Turkey’s new medium-term economic program, branded the New Economy Program (NEP), acknowledges that the country faces a lengthy period of adjustment following last summer’s sharp lira depreciation. How far the NEP contributes to macroeconomic balancing and helps restore economic policy credibility will depend on its implementation, and whether it is part of a broad-based and durable policy response by the Turkish authorities.
The NEP covers the period 2019-2021 and is allegedly based on the themes of economic rebalancing, fiscal discipline and structural transformation. It represents the first major policy document since June’s elections, which completed the transition to an executive presidency, and the plunge in the lira in summer.
The marked narrowing in Turkey’s monthly current account deficit to USD 1.8 billion in July from an average of USD 5.2 billion over 1H18 (first half of 2018) indicates that rebalancing has begun. In the month of September, the foreign trade deficit contracted 77.1 percent compared with the deficit of the previous September and declined to roughly USD 1.87. This also signifies perhaps the beginning of a significant contraction of economic activity. But rebuilding economic policy credibility is critical as Turkey faces a challenging adjustment path that will most probably see the economy contract in 2H18 (second half of 2018), inflation climb further and roll-over rates on external liabilities fall below 100 per cent.
The macroeconomic forecasts given in the NEP are somewhat more realistic than earlier political statements. They indicate that the authorities will tolerate weaker GDP growth (which averaged 6.1 percent in 2013-17) as part of Turkey’s forced external adjustment. Growth is expected to slow to 3.8 percent in 2018 and 2.3 percent next year, before rising to 3.5 percent in 2020 and reaching 5.0 percent in 2021. The NEP sees end-year inflation at 20.8 percent in 2018 before it falls to 9.8 percent in 2020.
Personally, I find the real GDP growth and inflation forecasts slightly on the optimistic side. It is more likely that the GDP growth will be around 3.5 percent in 2018 and less than 1 percent in 2019 whereas the year-end inflation will be 25-30 percent in 2018 and 10-15 percent in 2020. The current account deficit is likely to narrow to around 4 percent of GDP this year and to under 2 percent in 2019 as currency weakness and the significant economic slowdown will curb imports and support exports.
From the vantage point of macroeconomic rebalancing, the good thing is that the NEP does not envisage fiscal stimulus to bolster growth. Fiscal projections suggest considerable policy tightening over the remainder of 2018, and throughout 2019 as reflected in the 2019 budget. The NEP projects the central government budget deficit remaining stable at around 1.8 percent of GDP and a gradual rise in the primary surplus through 2021. The suspension of investment projects for which tendering has not started or been finalized will support public finances in the near term, with some cost to GDP growth. It is important to remember that public finances represent a key rating sovereign strength, but there has indeed been a gradual recent deterioration both on and off balance sheet.
Structural reforms aim to address some causes of Turkey’s large current account deficit. These include increasing local content and moving up the value chain, and labor market reforms such as changes to severance payments.
While the NEP acknowledges the challenges facing the Turkish economy, and attempts to address their underlying causes, it lacks details notably on the financial sector. It is to be noted at this point that restoring growth to a sustainable and balanced path is a long-term process, and implementation of similar political announcements in previous medium-term programs has fallen short of satisfactory.
The shift to an executive presidency may be supportive of implementation. But political risks to an effective policy response are likely to remain, particularly in view of the approaching local elections. The minister in charge of the Treasury recently said that the independence of Turkey’s Central Bank was crucially important. The markets would naturally expect to see adherence to this statement. There is absolutely no doubt that a long period of high interest rates is necessary to sustain lower inflation and the rate hikes of September were against the public statements of the President.
In the financial sector, the refinancing of Turkish Banks’ external debt has materially heightened due to market volatility, rising funding costs, currency depreciation and shifts in investor confidence. Whether or not the banks will be able to refinance their external debt on reasonable terms remains to be seen. Turkey’s total reported gross external debt was around USD 453 billion at end-1H18. Banks remain Turkey’s main borrowers, accounting for over 41 percent of the country’s foreign debt. Even though the current account deficit will shrink significantly to less than 2 percent of GDP in 2019 as slowing economic growth and the weak Turkish currency suppresses imports and supports exports, the country’s financing requirement will still remain large as a proportion of liquid foreign assets due to maturing external debt.
Finally, understanding the institutional background to Turkey’s problems is important for at least three reasons. First, any policy response that fails to tackle the root causes of the current crisis is unlikely to restore high-quality economic growth. Second, past experience shows that a growth path based on improving economic and political institutions is possible. Third, since a major part of the short-term problem is foreign capital flight, a strategy for tackling the structural problems of the Turkish economy could – by reassuring foreign investors – generate a short-term divident, too. Rather than hope that capital controls or other forms of financial engineering will miraculously restore an economy ailing from institutional ills, it is better to be clear-headed about what the Turkish economy really needs: more inclusive economic institutions guaranteed by democratic institutions.
In their brilliantly stimulating book, “Why Nations Fail”, Daron Acemoglu and James A. Robinson underline the link between inclusive economic and political institutions and prosperity. Inclusive economic institutions that enforce property rights, create a level playing field, and encourage investments in new technologies and skills are more conducive to economic growth than extractive economic constitutions that are structured to extract resources from the many by the few and that fail to protect property rights or provide incentives for economic activity. Inclusive economic institutions are in turn supported by inclusive political institutions, which distribute political power widely in a pluralistic manner and maintain some amount of political centralization to establish law and order. On the other hand, extractive economic institutions are synergistically linked to extractive political institutions, which concentrate power in the hands of a few, who will then have incentives to maintain and develop extractive economic institutions for their benefit and use the resources they obtain to cement their hold on political power.
Because Turkey changed its constitution in a more authoritarian direction, it would be realistic to assert that its political institutions are now in a transition phase gradually turning from inclusive to extractive. Let’s not forget. Political power under extractive institutions is highly coveted, making many groups or individuals fight to obtain it. Put differently, societies under extractive institutions could turn out to be conducive to development of powerful forces that would threaten political stability.
Let’s hope that the New Economic Program turns out to be a success in terms of macroeconomic rebalancing and restoring economic policy credibility. It is not going to be easy. But, remember, the fundamental prerequisite lies in the domain of inclusive economic institutions guaranteed by democratic institutions. The unwavering pursuit of a sound and balanced foreign policy is also of crucial importance.