Country Report Turkey
Turkey’s external vulnerabilities decreased in the first quarter of this year, as the current account deficit started to decline and net capital inflows resumed. Meanwhile, Prime Minister Erdoğan’s dominant position was strengthened by his party’s victory at the March 30th municipal elections.
Strengths (+) and weaknesses (-)
(+) Low government debt
Public debt was relatively low at 38% of GDP in 2013 and the government has a track record of posting primary fiscal surpluses.
(+) Favourable demographics
Turkey’s relatively well-educated working-age population will continue to grow in the medium-term, which boosts potential economic growth and limits ageing-related public spending increases.
(-) Vulnerable external position
Turkey’s high current account deficit (7.9% of GDP in 2013) and relatively low level of foreign exchange reserves expose the country to a deterioration of external financing conditions and a sudden reduction of capital inflows.
(-) Domestic and external political tensions
Turkey’s politics and society are characterized by deep polarization between secular and religiously-conservative groups, leading to a preference for confrontation rather than co-operation that at times results in violent protests. The still unresolved conflict with Kurdish separatists and Turkey’s proximity to the civil war in Syria also adds to political risk.
1. Heading for external rebalancing, as growth slows and net exports strengthen
Turkey’s recent large external imbalances started to decline in February, as its sizeable current account deficit started to narrow and net capital inflows turned positive again. Capital inflows had declined strongly since mid-December amid rising investor concerns about the start of US Federal Reserve tapering in January and a corruption probe in Turkey involving high-ranking cabinet members. The lira depreciated strongly as a result. In response, Turkey’s central bank opted for a major interest rate hike in late January, which calmed financial markets and led to a strengthening of the lira. The interest rate increase, the weaker lira and earlier-adopted macro-prudential measures meant to rein in consumer credit growth have been depressing domestic demand since, while external demand is still too weak to compensate for this effect. Consequently, real GDP growth is expected to decline from 4% in 2013 to 2.2% this year. In line with the weakening of domestic demand, import growth is slowing. Meanwhile export growth is benefiting from the beginning, yet moderate, economic recovery in the euro area (Turkey’s main export market), as well as improved competitiveness arising from the weakness of the lira. As a result, Turkey’s large trade balance deficit has started to decrease and, consequently, Turkey’s current account deficit in February - the most recent month for which data is available - declined by about USD 1.9bn yoy to USD 3.2bn. Assuming that the external rebalancing continues, the current account deficit is expected to narrow from 7.9% of GDP in 2013 to a still sizeable 6.0% in 2014. This improvement would reduce the country’s exposure to challenging external financing conditions to some degree and support investor confidence. Meanwhile, net capital inflows, which had turned negative in January, resumed and financed about 80% of the current account deficit in February. Given a limited net outflow of portfolio investments and weak net foreign direct investment inflows, the repatriation of domestic banks’ currency and deposits held abroad, as well as external loans extended to Turkish banks accounted for the lion’s share of the capital inflows. As FX reserves levels in both March and April stayed more or less stable, net capital inflows seem to have financed most of the current account deficit in these months as well, suggesting that investor confidence has been preserved. Turkey’s continued external rebalancing remains necessary given still challenging external financing conditions as the tapering of the US Federal Reserve’s loose monetary policy continues. Still, considerable risks remain that could lead to a widening of the current account deficit or weaker capital inflows. Strongly rising oil and gas prices (e.g. as a consequence of an escalation of the conflict in Ukraine) would hit Turkey’s trade balance. A renewed deterioration of global investor sentiment, rising domestic political tensions ahead of the August 10th presidential elections or a premature interest rate cut, possibly driven by rising political pressure on the central bank, could undermine regained investor confidence and hurt capital inflows.
2. Municipal elections confirm Prime Minister Erdoğan’s dominance of Turkish politics
Prime Minister Recep Tayyip Erdoğan’s AKP won a major victory at the March 30th municipal elections, securing about 46% of the nationwide vote in spite of an ongoing corruption probe and a series of leaks of (possibly fabricated) incriminating telephone calls. Amid a strong voter turnout, AKP mayors were elected in Turkey’s major cities, including Ankara and Istanbul, while the opposition failed to benefit from the governing party’s current problems. Due to his strong involvement in the campaign, Prime Minister Erdoğan interprets his party’s success as a personal vote of confidence that reflects the AKP voters’ support for his policies and handling of the ongoing conflict with the Hizmet-movement - led by U.S.-based cleric Fethullah Gülen. Consequently, Mr Erdoğan will most likely run in the August 10th presidential elections, as current president Abdullah Gül decided to withdraw from politics. Having promised not to merely fulfil a representative function, as he would be Turkey’s first popularly-elected head of state, he may try to shift Turkey’s current parliamentary system to a more presidential set-up. Unlike most previous presidents, he would likely use all the powers available under the current constitution, such as the president’s right to head the weekly cabinet sessions. Meanwhile, as announced in his recent victory speech, he will continue to purge suspected Gülenists from public institutions, possibly including the central bank, which could result in rising political influence on currently relatively independent institutions. Moreover, efforts to consolidate his power may bring rising authoritarian tendencies, as recent shutdowns of Twitter and YouTube, and a contentious reform of Turkey’s judiciary have shown. Yet, these efforts will likely face recurrent opposition from the Constitutional Court, which recently rejected the above-mentioned policy measures. While Mr Erdoğan’s continued domination of Turkish politics augurs well for policy continuity, his preference for confrontational policies could lead to further clashes with his political opponents and enhance lingering risks of social unrest, particularly ahead of the presidential elections, as the polarization of Turkish society deepens.
Turkey has a turbulent economic and political history. It encountered a huge financial crisis in 2001, but afterwards its economy has grown rapidly. The business environment has improved in recent years and Turkey now occupies a respectable 44th place (out of 148 countries) on the WEF’s Global Competitiveness Index. Tourism is a very important sector of the Turkish economy. Furthermore, the country also has a well-developed manufacturing sector. The country’s export diversification, both in terms of goods and export destinations, has increased in recent years, which has lowered the dependency on textile exports and exports to Europe. Public debt has fallen in recent years and is relatively low at 38% of GDP in 2013, thanks to structural primary fiscal surpluses and high economic growth. However, a large current account deficit, a resulting dependency on short-term foreign capital inflows and low foreign exchange reserve levels lead to a relatively high balance of payments risk. The government is trying to reduce this external vulnerability by undertaking reforms that seek increase the very low domestic savings rate and reduce the dependency on energy imports, which have yet to bear fruit. Meanwhile, the strong economic growth of the past decade has underpinned the popularity of the centre-right, socially conservative, Justice and Development Party (AKP), which won the 2002 elections. At that time, it took over power from the traditional secular elite, which until then, with occasional help from the military, had governed Turkey. The AKP has remained in power ever since, but political polarization between the country’s secular and religious parts of the population has increased considerably in recent years, which contributes to a lingering risk of sizeable social unrest. Meanwhile, the level of press freedom is low in Turkey. The proximity to the war in Syria and the still unresolved conflict with Kurdish separatists add to geopolitical risk.