Turkey: long term outlook
The past decade saw Turkey break with its turbulent past. The AKP government, which came into power in 2002, restructured the economy, stabilized the banking sector and cleaned up public finances. In addition, it was able to break the military’s grip on power, thereby leading the country into a period of democratization. However, as became clear in our previous Special Reports on Turkey, much remains to be done. In order to further stabilize the economy and continue to record the growth rates seen over the last decade, the government should address the country’s large and persistent current account deficit. This final Special Report on Turkey’s long-term economic prospects discusses our expectations for the coming decade in all these areas.
Breaking with a turbulent past
During the last decade, Turkey’s economy expanded rapidly, growing by 6.8% on average between 2002-2007. Economic and export diversification helped strengthen theeconomy, while Turkey’s growing role as a regional power has lowered its dependence on Europe as its single most important export market. Underlying this success were the fiscal and monetary reforms implemented after Turkey’s currency and banking crisis in 2001, as well as a restructuring of the financial sector. Reduced public spending lowered the public debt from 75% of GDP in 2001, to 40% of GDP now, while inflation fell from 54% to (a still elevated) 6.4%, in the same period. Indeed, the government and central bank’s commitment to macroeconomic stability are comfortting, given Turkey’s poor track record in this area. A complete restructuring of the banking sector helped build a healthy and stable financial system, as underscored by the banks’ solid performance during the recent global crisis. Increased stability facilitated the development of a healthy business environment, which was further aided by an improved regulatory environment.
Unfortunately, as noted in our Special Report “coping with external imbalance” a number of structural issues cast a shadow over the many achievements of the past decade, while inciting concern over the future stability of Turkey’s economy. Especially Turkey’s large external imbalance is worrisome. The large and persisting current account deficit (CAD), which rose to 10% of GDP in 2011, is the result of a dependency on energy imports, a low propensity to save and, even though labour productivity increased, a lack of competitiveness. Another weakness is the fact that the CAD is largely financed out of short-term external debt and volatile portfolio inflows, which makes Turkey especially vulnerable to changes in investor sentiment. This became abundantly clear shortly after the outbreak of the global financial crisis, when investors became increasingly risk averse and fled the more risky emerging markets, like Turkey (Rabobank, 2013).
The need for adjustment
Although the external imbalance is likely to persist in the short term, steps can be taken to reduce the current account and trade deficits over the medium term. These include efforts to enhance the competitiveness of the export sector, by raising labour productivity, as well as investments to increase the value-added of Turkey’s exports. In addition to spurring exports, further reforms should address Turkey’s dependence on energy imports, as well as its dependence on foreign investments to finance its growth. Together, these steps should help move the economy to a more sustainable growth path and allow Turkey to break with its turbulent past, for good.
However, this also implies that Turkey’s economic future in large part depends on the government’s willingness and ability to implement these essential, but painful reforms. As observed in our Special Report “Turkey: ready to compete?” Especially efforts to enhance the competitiveness of Turkish export sector will require the government to implement labour market reforms that address the high minimum wage and make the labour market more flexible. In addition, it needs to improve the education system so as to raise the percentage of highly skilled workers. A failure to follow through would undermine Turkey’s economic achievements and result in periods of prolonged instability, or crisis.
Base scenario: muddling through
In the medium term, Turkey’s political outlook will likely be dominated by the upcoming local, parliamentary and presidential elections in 2014 and 2015. As the ruling AKP will have to gather support in the run-up to the elections, it is unlikely to record much progress on vital reforms (including labour market reforms). As a result, our base scenario is one of little change. We do expect the government to continue to invest in the export sectors, while it is also expected to continue to improve the business climate so as to attract more foreign direct investments. Underlying this expectation is the assumption that the economic turmoil witnessed over the past few years created awareness for the need of a more export-led growth strategy. In addition, these investments, though costly, will be relatively painless as compared to labour market reforms. That said, without the much needed labour market reforms, it seems unlikely the competitiveness of the export sector will increase much. In addition, high minimum wages will continue to deter foreign direct investors.
