Turkey: coping with external imbalance
Over the last decade, Turkey has made great strides to break with its turbulent past. But, despite major economic and institutional improvements, the boom-bust cycles of the past linger, albeit in a milder form. Especially the large and persistent deficit on the current account has left the country vulnerable to external shocks. This report considers the dynamics of the current account deficit, as well as the financing of this deficit. Following that, we consider the vulnerability created by the imbalance to the overall economy, as well as some structural measures needed to improve the external balance in the future.
Explaining the current account deficit
Ever since the economy recovered from the crisis in 2001-2, Turkey’s current account balance has been in deficit, which is caused by a large and persistent deficit on the trade balance. Outside of temporary factors that have pushed the current account deficit (CAD) up or down over the years, there are three main structural factors underlying the CAD.
The first is the fact that Turkey is extremely dependent on energy imports, which account for roughly 90% of all energy consumption.
Secondly, the CAD is explained by a wide imbalance between private investments and savings. In light of Turkey’s young population, as well as the country’s long struggle with hyperinflation, savings have been low at roughly 11% of GDP (2011). Despite the fact that public savings did increase, investments cannot be entirely financed out of total domestic savings and funds need to come from abroad. On the flip side, this also implies that the country as a whole consumes more than it earns (i.e. imports more than it exports).
The good news here is that imports have largely benefitted private investments, rather than private consumption. Assuming that these investments yield a positive return, future domestic earnings should increase.
Finally, the CAD is not only explained by a large import demand, but also by insufficient export growth. This is in part the result of a low competitiveness. Turkey’s large informal economy and relatively high minimum wage are pressing on productivity growth.
As a result of these structural factors, the current account deficit averaged 4.1% of GDP between 2002 and 2008. After that we see a more volatile picture, with the CAD shrinking to less than 2% in 2009, on account of the global crisis, and jumping to nearly 10% of GDP in 2011 as the economy almost overheated. These facts underscore that while Turkey is not considered a very open economy, its large CAD makes it vulnerable to external shocks.
Figure 1: Current account deficit
Financing the CAD
Unfortunately, Turkey’s vulnerability to external shocks is furthered by the fact that, as a result of the crisis, the CAD is increasingly financed out of short-term debt inflows. Indeed, with the outbreak of the global crisis, both FDI and long-term debt dried up, leaving Turkey dependent on short-term capital inflows (see graph 2). In addition, short-term debt also gained importance as a source of CAD financing. Although this is a worrying sign, it is also part of a global trend. Given that Turkey’s fundamentals have not changed significantly, we fully expect foreign direct investment to return once external conditions improve.
But, in the meantime, short-term external debt has risen considerably. Although external debt remained relatively stable at roughly 40% of GDP, short-term debt as a share of total debt increased from 19% to 27% between 2008 and 2011. Over half of all external debt is held by banks, while banks also hold the lion’s share of all short-term debt. In fact, out of the total of USD 141bn (18% of GDP) of external debt to be repaid within a year (from July 2012), roughly half is held by banks. Trade credits and intercompany lending together account for another USD 38bn, while the government only has to refinance USD 5.3bn (6.8% of GDP) of its external debt holdings over this period.
Figure 2: Financing the CAD
A managed adjustment
Until FDI flows return and until the CAD improves, Turkey remains vulnerable to shifts in investor sentiment, which could push the country into a balance of payments crisis. Thus, a structural adjustment is deemed vital. One way to achieve such an adjustment is by curtailing domestic (energy) demand, while simultaneously increasing exports. In some ways, such an adjustment is already underway. Exports are growing and have become more diversified (see graph 3). Especially exports of industrial and manufactured goods have taken a larger role, as well as services. Furthermore, Turkey is increasingly shifting its focus to the east, thereby diversifying its export partners. Although it is true that the new trade partners (e.g. Iraq) are politically unstable, reducing dependence on Europe as the main export destination is a logical step, considering the current economic climate.
