November 30, 2015 TURKEY: MEDIUM TERM PROSPECTS FOR THE ECONOMY Overview of the Recent Developments Most recent financial market indicators reflected the high volatility and uncertainty that Turkey has been going through for the last year, resulting from political uncertainties as well as other factors affecting global markets. Lira depreciated as low as 24 percent against the dollar between the end of 2014 and mid-September while the equity price index in USD terms declined by 36 percent. Two year treasury benchmark yields rose from 7.9 percent on December 31, 2014 to 11.2 percent by mid-September and the five year corporate CDS from 183 to 327 by end-September. Following the peaks and troughs reached in September, Lira’s year-to-date depreciation has been 18.3 percent to the dollar and 12.6 percent against the basket. An index for Turkey’s equity markets declined 29.3 percent year-to-date compared with 13.6 percent for emerging markets 1 . As of November 20, 2015, annual average returns in USD terms were negative for the last three-, five- and ten-year periods and almost about twice the returns for the average of emerging markets, tarnishing the country’s image of being the poster child of emerging markets. 1 MSCI Emerging Markets Indices. Standard (Large and Medium Cap) in USD as of November 27.2015
Transcript
November 30, 2015
TURKEY: MEDIUM TERM PROSPECTS FOR THE ECONOMY
Overview of the Recent Developments
Most recent financial market indicators reflected the
high volatility and uncertainty that Turkey has been
going through for the last year, resulting from political
uncertainties as well as other factors affecting global
markets.
Lira depreciated as low as 24 percent against the
dollar between the end of 2014 and mid-September
while the equity price index in USD terms declined by
36 percent. Two year treasury benchmark yields rose
from 7.9 percent on December 31, 2014 to 11.2
percent by mid-September and the five year
corporate CDS from 183 to 327 by end-September.
Following the peaks and troughs reached in
September, Lira’s year-to-date depreciation has
been 18.3 percent to the dollar and 12.6 percent
against the basket. An index for Turkey’s equity
markets declined 29.3 percent year-to-date
compared with 13.6 percent for emerging markets1.
As of November 20, 2015, annual average returns in
USD terms were negative for the last three-, five-
and ten-year periods and almost about twice the
returns for the average of emerging markets,
tarnishing the country’s image of being the poster
child of emerging markets.
1 MSCI Emerging Markets Indices. Standard (Large and Medium Cap) in USD as of November 27.2015
2
There has also been a significant outflow of capital
from Turkey during 2015. Short-term capital (or
portfolio investment or hot-money) exited both the
equity and treasury securities markets at a rapid
pace. During the first three quarters of the year, $43.1
billion in portfolio investments and $34.7 billion in
foreign direct investment left Turkey.2
Underlying these changes were a relatively meager
GDP growth and a dismal export performance despite
the depreciation of the real effective exchange rate.
While exports in real terms remained unchanged
during the first three quarters of the year, they
declined by 9.1 percent in nominal terms. The fact
that about half of Turkey’s exports are denominated in
euros contributed to the decline in dollar terms.
Shuttle trade which has been an important part of
exports to the former Soviet Union countries declined
by a third. Imports which declined 21.3 percent in
nominal terms benefitted from the lower commodity
prices (e.g. oil) increased 2 percent in real terms.
While these developments helped reduce the current
account deficit from $31.6 billion in 2014 to $25.6 billion through Q3 in 2015, its financing
proved to be difficult and unorthodox. During the first nine months of 2015, more than half of the
current account deficit, to the tune of $13.5 billion was financed by errors and omissions or
simply sources unaccounted for.
A number of factors may have contributed to the bloating of errors and omissions from
smuggling and illicit trade with ISIS and the like, repatriation of funds abroad by AKP leadership
for manipulating the exchange rate in the days running up to elections to the assets brought by
Syrian refugees to buy real estate in Turkey. No matter how one looks at it, such levels of errors
and omissions in financing a country’s external deficit point out to serious financing difficulties it
is facing and a very unhealthy trade structure.
2 CBRT, International Investment Position
3
The consumption driven growth that Turkey has pursued has been heavily dependent on
imports. Because Turkey’s competitiveness has been eroding as a result of lopsided taxation
system which collects most of its revenues from indirect taxes, Turkey’s exports have also
become heavily dependent on imported inputs. When external financing constraints become
binding, private consumption has become the first to suffer. Analysis show that a percentage
point increase in private consumption in real terms would increase imports by 130 basis points
while a percentage point increase in machinery and equipment private investment would result
in a 27 bps increase in imports. Conversely, a percentage point decrease in imports would
reduce private consumption by 77 bps.
