Country Report Turkey
After nearly overheating in 2011, Turkey’s economic growth came to a halt in 2012, as the government and Central Bank successfully cooled domestic demand and reined in the massive influx of portfolio investments. As a result, the economy grew by less than 3% in 2012. This also helped reduce the trade deficit, which contracted from an alarmingly high 11% of GDP in 2011, to 8% of GDP in 2012. For 2013, we expect domestic demand to recover somewhat, albeit slowly, with growth coming in at roughly 4%. However, in order to avoid overheating in the future, Turkey should move to an export-led growth strategy. To achieve this result, it should increase the competitiveness of its export sector, by creating a more flexible labor market. Unfortunately, however, with presidential elections scheduled for 2014, we do not expect major process in this area, as the government will likely stall any major (and painful) reforms.
Economic structure and growth
Turkey’s turbulent political and economic past long cast a shadow over its most recent economic achievements. However, with a large and young population, a proximity to both Western and Eastern markets, long coastlines and an ever-improving business climate, Turkey has become an increasingly popular destination for tourists and investors alike. This is not to say that Turkey was not impacted by the global crisis. In 2009, GDP contracted by over 5%. Although 2010 brought a quick recovery, subsequent inflows of portfolio investments (fuelled by monetary easing in developed countries) almost caused the economy to overheat in 2011. This rollercoaster finally slowed in 2012, when economic growth dropped to just over 3%, cooling fears of overheating.
The turbulence described above is largely caused by Turkey’s significant and persistent current account deficit, which has been increasingly financed out of short-term external debt (rather than long term foreign investments). Therefore, despite the fact that Turkey’s economy remains relatively closed, it is vulnerable to external shocks. In order to reduce this vulnerability Turkey should reduce its dependency on imported energy, which now accounts for roughly 70% of the country’s entire energy consumption. In addition, a more flexible labor market and lower minimum wage would render Turkey’s labor market more attractive and raise the competitiveness of especially Turkey’s manufacturing exports. Only by realizing both objectives will Turkey be able to record the high growth rates seen in the last decade, without jeopardizing long-term stability.
In the meantime, the most favorable scenario would be an average growth rate of 5%. Given the current production capacity and dependency on imported energy, a higher growth rate would create a risk of overheating, while a lower growth rate would likely mean an increase in unemployment. The latter is especially relevant in light of Turkey’s young population and, consequently, growing work force. Generating jobs for these new labor market entrants is vital if Turkey is to benefit from its demographic advantage. For 2013, we expect growth to come in at roughly 4%, as both productivity in the industrial sector and domestic demand pick up. Nonetheless, this projection is subject to substantial downside risks, including a worsening of the eurozone crisis (as the eurozone remains the main destination for Turkish exports), as well as severe spillovers from regional conflicts, including the ongoing war in neighboring Syria (more below).
Turkey’s financial sector is in good shape. 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 into one of the most stable systems in Europe. This was underscored by the sector’s robust performance throughout the recent global crisis. Banks remained well capitalized, with an average capital ratio of 16%, while NPLs stand 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 (both in domestic and foreign currencies), 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 removing exchange rate risks.
Political and social situation
Turkey’s political and social situation remains turbulent, due in part to its proximity to some of the world’s least stable countries. In particular, the ongoing war in neighboring Syria impacts Turkey’s political situation. In the second half of 2012, violence along the Syrian-Turkish border worsened, as Syrian fighters are increasingly active in Turkish border towns. This, in turn, forced the Erdogan government to break with its zero-problems-with-neighbors policy. Indeed, Erdogan repeatedly called on Syria’s president Bashar al-Assad to step down and continues to accommodate the thousands of refugees fleeing Syria. However, despite the fact that Turkey did shoot some warning shots (which hit strategic military posts in Syria), we do not expect this will result in a full-blown war, as this would not be in the best interest of either country.
The war in Syria did increase the risk of a further deterioration of the ongoing conflict between Turkey and the PKK. When the Syrian army abandoned the Kurdish areas in Syria (near Turkey’s south-east border), the consequent vacuum has been filled by the PKK, which has reportedly started to employ the area as a military base. This development is especially dangerous in light of the fact that after the last round of negotiations between the government and the PKK failed in 2011, violence once again flared up. It is hoped that renewed negotiations, which reportedly started at the beginning of 2013, will yield better results. However, despite these new negotiations, the Turkish military did not suspend its operations against the PKK. This alone could jeopardize any progress at the negotiation table. In addition, the outcome of the negotiations depends in large part on the ability of the PKK’s jailed leader, Abdullah Ocalan, to rally the PKK behind a peace accord. Given these obstacles we do not expect an agreement to come about in the short-term.
