Country Report Turkey
While Turkey’s economic growth started to slow in the second quarter, the central bank faces pressure to reverse its major January interest rate hike ahead of the 2015 parliamentary elections. As expected, Recep Tayyip Erdoğan became Turkey’s first directly-elected president.
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 add to political risk.
1. Slowing economic growth increases pressure on central bank to cut interest rates
Turkey’s economy slowed strongly in the second quarter of this year, as economic growth fell from 4.7% yoy in Q1 to 2.1% yoy in Q2. The growth deceleration comes as the central bank’s major interest rate hike in late January and various macroprudential policy measures aimed at slowing credit growth introduced last year leave their mark on private domestic demand. In both quarters, growth was mainly driven by surging exports and solid public spending. Private consumption growth slowed markedly, however, and private investment even contracted in yoy terms. Weakening consumer confidence, as well as markedly lower credit growth, particularly in the consumer segment, are holding back private sector spending growth, leaving net exports and public spending as the main growth drivers. While contributing to the necessary rebalancing of the Turkish economy away from domestic to external demand, the current weakness of private domestic demand led to strong political pressure on the central bank for a reversal of the January rate hikes ahead of the August 10 presidential elections.
As the Turkish lira remained relatively stable in recent months thanks to strong portfolio investment and debt inflows and foreign exchange reserves rebounded, Turkey’s central bank opted to partly give in to these demands and gradually cut its main policy rate by a cumulative 175bps to 8.25% since May. Yet, as inflation rose to 9.5% in August, it has refrained from further cuts and will likely do so until the inflation outlook improves. Still, political pressure for further rate cuts is unlikely to abate soon. Even though Turkey’s current account deficit declined by 35% yoy in the first half of this year (21% excluding gold trades), in our view there is no room for further monetary easing. Escalating geopolitical tensions in Ukraine and the Middle East could result in both a renewed widening of the current account deficit (e.g. through higher energy prices and lower exports) and a major increase in global risk aversion, which could confront Turkey with difficulties in financing the deficit, particularly so as the US Federal Reserve continues to reduce its monetary stimulus.
2. New cabinet takes office, as Erdoğan becomes Turkey’s first popularly-elected president
Following his AK party’s victory at the March 30 municipal elections, former prime minister Recep Tayyip Erdoğan won the August 10 presidential elections in the first round and became Turkey’s first directly elected president. Mr. Erdoğan’s election will likely push Turkey closer to becoming a semi-presidential republic, as the new president promised to remain involved in daily politics. Yet, given the relatively narrow victory amid a low turnout, Mr. Erdoğan may face difficulties in winning the two-third majority at next year’s parliamentary elections that is needed to implement constitutional changes. Notwithstanding, given the appointment of former minister of foreign affairs and close confidant Ahmet Davutoğlu as new prime minister, policy co-ordination with the president will likely remain close, which should also contribute to considerable policy continuity. Likely policy priorities of the new cabinet comprise boosting economic growth to ensure a large enough majority at the 2015 parliamentary elections to amend the constitution, the continued fight against the Gülen movement, and the advancement of the peace process with the Kurdish PKK. The composition of the new cabinet also underlines the apparent preference for a continuation of current policies, as only 4 of the 26 minister have been replaced, which also suggests weak appetite for needed structural reforms. Most importantly for foreign investors, Turkey’s economic policy team remained in place, as incumbent deputy prime minister Ali Babacan stays head of economic management and Mehmet Simşek kept his post as finance minister. Since both are seen as guarantors of central bank independence, they may play a crucial role in ensuring economic stability going forward, at least until internal AKP term limits would require Mr. Babacan to resign after the 2015 elections. Meanwhile, the appointment of former minister of European Affairs Mevlut Çavaşoğlu as new minister of foreign affairs may result in renewed efforts towards EU accession in the coming years. Nonetheless, risks remain that economic and foreign policies may become more populist in the aftermath of the 2015 parliamentary elections.
3. Renewed efforts to boost the Kurdish peace process
The outlook for considerable progress of the Kurdish peace progress has improved, as recent legal changes allow for direct talks with the PKK, while the strong performance of the Kurdish candidate Selahattin Demirtaş during the presidential elections illustrated the rising importance of the Kurdish electorate. As president Erdogan will likely need the Kurdish vote to win a two-third majority at next year’s parliamentary elections, an intensification of peace efforts in the coming months are likely. While currently incarcerated PKK leader Abdullah Öcalan’s support for the peace process, as well as the fact that a unilateral ceasefire agreed upon by the PKK in March 2013 has more or less been maintained both augur well for the eventual cessation of the thirty-year long conflict, risks of a return to widespread violence remain high.
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.