The Turkish economy is going through a crisis marked by a large external financing requirement, inadequate foreign reserves, high net external debt, high inflation, contracting growth and political as well as geopolitical risks. However the public finances are still relatively strong, the economy is large and diversified and the private sector is vibrant. With the correct mix of fiscal and monetary policies supported by adherence to reforms to address the economy’s structural vulnerabilities, these assets could be extremely helpful in overcoming the crisis.
The economy is adjusting to a sharp depreciation of the Lira in 2018, which was closely linked to the materialisation of external financing vulnerabilities, exacerbated by political and geopolitical developments. The rapid correction in the current account deficit during the past six months is a necessary step on the path towards rebalancing and stabilisation. However, in the wake of the local elections held on March 31, significant uncertainties still remain around the outlook for economic recovery and inflation, economic policy implementation, the impact on the public finances and the banking sector.
There has been a significant adjustment of the current account, notably driven by import compression and supported by exports of services helped by the floating exchange rate. On a rolling six-month basis, the current account posted a surplus of USD 2.7 billion at end-February, compared with a deficit of USD 32 billion a year earlier. Gross foreign exchange reserves rose by USD 7 billion in the first two months of the year, but declined to around USD 96 billion in March ahead of the elections, with the decline being particularly sharp in net terms to around USD 28 billion. This was possibly due to efforts under political pressure to keep the exchange rate stable ahead of the polls. Not surprisingly, a renewed fall in the lira materialised in the wake of the elections, attributable to market concerns about the reserves position. It is very likely that the current account deficit will be below 1.0 percent of GDP in 2019, underpinned by weak domestic demand and a further improvement of services exports. However, FDI inflows will probably be considerably less than the official projections at around 1.2 percent of GDP.
The external financing requirement will in any case remain large due to private sector debt repayments. The total external financial requirement including short term debt is estimated to be around USD 173 billion in 2019. This means Turkey will remain vulnerable to global investor sentiment and financial conditions, uncertainties in the domestic political and economic environment and the seemingly deteriorating relations with the US due to conflicting interests.
There is no doubt that the fiscal performance has been hit by the weak economy. The central government deficit was TRY 36 billion in 1Q19 up from TRY 20 billion in 1Q18, despite a TRY 43 billion jump in non-tax revenues due to the early payment of the Central Bank dividend. Pre-election stimulus measures affected both tax revenues (up only 5.8 percent) and primary expenditures (up 33.5 percent). This really was politically driven reckless spending. There is an absolute necessity now for the fiscal policy to be tightened to prevent a further aggravation in public finances. It seems likely that the central government deficit will be considerably higher than the official target of 1.8 percent of GDP and exceed 2.5 percent of GDP in 2019 taking into account that the economy will contract by at least 2 percent of GDP as opposed to the rather optimistic official growth assumption of 2.3 percent of GDP.
The level of gross general government debt is moderate. GGGD/GDP ratio stood at 30.4 percent at the end of 2018. It is expected that it will rise to around 31 percent at end-2019. However, it should be borne in mind that 47 percent of central government debt was denominated in foreign exchange at end- February. It naturally follows that exchange rate volatility poses a serious risk to debt dynamics.
As for the banking sector, overall capital adequacy remains above the regulatory requirement, at slightly over 16 percent. Stress tests show that pre-impairment profit and capital buffers provide a significant cushion against a potential marked deterioration in asset quality, a weakening in profitability and a potential Turkish Lira depreciation. However, refinancing risks for Turkish banks remain high. It is estimated that banks’t total external foreign exchange debt due within 12 months, net of more stable sources of funding, is USD 40-45 billion compared with available foreign currency liquidity of USD 75-80 billion.
Nearly all macro as well as micro-economic indicators indicate that Turkey is undergoing a deep economic recession. Economic growth will certainly be in the negative territory in 2019. Most analysts predict that the economy will contract between 1-2 percent. However, the rapid rise in unemployment doesn’t bode well for economic growth. In my judgement, a contraction over 2.5 percent is possible.
Inflation might have dipped from its peak but it is still high at slightly below 20 percent. Weak domestic demand and base effects should put inflation on a downward path, but the PPI remains quite high at 29.6 percent. The monetary policy credibility is questionable and the likelihood of mis-steps constitute a downside risk to the economic adjustment and stabilisation path.
Political and geopolitical risks are adversely affecting the investor sentiment. The opposition won several key cities in local elections on March 31. The ruling AKP contested a narrow defeat in Istanbul which was arguably accepted by the Higher Election Board leading to the abrogation of the election. The Higher Election Board ruled on May 6 that the election in Istanbul would be repeated on June 23. This legally controversial decision could potentially lead to further market volatility. In fact, repercussions of the decision in question could ultimately build up economic and political dynamics that would constitute a further risk to the economic adjustment and stabilisation path.
Amidst such a slippery backdrop marked by uncertainties in a multitude of different areas it would be wise to reevaluate the state of the economy after the rerun of the Istanbul election on June 23.