Another source of political instability could be the upcoming presidential elections in 2014. Erdogan, Turkey’s current Prime Minister, is expected to run for president, leaving the slot for Prime Minister unfilled. The consequent power vacuum could disturb the hierarchy within the ruling party, the AKP. However, it seems more likely that in the run-up to the elections Erdogan will start to reform the constitution in such a way as to direct more power to the president. Of course this is not a positive development, as it should not be possible to adjust the constitution to benefit one person. Nonetheless, the result would be a situation that resembles the status quo. A more prominent risk is that, in an effort to win votes, the government will stall the implementation of some important, but unpopular reforms, including much-needed labor market reforms. Given that Turkey’s accession to the EU appears more of a distant dream than a short-term reality, we also do not expect the European Commission to provide the needed incentive for reform. This would mean that any meaningful change in these areas could only be expected from 2015 onwards, which would negatively impact Turkey’s economic progress.
Given Turkey’s large external imbalance it is vital for the government to maintain a tight budget so as not to spook foreign investors. For the better part of the last decade, it has managed to keep spending under control, while reducing public debt to below 40% of GDP. More recently, spending increased somewhat, resulting in a budget deficit of 2% of GDP in 2012, from 1.5% of GDP in 2011. We are not overly worried by this slight increase. Still, a steep rise in spending in the run-up to the presidential elections would warrant concern. More worrisome, however, is the fact that about half of Turkey’s labor force is employed in the informal economy, which obstructs the government’s ability to generate revenue. In the long term, a more flexible labor market would help formalize the economy and thus increase public revenue. Unfortunately, as mentioned earlier, the upcoming elections are likely to stall any of the reforms needed to achieve this.
The massive inflow of portfolio investments in 2010 and 2011 pushed up domestic demand and inflation, which rose to 8.5% in 2010, easing to 6.5% in 2011. Despite slowing growth and the Central Bank’s efforts to control inflation, it averaged 8.9% in 2012. Nonetheless, high inflation in 2012 was partly caused by one-off tax increases. Moreover, inflation slowed at the end of 2012, reaching about 6.2% in December. For 2013, we expect inflation to come in between 6% and 6.5%. This projection is based on the assumption that consumer demand will recover slowly and that international commodity prices will stay more or less flat (or even fall) over the course of this year. In addition, the Central Bank is expected to maintain a relatively tight monetary policy. This will also stabilize the value of the lira, which is allowed to float freely vis-à-vis other currencies. Of course, there are substantial up-and downside risks to this projection, given the current volatility of global financial markets.
Balance of payments
As mentioned above, Turkey’s large and persistent current account deficit is largely the result of its dependency on energy imports. As a result, Turkey generally reports a large deficit on the trade balance. In 2009, when the global crisis hit Turkey and domestic demand rapidly contracted, this deficit came down to a mere 3.5% of GDP. Nonetheless, as soon as economic recovery set in, the trade deficit began to grow as well, reaching an alarming 11.5% of GDP in 2011. In 2012, reduced domestic demand and increasing exports helped reduce the trade deficit to roughly 8% of GDP. Nonetheless, it should be noted that the increase in exports was in large part the result of increased gold exports, which where used to pay for oil imports from Iran. Indeed, the exports of precious metals (including gold) increased by 21%. For 2013, we expect the trade deficit to grow only slightly, while falling as a percentage of GDP (to slightly below 8%). In contrast to the trade balance, the services balance generally reports a surplus, reflecting Turkey’s flourishing tourism market. In 2012, this surplus came in at 2.6% of GDP and we expect it to remain at roughly that level in 2013 as well. A small deficit on the income balance is the result of profit repatriation by multinationals, while a small surplus on the transfer balance reflects the inflow of remittances by Turkish migrants.
In 2012, the current account deficit contracted to 6.2% of GDP, from 10% of GDP in 2011. For 2013, we expect it to remain at roughly this level. This reduction has calmed fears of overheating and reduced chances of foreign investors running for the exits. Unfortunately, however, investments in Turkey are not only motivated by Turkey’s own fundamentals. Indeed, from the onset of the global crisis we saw an increase in short term investments and debt, while long term investments (and foreign direct investments) fell. Consequently, Turkey has become more dependent on short-term funds to finance the current account deficit, making it vulnerable to external shocks. The good news is that Turkey has been building FX reserves, which now cover roughly 4.5 months of imports.
Over the last years, the level of external debt to GDP has remained stable at roughly 40% of GDP. Nonetheless, the share of short-term debt in total debt increased sharply, reflecting increased risk aversion among international investors. As a result, short-term debt increased from 16% of total foreign debt before the crisis (2007), to roughly 25% of total foreign debt now. In addition, and as a consequence, total debt service has been on the rise over the last year. For 2012, total debt service due came in at USD 14bn, from USD 13bn in 2011. Turkey’s banks and private sector hold the largest share of all external debt, with the government mostly holding mostly long-term external debt.