Figure 3: Exports
In addition, reducing the dependency on imported energy and intermediaries is vital. The government is currently investing in alternative sources of energy (see box 1). Also, various public programs aim to reduce the dependency on intermediary goods, by motivating exportters to produce a larger share of the final export product. This should not be confused with import-substitution, as the government does not impose import restrictions, but merely aims to increase the competitiveness of domestic inputs.
Finally, increasing the savings rate and thus reducing the dependency on foreign capital, is a crucial part of any adjustment strategy.
Box 1: Reducing energy imports
At this moment, Turkey imports roughly 70% of its energy needs. There are two main roads to reducing the dependency on energy imports. The first is the exploitation of Turkey’s coal reserves. This appears to be the direction the government is heading. Recently, it announced its goal to reduce the amount of electricity generated from gas (which is imported) from 50% to 30%, while spurring investments in coal. Turkey sits on 1.3bn tonnes of hard coal and 11.5bn tonnes of lignite resources. In 2010, it produced 2.8m tonnes of hard coal and 69m tonnes lignite, around 15% of the country’s energy consumption. Clearly, there is room for growth, but solely relying on coal would not be a sustainable strategy.
The second and more sustainable road would be the development of alternative energy. In terms of solar and wind energy, Turkey has the potential to become the second largest producer in Europe. In addition, a combination of wind, solar, hydro and geothermal energy could provide 60% of the country’s energy needs. Recently, the government has announced a strategy for developing the sector, with the aim to increase production to 30% of Turkey’s energy needs by 2023. Unfortunately, so far, developments in the sector have been slow. The energy sector is controlled by a few large domestic companies, which lack the appropriate techniques to produce durable energy. At the same time, market penetration by foreign energy companies is limited, due to the difficulties of obtaining a license. The government should therefore step up its efforts to attract foreign investments (and thereby expertise) if it is to reach its own goals.
A recent pension reform takes a step in the right direction, as the government has started to match private pension savings. This should help raise the savings rate, to reach 15% of GDP in 2014.
The risk of a forced adjustment
The alternative to this managed adjustment, is a forced adjustment, which would be more disorderly. If Turkey fails to implement the adjustments mentioned above, it will remain vulnerable to shifts in investor sentiment and risks a balance of payment crisis, which will force it to adjust. Nonetheless, we hold that the flexibility of imports reduces this risk somewhat.
As outlined by Akay and Ocakverdi (2011), the sensitivity of imports to changes in the real effective exchange rate, as well as shocks in industrial production has increased. This means that if the real effective exchange rate falls, or if industrial production slows, the volume of imports rapidly comes down as well. A possible explanation for this outcome is the fact that the share of consumption goods in total imports has fallen over the years and has been replaced by inputs for industrial production. Thus, when production slows, so do imports. We find a clear example of this dynamic in the events of 2009, when investments (both FDI and portfolio investments) came to a standstill, which forced the economy into recession. Simultaneously, imports fell rapidly and the current account reported a historically low deficit of 2.2% of GDP.
Impact of balance of payment crisis
Despite the mitigating factors mentioned above, a balance of payment crisis remains a possibility. The impact of such a crisis depends both on its duration and, strongly related, whether or not a capital account crisis spirals into a banking and/or public debt crisis. This in turn depends on initial conditions, of which the pre-crisis stability of the banking sector and public finances are considered most important. Low public debt levels give the government room to manage a sudden increase in yields, while a high capital ratio should function as a coping mechanism for banks. In addition, low exposure of the government, banks and households to external debt denominated in foreign currencies helps shield these entities from a sudden depreciation of the exchange rate. Currency depreciation will also increase the value of imports, which would push up the domestic price level. An ability to absorb a sudden spike in prices is therefore preferred. If imports do not come down fast enough, this would also increase the CAD. But, in light of the arguments made above, this is an unlikely scenario for Turkey. Finally, policy response is a significant determinant of the duration of a capital account crisis. Especially a swift reduction of the fiscal deficit is considered vital for restoring investor confidence (IMF, 2007). Of course, the exact policy mix will depend on nature and characteristics of the crisis itself.