Consequently, economic trend growth in our base scenario is capped at around 4%. Higher growth is possible, but would result in the same external imbalance we saw 2010 and 2011 and is thus not deemed sustainable. In addition, without the mentioned reforms, the current account deficit is expected to remain elevated. Although exports are expected to continue to grow, this growth would largely be offset by an increase in domestic demand and thus energy imports. This, in turn, means that Turkey remains vulnerable to external shocks and, as such, the risk of a balance of payment crisis lingers. Although in this scenario the risk of a balance of payment crisis does not increase substantially in the immediate term, over the medium term, a failure to implement any of the aforementioned reforms would become unsustainable, increasing the risk of a crisis.
Finally, without labour market reforms, we expect the informal economy to remain large, which will continue to limit the government’s ability to raise revenues.
Worst-case scenario: stagnation
Another scenario is that, after a decade of reforms, the government looses all momentum. Without the prospect of joining the EU in the near future and without IMF conditionality to push further reforms, the government could stall reforms indefinitely. In addition, the upcoming elections could encourage pre-election spending which would steer funds away from the much-needed investments in exports, alternative energy sources and infrastructure. Under this scenario, export growth would stagnate, while the increase in public spending would raise domestic demand to unsustainable levels, leading to inflation and a widening current account deficit. The result is volatile GDP growth, an outflow of foreign investments and thus a high risk of a balance of payments crisis. In addition, loose fiscal policy (and thereby an increasing public debt to GDP ratio) would also increase the impact of such a crisis. Nonetheless, since public spending did not increase considerably before previous elections and given the government’s apparent awareness on the importance of curtailing public debt, this scenario does not seem the most likely one.
Best-case scenario: reform
Alternatively, it is still possible that the economic turmoil of the last years motivates the government to not only invest in the export sectors, but also implements much-needed labour market reforms, while stepping up investments in alternative energy. Clearly these efforts would not immediately result in higher growth. In fact, the sensitivity of these measures could result in some social tensions, which could undermine growth in the short term. Nonetheless, over the longer term, these reforms would help reduce the external imbalance and help Turkey move to a higher growth path. With a more flexible labour market, the informal economy would shrink, while job formation would increasingly take place in the formal economy. This means Turkey would be able to benefit from its young and growing population. Not only would this increase public revenue, the formalization of the labour market would also enhance labour productivity. Finally, as a lower minimum wage would render Turkey more attractive to foreign investors, we should see inward FDI flows increase. Consequently, after five years of growing by 4% on average, we would expect the economy to grow by around 6-7% from 2018 onward. As mentioned above, given the lack of external pressure for reform and in light of the upcoming elections, we deem this scenario far less likely than our base scenario.
After a decade of reform the most important factor determining Turkey’s economic future is whether the government will be willing and able to implement the much-needed labour market reforms, raise the savings rate and reduce the country’s dependency on imported energy and intermediary goods. In addition, further investments in the export sector are needed if Turkey is to move to an export-led growth path. Unfortunately, the upcoming elections in 2014 and 2015 render it unlikely that much progress will be made in these areas. In contrast, our base scenario is that the government will stall painful reforms. Still, we do expect it to continue to support inward FDI, as well as the export sectors. However, without further reform, a growth rate beyond 4% would be unsustainable. In addition, as the current account deficit is not expected to come down in this scenario, Turkey would remain very vulnerable to external shocks.
A less likely, but still realistic scenario is one in which the government not only fails to implement reforms, but also increases spending in the run-up to the election. This would increase the risk of overheating, while the increasing fiscal deficit would further spook investors.
Finally, the best-case scenario is one in which the majority of all the necessary reforms is implemented. This would greatly improve the external balance, allowing the economy to grow by 6-7% in the long run.