Two weeks ago, the people of Turkey went to the polls and re-elected Recep Tayyip Erdogan as President for another five years, this time under the new executive presidency that replaced the previous parliamentary system. The electorate also delivered a parliamentary majority for the alliance led by Erdogan’s Justice and Development Party (AKP).
The extent of President Erdogan’s commitment to responsible monetary and fiscal policies will therefore be a key element in Turkey’s economic performance. Concerns that the economy is overheating amid a broader sell-off across emerging markets have led to the lira weakening by 22 per cent against the US dollar in the first half of the year. But the newly powerful Erdogan is far from the whole story.
Inflation and interest rates
Even last year, when the emerging world in general was growing fast, Turkey’s 7 per cent real growth rate stood out. It has remained strong this year, at 7.4 per cent in the first quarter, driven very much by accommodative monetary and fiscal policies that boosted credit growth, consumption, and the real estate and construction sectors.
This is all in line with Erdogan’s push for mega projects ahead of the centennial of the republic in 2023, but it is at odds with the usual Central and Eastern European playbook of boosting value-added in export sectors, and it has left Turkey with significant macroeconomic imbalances. The current account deficit has continued to widen, partly due to higher oil prices (Turkey is a large net oil importer) and partly because foreign direct investment remains low, covering just 15 to 20 per cent of the current account deficit versus an average of around 80 per cent in the rest of Central and Eastern Europe.
These imbalances have strained the investment environment, fuelling the lira sell-off and forcing the central bank to hike rates by five percentage points in a fight to curb inflation. The official inflation target is 5 per cent, but last week’s Consumer Price Index print for June showed a rate at 15.4 per cent, the highest since the introduction of a new method for measuring inflation in 2004. Current expectations are for a peak as high as 17 per cent. Turkey’s Producer Price Index already shows inflation at 24 per cent.
In short, Turkey’s economy will have to adjust through a significant slowdown, with domestic demand growth likely halving from last year. To do so successfully, the central bank will need more space than it has been allowed recently. Before the recent hikes, its ability to respond was impaired by persistent political interference — Erdogan takes the unorthodox view that higher interest rates cause higher inflation rather than the other way around, and last week outgoing Prime Minister Binali Yildirim reiterated that “lowering interest rates and lowering inflation” would be the government’s top priorities.
Nonetheless, for all the challenges, Turkey’s starting point appears strong.
Public debt is only 25 per cent of GDP and the budget deficit was just 2.1 per cent of GDP last year. While there is a material risk of a rise in non-performing loans given the weak lira and the pending slowdown, on the whole, Turkey’s banking sector appears healthy and liquid. The economy stands out among countries with external imbalances exposed to higher global borrowing costs, but market discipline as well as the large foreign-exchange liabilities in the non-financial corporate sector serve as an effective check on ultra-pro-growth monetary and fiscal policies. Turkey also has a number of structural strengths, including strong demographics and a vibrant and competitive private sector that provides key links in the European supply chain.
— Rob Drijkoningen, co-Head of the Emerging Markets Debt team at Neuberger Berman, and also Kaan Nazli, Senior Economist – EMD