The relationship between the current account balance and the GDP growth is best illustrated by
the following graph which plots the four-quarter moving averages of current account balance as
percent of GDP and the y-o-y GDP growth rate.
Turkey which has a low savings economy needs foreign savings to grow and has to run larger
current account deficits for higher growth. Conversely, it cannot grow and run a current account
surplus unless the economy and economic policies are radically restructured. Turkey enjoyed
rapid growth in the early to mid-2000s when the global financial environment was favorable by
running large current account deficits, but the growth started stuttering when international
capital flows became constrained and Turkey began to lose its luster.
These deficits were financed by short-term capital flows as discussed above and external
borrowing by the commercial banks and private sector. Private sector’s long-term external debt
rose from $29.2 billion in 2002 to $184.3 billion at end-September 2015 and the short-term
private debt from $13.6 billion to $108.8 billion respectively. If the short-term trade credits and
other short-term external obligations, totaling $56.2 billion are added, Turkey’s total private
external debt is estimated at about $346.2 billion or about 50 percent of GDP in 2015, compared
to 20.8 percent in 2002.
4
Global Prospects
Many institutions have revised down their outlook for 2016 and beyond reflecting an
“environment of declining commodity prices, reduced capital flows to emerging markets and
pressure on their currencies, and increasing financial market volatility”3. The IMF lowered its
global growth projection by 0.2 percentage point below the July 2015 forecasts to 3.1 percent.
Forecasts by the Institute of International Finance point out to sharp drop in capital flows to
emerging markets, almost halving from its level $1,074 billion in 2014 to $548 billion in 2015
while expecting an increase to $776 billion by 20164.
Key points in the IIF report are:
“Capital flows to emerging markets have weakened sharply in recent months. With non-
resident inflows looking likely to fall below 2008 levels and rising resident outflows, we
now expect that net capital flows to EMs in 2015 will be negative for the first time since
1988.
Unlike the 2008 crisis, the pullback from EMs has been driven primarily by internal
factors, basically reflecting a sustained slowdown in EM growth and amplified by rising
uncertainty about China’s economy and policies.
We project only a moderate rebound of EM capital flows in 2016 as structural factors
continue to weigh on EM growth prospects.
Monetary policy divergence in mature markets could contribute to market volatility as the
Fed starts to raise rates. The possibility of further RMB weakening is another potential
source of risk.
Countries most in jeopardy from EM turbulence include those with large current account
deficits, questionable macro policy frameworks, large corporate FX liabilities, and acute
political uncertainties. Brazil and Turkey combine these features.
3 IMF, World Economic Outlook (WEO) October 2015
4 Institute of International Finance, Capital Flows to Emerging Markets, October 2015
5
From a markets perspective, EM equity
valuations have fallen to very low levels, but near-
term downside risks are high enough to keep
investors cautious, absent a clear catalyst for re-
entry. Risks for EM corporate bond markets remain
elevated, especially given substantial corporate
foreign currency exposures as well as pressure on
earnings.”5
Other External Factors
In addition to uncertainties described above, there
are external factors specific to Turkey that are likely
to affect Turkey’s growth prospects adversely.
The first is the loss of markets for goods and
services as a result of misguided policies for Syria
that Erdoğan6 has been pursuing. The shooting
down of the Russian aircraft last week has already
started generating ripple effects on all facets of
Turkey-RF relations. Turkey’s imports from Russia
accounted for about 10 percent of total imports and
more than half of natural gas imports. Russia was
the largest trading partner in terms of imports in
2013 and 2014 and the second largest during the
first nine months of 2015.
While the Russian Federation was the fifth largest
trading partner in terms exports of goods and
accounted for 3.8 percent of total exports during the
last three years, it has been the second largest
source of tourists visiting Turkey after Germany in
the last three years. While the number of Russian
tourists had already started to decline in late 2014
because of the financial crisis Russia is facing, if the
Russian tourism to Turkey is halted, its direct impact
would be around $4 billion to $5 billion in 2016. Add
to this, contractors’ services, the cost of Erdoğan’s
ego trip could easily reach to $10 billion to $12
billion.
The third is the fate of large projects, e.g. Akkuyu
NPP and “Turkish Stream” which might result in
substantial penalties and litigation.
5 Ibid, p. 1 6 In this report, references to “Erdoğan” also refer to the government or administration as under the “one-man rule” no policy can be designed or implemented without Erdoğan’s knowledge or blessing.
6
The fourth is the likely disappearance of illicit markets such as contraband trade with the ISIS-
controlled areas in Syria and Iraq as the international scrutiny of ISIS financing intensifies. The
recent increases in unaccounted for inflows in the balance of payments may have been
generated by such activities.
