Turkey: ongoing political instabiliy
Turkey’s economy expanded by 4% last year, but Russian sanctions and weaker tourist arrivals will negatively affect growth this year. In spite of the AKP’s regained parliamentary majority, Turkey’s political situation remains volatile which could once more weigh on essential foreign capital inflows.
Strengths (+) and weaknesses (-)
(+) Strong government finances
Public debt was relatively low at 35% of GDP in 2015 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 (4.5% of GDP in 2015) 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. AKP's regained parliamentary majority only partially restores domestic political stability
Even though the AKP regained its absolute parliamentary majority at the November 2015 repeat elections, Turkey’s domestic political stability remains volatile. Risks of early elections ushering in yet another period of political instability and policy paralysis remain elevated, as the party currently lacks a necessary super-majority to put President Erdoğan’s plans for an executive presidency up for referendum. For now, Turkey’s current de-facto presidential system entailing close policy coordination between prime minister Davutoğlu, a proponent of orthodox economic policies, and President Erdoğan, who at times supports populist measures, will stay in place. Populist fiscal and monetary policies may be implemented to boost currently weak public support for an executive presidency, while progress on needed structural reforms will likely remain weak. The recent adoption of a 30%-minimum wage hike bears witness to this, while simultaneously-presented structural reforms still await implementation. The appointment of compromise candidate Murat Çetinkaya as the new central bank head raises concerns about the central bank’s independence. Premature monetary easing due to political pressure for large interest rate cuts could trigger sizeable capital outflows. In terms of domestic security policies, the government in unlikely to soften its stance, which brings with it elevated risks of terrorist attacks and a further deterioration of media freedom and the rule of law. Given the government’s commitment to a military solution of the conflict with the Kurdish separatist PKK, large-scale military operations in the country’s south-east will likely continue. Therefore, risks of terrorist attacks also in the western part of the country remain high. Meanwhile, as illustrated by the government takeover of Gülen-affiliated media groups and the arrests of business people with alleged ties to US-based Islamic cleric Fethullah Gülen, the government’s fight against his movement continues. Should Turkey’s institutional quality and so far strong fiscal discipline falter, risks of a sovereign downgrade to junk triggering large capital outflows by institutional investors could rise.
2. Economy heading for a slowdown, as Russian sanctions and weak exports weigh on growth
Turkey’s economic growth came in at 4% last year, up from 2.9% in 2014, as domestic demand, partly boosted by the large influx of refugees, remained resilient. Economic growth is expected to slow down to about 3-3.5% in 2016, as consumer spending, though stimulated by a 30% minimum wage hike, will face headwinds from elevated unemployment and inflation. Private investments will likely remain weak amid lingering political instability, as well as higher debt servicing costs given the impact of recent years’ lira weakness on the corporate sector’s large net open FX position. More generous fiscal spending will likely support domestic demand, but it is unlikely to compensate for considerable export weakness. Turkish exports will face headwinds by weak demand from oil-exporting economies, as well as Russian bans on Turkish food imports and charter travel to Turkey, which further undermine tourist arrivals already weighed down by recent terrorist attacks.
3. Sustained external financing difficulties bring with it risks of major monetary tightening
Notwithstanding last year’s cyclical decline of the current account deficit on the back of lower oil prices, Turkey faced considerable difficulties in attracting sufficient external financing, as concerns about political stability exacerbated a global withdrawal of funds from emerging markets. FX reserve use (USD 11.8n) and unidentified capital flows (USD 9.8bn) financed two-third of last year’s current account deficit. Consequently, the central bank’s net official FX reserves declined to about USD 28bn (equal to only 1.5 months import cover) in December 2015, which brings with it increased risks of a balance-of-payments crisis. Even though net capital inflows surged recently amid signs of a more dovish US monetary policy, Turkey’s volatile political situation and eventual US Federal Reserve interest rate hikes bring with them risks of a renewed decline in capital inflows. Meanwhile the uncertain outlook for the tourism sector and a possible rise in oil prices could lead to a widening of the current account deficit. Consequently, Turkey’s central bank might be forced to abruptly abandon monetary easing and tighten monetary policy drastically to avoid FX reserve depletion. As emergency rate hikes would lead to major domestic demand suppression, political opposition may delay such steps. Eventually, however, as has been the case during the 2014 emergency rate hikes, politicians will likely remain pragmatic and tacitly approve large rate hikes.
4. Proximity of Syrian civil war brings with it tail risks of Turkish military intervention
Turkey’s vicinity to the Syrian civil war and its strong ties with Armenia’s enemy Azerbaijan bring with it tail risks of direct military involvement in regional conflicts. In particular, territorial gains by Syrian-Kurdish forces along the Turkish border and the proclamation of a (semi-) independent Kurdish state could trigger a (unilateral) Turkish ground offensive. Costly direct Turkish military involvement in either of these conflicts, though unlikely, could seriously affect investor confidence.
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 51st place (out of 144 countries) on the WEF’s Global Competitiveness Index. Manufacturing and tourism constitute important sectors of the economy. 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 2015, 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. Reforms seeking to increase the very low domestic savings rate and to reduce the dependency on energy imports 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 and has stayed in power since. As of August 2014, when former prime minister Recep Tayyip Erdoğan became Turkey’s first popularly elected president, Turkey has been governed under a de-facto presidential system that has shifted considerable political power away from the cabinet. While constitutional changes reflecting this system are still pending, political polarization between mainly socially-conservative supporters and oftentimes secular opponents of President Erdoğan has deepened, leading to risks of social unrest. Already poor press freedom has deteriorated in recent years, while political pressure on officially independent intuitions such as courts, regulators or Turkey’s central bank has increased. The proximity to the war in Syria and the still unresolved conflict with Kurdish separatists add to geopolitical risk.