Country Report Turkey
The Turkish lira has depreciated strongly against the USD, as political pressure on the central bank not to raise interest rates ahead of the June 7 parliamentary elections has intensified. While it remains uncertain whether the AKP will win a two-third majority needed to introduce an executive presidency, investors remain concerned about the future of economic policymaking.
Strengths (+) and weaknesses (-)
(+) Low government debt
Public debt was relatively low at 35% of GDP in 2014 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 (5.8% of GDP in 2014) and relatively low level of foreign exchange reserves make the country vulnerable 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. Lira depreciates strongly amid investor concerns about the direction of economic policy
Following its earlier stabilization in the aftermath of a major interest rate hike in January 2014, the Turkish lira has once more depreciated against the USD since the second half of last year, losing almost 30% of its value. Initially, lira depreciation mainly reflected capital outflows ahead of the expected US Federal Reserve interest rate hike and the gradual easing of Turkish monetary policy amid a pronounced slowdown of economic growth. In recent months, however, the weakening of the lira was exacerbated by investors’ concerns about the direction of Turkey’s economic policies and central bank independence in the aftermath of the June 7 parliamentary elections. These concerns were sparked by harsh criticism by several cabinet ministers and, most importantly, President Erdoğan, of the central bank’s refusal to implement major interest rate cuts to boost economic growth ahead of the upcoming vote. Partly giving in to this pressure, the central bank gradually cut its main policy from 8.25% at the beginning of this year to 7.5%, even as inflation remained stubbornly high (7.6% in March). Meanwhile, in order to dampen the rate cuts’ effects on the exchange rate, reserve requirements and amounts of FX selling auctions were adjusted, but these measures proved insufficient to halt the lira’s slide. After having depreciated by about 15% against the USD this year, the lira finally stabilized when President Erdoğan and the central bank reached a truce that has so far relieved political pressure for additional rate cuts.
Still, given that these events have increased fears among investors about increasing politicization of monetary policy, risks of renewed major capital outflows weakening the lira remain high. At a time when the expected US Federal Reserve interest rate increase weighs on financial flows to emerging economies, this could render the financing of Turkey’s current account deficit more difficult, notwithstanding its welcome decrease from 7.9% in 2013 to a more manageable, though still large, 5.8% of GDP last year. Meanwhile, recurrent lira depreciation could negatively affect foreign investors’ appetite for direct investments generating lira revenues. Consequently, already markedly weaker foreign direct investment inflows could suffer and make Turkey even more dependent on FX-denominated debt funding. Moreover, on the domestic front, ongoing lira weakness could lead to rising corporate defaults in the medium-term, given the sector’s large net open FX position of USD 177bn in early 2015. Prior to the June 7 vote, this situation is unlikely to change, unless the government succeeds in convincing investors that a possible shift to an executive presidency, as demanded by President Erdoğan, does not result in deteriorating central bank independence and a shift towards more authoritarian populist economic policies. Meanwhile, (foreign) investors are expected to remain in a wait-and-see mode until the implications of the elections become more clear. In the meantime, the central bank will likely try to stabilize the lira, while major (post-election) monetary tightening remains in the cards, possibly through the provision of funding at the overnight lending rate (10.75%) instead of the main policy rate.
2. AKP likely to win parliamentary elections, but pro-Kurdish party holds key to introduction of presidential system
Notwithstanding high unemployment levels, weak economic growth and a markedly polarized society, the incumbent AK party (AKP) is expected to win the June 7 parliamentary elections by a large margin. However, its chances of realizing its planned introduction of an executive presidency lacking robust mechanisms of checks and balances hinge upon the performance of the pro-Kurdish HDP, which has recently stressed its opposition to the AKP’s plans. Should the HDP fail to enter parliament, the AKP will most likely be able to at least get a 3/5 majority, providing the party with the opportunity to put the introduction of an executive presidency up for a referendum. Still, given lingering doubts among the Turkish electorate and within the ruling AKP about the benefits of a presidential system, public support for such constitutional changes remains highly uncertain. As recent polls gauge support for the HDP at up to 11%, it will likely pass Turkey’s 10% electoral threshold and prevent the AKP from winning enough seats to implement constitutional changes. Given latent conflicts within the AKP, failure to introduce an executive presidency could lead to a gradual shift in power away from President Erdoğan toward prime minister Davutoğlu, who, in contrast to the president, is a proponent of conventional economic policies and necessary structural reforms. This would also bode well for some future role in politics of deputy prime minister Ali Babacan and finance minister Mehmet Simşek following their upcoming resignations in line with the AKP’s three-term limit. Both are seen as guarantors of more orthodox economic policies. If, however, President Erdoğan succeeds in introducing a presidential system, this would likely lead to the marginalization of Mr Davutoğlu. This could bring with it risks of a shift towards more populist, short-term oriented interventionist economic policies that could seriously affect investor confidence in the Turkish economy.
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 45th place (out of 144 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 35% of GDP in 2014, 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 though. 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.