The fifth the impact of the massive influx of Syrian refugees on the budget, delivery of social
services and labor markets. Even though the EU has promised an assistance to the tune of $3
billion to “keep the refugees from leaving Turkey to Europe”, it is not clear whether this is a
commitment that EU would see through under the evolving uncertain environment.
The sixth is the impact of low oil prices for oil exporting countries’ imports of goods and
contractors’ services from Turkey, ranging from Kazakhstan, Azerbaijan, Turkmenistan to Gulf
States.
Domestic Politics
Although the “do-over” elections held on November 1, 2015 fell short of the parliamentary
arithmetic that Erdoğan wanted to enable him to amend the constitution to establish his idea of
presidential rule – a one man rule without checks and balances, it gave AKP the parliamentary
majority to form a government.
The new government formed last week reflects Erdoğan’s preferences for key ministerial
positions to which most of the “palace henchmen” were appointed. While the former Deputy PM
Babacan responsible for economic policy was left out of the government, Erdoğan son-in-law7
was appointed as the Minister of Energy. It was known for some time that Erdoğan was
unhappy with Babacan8 who, on occasion, tepidly criticized Erdoganomics and defended the
independence of the central bank. Replacement of Başcı, the embattled governor of the Central
Bank, with a more loyal subject is a matter of weeks, if not days.
It is unlikely that this government will be able to manage the crises that Turkey is facing from a
self-destructive foreign policy to misguided growth policies turning the country into a huge
concrete slab in the name of urban renewal, flooded with cheap Chinese consumer goods. But it
appears to be well equipped to manage state capture which seems to be Erdoğan’s not-so-
veiled objective.
Medium-Term Prospects
Some of these would have been perhaps possible in an environment where access to global
capital flows was easy and external debt could be run up without raising eyebrows. Low interest
rates, politically driven monetary policy and excessive infrastructure spending are bound to lead
to an out of control inflation and a crash a-la-Greece without the EU there to bail out.
Global prospects do not seem to be conducive to allow countries pursuing egregious policies.
Most recent forecasts by major international financial institutions point out to a GDP growth rate
of around 3 percent for the next two years and assume a current account deficit in the 5 percent
to 6 percent of GDP range.
7 Concepts like “nepotism”, “conflict of interest” and “ethics” are alien to the ruling crowd 8 Babacan who decided not to run for the elections was convinced by Davutoğlu to run again. By vetoing his reappointment as the Deputy PM for economic affairs, Erdoğan not only punished him, but also told Davutoğlu to learn his place.
7
8
EPA’s own estimates show that maintaining a 3 percent growth rate for GDP and private
consumption would be extremely difficult with the underlying current account assumptions.
Even with a 5 percent real export growth that EPA assumed, the current account deficit
would need to rise, to 7 percent in 2017 to sustain growth at 3 percent. Even under this
scenario, private consumption growth – a main staple of AKP’s popular support – cannot be
sustained. In the absence of capital flows to allow running higher current account deficits,
both GDP and consumption growth would have to take serious haircut.
9
Even under the best of the scenarios, running a 5 percent current account deficit would mean
mobilizing $35 billion in 2016 after rolling over $43 billion medium- and long-term and $148
billion short-term private debt in addition to $23 billion public debt falling due in 2016. It is not an
easy feat to roll over $214 billion and mobilize $35 billion to $40 billion for any country.
Another important factor to watch is the impact of Lira depreciation on corporate balance
sheets, particularly those carrying external debt and producing non-tradables such as the
construction companies with Lira denominated revenues. A back of an envelope calculation
shows that the corporate debt has gone up by about 17 percent between end-2014 and end-
September 2015, bloating the liability side depending on its leverage.
Given the banks’ share in external debt, they also face stress levels higher than anticipated
before. Unlike the 2001 crisis when banks’ exposure to consumer debt was negligible,
consumers have been leveraged to the hilt as a result of AKP’s “let’s make them feel good”
policies – and the consumer loans accounted for 23 percent of GDP by end-October 2015. A
disconcerting development regarding the banking sector that public sector banks were forced to
lend for large infrastructure projects (e.g. the third airport or the third bridge) when mobilizing
external financing proved to be impossible.
A related concern is the contingent liabilities created by Treasury guarantees extended to
private sector contractors close to the “palace” which are awarded large public sector projects
outside acceptable procurement rules. They will eventually come back and bite the Treasury.
To sum up, prospects for the economy are not very encouraging. They would prove to be a
serious challenge for serious policymakers and possibly a nightmare for the dysfunctional
