
The Turkish economy is still in trouble with annual inflation at 15 per cent, mainly driven by the falling lira, which has lost 27 per cent so far this year. “Inflation is at its highest since 2003, despite the benign global inflation environment, and expectations are well above target,” the IMF noted. “Initially sparked by the large lira depreciation, inflation has received further impetus from higher demand, rising cost pressures, and rising inflation expectations. Accelerating core inflation replaced food and energy prices as the main inflation driver in 2017.” In Fitch’s view, a sustained reduction of inflation would require an increase in the credibility and independence of monetary policy and tolerance of a period of weaker economic growth.
The prospects for this as well as structural economic reform seem rather bleak following the President’s cabinet reshuffle, which banished key figures with reformist credentials. Moody’s had already put Turkey on review for a downgrade in June, citing the erosion of confidence triggered by the shock early elections, which were called 17 months ahead of schedule. “That decision exacerbated existing investor concerns regarding the negative credit impact of the economic, fiscal and monetary policy settings, and heightened concerns that the next administration would move further down the path of policy options detrimental to economic and financial stability,” said Moody’s.
A country deeply dependent on net capital inflows simply cannot afford a negative shift in investor sentiment. Turkey needs to finance annual gross external borrowing requirements in excess of $200 billion, according to Moody’s, reflecting the large current account deficit, sizeable short-term debt and maturing long-term debt maturities. The country’s reserves are already low-- Moody’s estimates that the Central Bank’s foreign exchange reserves cover less than half that amount. Even if the current account deficit narrows in the second half of the year due to the impact of the weaker lira and a slowdown in domestic demand, the deficit will remain large in absolute and relative terms. Moreover, external debt risks have increased, hitting a record high of $453.2 billion at the end of 2017—equivalent to 53.3 per cent of GDP—compared to $408.195 billion in 2016, according to Future for Advanced Research and Studies. The authorities have made limited progress in addressing Turkey’s structural economic problems, most notably its structural external deficits, in recent years. “The period since the failed coup in 2016 has seen increasingly expansionary fiscal policy that has stimulated growth to unsustainable levels,” Moody’s warned.
Tougher financing conditions and a weaker economy will likely hit the performance of the banking sector, heightening pressure on asset quality, capitalisation and liquidity and funding profiles, Fitch warned. External debt rollover rates for banks have held up, and banks generally have sufficient foreign currency liquidity to meet foreign currency wholesale liabilities maturing within a year. The IMF noted that the Turkish banking system is well-capitalised with strong liquidity buffers and asset quality. However, the cost of financing has gone up and market demand for some instruments has tailed off. “Headline NPLs remain stable at around three per cent, but the volume of at-risk restructured loans and watchlist loans continues to rise,” said Fitch. “Banks may not be able to fully pass on higher CBRT rates, putting pressure on margins, and the high loan-to-deposit ratio and weaker demand for foreign currency lending will likely constrain credit growth.”
Fitch currently has 25 Turkish banks placed on Rating Watch Negative, while Moody’s has downgraded and placed on review for further downgrade the ratings of 17 Turkish banks and two finance companies. Moody’s said that the operating environment in Turkey has deteriorated, with negative implications for the institutions’ funding profiles. In March alone, the $4.7 billion outflow of central bank foreign exchange reserves roughly matched the $4.8 billion current account deficit. In the same month, the roll-over ratio for banks’ long-term external funding fell to only 64 per cent, compared to 88 per cent for the whole quarter. Also, since then, the cost of bank funding has risen sharply. “The cost of banks’ foreign currency funding has widened significantly this year, following an increase of the benchmark 10-year government bond yield of roughly 300bps between January 2018 and late May—of which almost 200 bps since March,” said Moody’s.
Furthermore, the roll-over ratio for banks’ long-term external funding declined in March, compared to the whole of the first quarter of 2018. Constrained funding conditions are a key challenge for Turkish banks, given their high reliance on US dollar short-term market funding, which stood at $75 billion, or about half of their foreign currency market funding at March 2018, according to Moody’s. Currency weakness also poses a test to the private sector, which is heavily reliant on external financing. “The private sector has regularly demonstrated capacity to cope with adverse financing and exchange rate shocks, but a series of recent corporate debt restructurings point to the crystallisation of risks stemming from high corporate borrowing in recent years,” said Fitch.
The IMF highlighted initiatives which seek to enhance the ease of doing business by simplifying the procedures for setting up new companies and shortening bankruptcy proceedings. However, “Policy uncertainty is found to negatively affect productive investment,” the IMF warned. “It is, therefore, important to restore policy certainty by addressing investors’ concerns about public institutional capacity, the predictability of the regulatory environment, and commitment to structural reforms.”
A good host
The influx of more than three million Syrian refugees in 2016-17 poses a separate challenge and opportunity. Turkey’s newcomers have created new social, economic and political demands, particularly in urban centres where most refugees have settled. The government will need to take strong measures to revitalise private investment, boost growth, and resume Turkey’s convergence with Europe, the World Bank warned. It does, however, give the world something to applaud Turkey for. “Turkey’s generosity in hosting refugees—the numbers hosted is estimated at more than 3.5 million—serves as a global example,” the IMF said. Turkey will need all the positive sentiment it can get. In 2018, economic activity is expected to decelerate to close to 4.5 per cent, according to the IMF.
“Continued accommodative monetary, fiscal, and financial policies will support growth, but inflation is projected to remain well above target and the current account deficit is expected to remain elevated,” it said. Fitch warned that the significant tightening of financial conditions will cause GDP growth to slow. After a buoyant growth in the first quarter of the year, it is likely that the economy has contracted and Fitch expects it to continue to shrink until the fourth quarter. A period of growth below trend— estimated by Fitch at 4.8 per cent—may allow a partial unwinding of imbalances. However, the risk of a hard landing for the economy has increased. “At present, the fact that economic and financial vulnerabilities are rising in parallel with an increasingly unpredictable political situation and rising global interest rates heightens the threat,” Moody’s said.
“The outcome will mainly rest on the coherence and predictability of the policies that are pursued after the upcoming elections and beyond and the extent to which an improved policy framework will restore adequate financing and refinancing of Turkey’s large external borrowing requirements.” Turkey is no stranger to economic shocks. Its large and diversified economy—along with its relatively strong fiscal position—has always cushioned its fall. However, its rising debts suggest that the economy is now on borrowed time. If Erdoğan doesn’t relinquish some control or use his power to cultivate a favourable economic climate, there will not be anyone to catch the economy when it falls hard.