Fortunately, Turkey scores relatively well in many of these areas. For one, over the course of the past decade, Turkey’s financial system, perceived as one of the country’s main weaknesses only 11 years ago, has been transformed in one of the most stable systems in Europe. In the run-up to the 2001-crisis, banks functioned mostly as the government’s private cash cows, leaving the private sector strapped for cash. However, as a result of the rehabilitation program adopted in the aftermath of the crisis, Turkey’s financial system became the backbone of its economy. The sector’s robust performance throughout the recent global crisis underscores the success of the rehabilitation program. Banks remained well capitalized, with an average capital ratio of 16%, while NPLs remained at a low 2.5% of all outstanding loans (relative to over 30% in 2001). In addition, even though banks are the largest holders of external debt, improved regulation forces them to hedge their positions, while it has become more common for banks to obtain external debt denominated in domestic currency, thereby reducing exchange rate risks. Plus, during the last episode of massive hot money inflows, the Central Bank of Turkey (CBRT) increased the bank’s reserve requirements in general, and FX reserves in particular, while also curtailing the amount of short-term loans banks were allowed to extend. These measures together with the sound initial position of the banking sector are comforting.
Secondly, the government has been eager to avoid spooking investors, resulting in strict fiscal policy and low public debt levels. Over the last decade, the government drastically cut consumption (leaving investments largely intact), while windfall revenues were allocated to a savings account. The result is a cut in expenditures, from 44% of the total budget in 2001, to 22% of the total budget in 2008. These achievements send a clear signal to investors that the government is prepared to take hard measures to keep its finances in check. It should, however, be noted that in light of a large informal economy, the government relies on a relatively small revenue base. This explains why we expect the fiscal deficit to widen in 2012, while economic growth slows. Still, the government’s resistance to introduce stimulus measures (in the face of slow growth) is considered a positive sign. Another positive fact is that, since public debt fell to below 40% of GDP, from 80% of GDP in 2001, the government has sufficient room to manoeuvre. Especially considering that only a quarter of public debt is denominated in foreign currencies and that the government has been successful in increasing the maturity of its debt, which makes it far less vulnerable to sudden (and temporary) spikes in yields.
Another factor that will prevent a capital account crisis from spiralling into a banking or public debt crisis is the fact that Turkish private sector holds very little debt. Especially households are relatively underleveraged and are by law forbidden to take up mortgages denominated in foreign currencies. Instead, most credit growth in the past years has benefitted the corporate sector. As a result, total private sector loans to GDP stand a low 88%. Only 30% of total loans are held in foreign currencies. Low household indebtedness should help prevent a severe drop in domestic demand and should help keep non-performing (consumption) loans low.
Finally, there are a number of soft factors that we believe would benefit Turkey in the event of a capital account crisis. The most important one being the fact that both the government and the central bank have learned from the most recent crisis and are now more experienced to handle shocks in investor sentiment. The CBRT specifically has found new ways to reduce the volatility of hot money flows and control the use of these flows. The success of the CBRT and the government to orchestrate a soft landing in 2012 should further boost confidence. In addition, another positive factor is the fact that Turkey maintains sound relations with the IMF.
Although the country refused a flexible credit line in 2009, it would be able to obtain such (or another) credit line if need be. Especially given that Turkey already adheres to most IMF conditions.
Turkey’s large external imabalance renders it vulnerable to external shocks and the resulting changes in investor sentiment. In order to reduce this vulnerability, it should reduce its dependency on energy imports, as well as the imports of intermediary goods. Next tot hat, the government needs to implement reforms that increase the flexibilty of the labor market, which would increase labor productivity and thereby competitiveness. Although we see some positive developments in all these areas many of the policies implemented will take time to yield results. Vulnerability would further be reduced by lowering the dependency on foreign investments (and specifically portfolio investments), by increasing the domestic savings rate. A failure to achieve this could result in a capital account crisis. However, although this is not a preferred outcome and would undermine Turkey’s efforts to move away from the boom-bust cycles of the past, we argue that a sound financial system paired with low public and household debt should help prevent a capital account crisis from spiralling into a public debt and/or banking crisis.