Turkey Watch – Resilient, but risks remain

by: Arjen van Dijkhuizen

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Turkey has been classified as one of the ‘fragile five’, being hit in 2013 and in early 2014 by market turmoil stemming from Fed tapering in combination with the country’s high external deficits and political turmoil. Market conditions have eased significantly in the course of 2014, due to a general improvement of market sentiment and country-specific factors. This has spurred the central bank to reverse part of the sharp rate hikes implemented in late January. Meanwhile, the current account deficit has started to fall due to several tightening measures, but remains high by EM standards (at around 6% of GDP). Growth proved remarkably resilient in Q1 (4.3% yoy). For now, we stick to our 2014 growth forecast of 3%, as we also some signs of a slowdown. Moreover, Turkey’s ongoing external and political vulnerabilities point to downward risks as well.


Market sentiment has eased since early 2014

During parts of 2013 and in early 2014, Turkey was clearly hit by a deterioration of market sentiment and capital outflows. This stemmed from general EM concerns related to Fed tapering in combination with Turkey’s high external deficits and political turmoil (social protests, corruption scandals). In early 2014, the lira came under severe pressure and the CDS premium reached the highest level since the euro crisis related peaks of early 2012. However, in the past few months, market sentiment versus Turkey has eased significantly. Several factors have contributed to the rebound of the lira and the decline in Turkey’s risk premium. Firstly, general market sentiment vis-à-vis emerging markets has improved significantly in recent months. Secondly, the central bank (CBRT) sharply hiked policy rates in late January. Thirdly, despite corruption scandals, PM Erdogan’s ruling AKP did well at the March local elections, and this resulted in a fall in the political risk premium.


Growth has remained resilient in Q1

Despite the sharp monetary tightening in January and the introduction of several macroprudential measures to stem bank credit growth, in particular consumer lending and credit card lending, economic growth proved remarkably robust in Q1. Annual growth in Q1 came in at 4.3% yoy, more or less at similar levels as the previous three quarters. Quarterly growth even jumped to 1.7% qoq in Q1 (2013-IV: 0.9% qoq). The composition of growth showed that some rebalancing started to take place in Q1, with the growth contribution of domestic demand falling and that of net exports rising to around 50%. The latter stemmed from stagnating imports stemming from the tightening measures which were aimed at reducing the current account deficit, in combination with exports picking up.


Despite the resilience shown in Q1, we still expect some slowdown of the Turkish economy in the remainder of the year, stemming from the tightening measures taken earlier this year. Illustrative for this has been the development of the forward-looking Manufacturing PMI, which has come down since late 2013 and has fallen below the neutral 50 mark (48.8) in June for the first time in a year. Industrial production also disappointed recently, falling back to 3.3% yoy in May.

CBRT rides the waves of improving market sentiment

Turkish inflation has fallen sharply compared to the 1990s, but remains high by EM standards. Past lira weakness has contributed to inflation rising rapidly in the past half year, reaching 9.7% in May. In June, inflation fell again (to 9.2% yoy), but this was less than expected partly driven by higher food prices. We expect CPI to fall somewhat in the course of this year towards 8% at the end of the year, remaining clearly above the central bank target of 5% +/- 2 %-points.


With the lira under severe pressure, the CBRT was forced to hike its interest rate corridor by a stunning 450-550 bps in January, hiking the benchmark repurchase rate from 4.5% to 10%. These moves contributed to an effective tightening of around 250 bps given that the CBRT had previously already pushed interbank rates upwards within its interest rate corridor. Despite inflation remaining very high, the central bank has used the improvement of market sentiment to unwind part of the sharp monetary tightening of early 2014. In its last three meetings, the CBRT lowered the benchmark rate by a cumulative 175 bps, to 8.25%. However, it has kept the ceiling of its interest rate corridor unchanged at 12%, while lowering the floor in July, by 50 bps to 7.5%. Although we view the CBRT moves as rather premature, we think the central bank is tempted to move the benchmark rate even lower, should inflation continue its recent fall and market sentiment remain benign. However, the CBRT could well be forced to reverse course should market sentiment turn negative again.


Current account deficit remains Achilles’ Heel

The combination of tightening measures aimed at cooling domestic demand and imports, rising exports (particularly to the EU) and a normalisation of gold trade patterns have already started to bring down the current account deficit. The 12-months rolling deficit has fallen from USD 65 bn in December 2013 to around USD 52.5 bn in May 2014. Moreover, the composition of external financing has improved somewhat, with the share of FDI rising and the share of portfolio capital falling. However, at an estimated 6% of GDP this year, the current account deficit remains high by EM standards, leaving Turkey vulnerable to abrupt changes in market sentiment. This is another reason why we think that more cautiousness with regard to easing (monetary) policies is warranted.

A heavy election schedule

Politically, Turkey is going through a turbulent episode. The 2013 ‘Gezi park’ protests and several corruption scandals have highlighted the sharp polarisation between religious conservatives – the ruling AKP’s support base – and a mixed group of opponents, of which the so-called Gülenist movement (the AKP’s former ally) is certainly a key one. All this takes place against a heavy election agenda. The AKP did well during the March local elections (gaining 43%). Still, there are growing concerns that policies/institutions are becoming more politicised, certainly after the expected election of PM Erdogan as president in August (he also looks to increase presidential powers). Markets will closely watch who will be the next PM and in what way the government will be reshuffled. General elections in June 2015 will shed further light on the AKP’s internal power balance, though it is likely that the AKP will win again also given the weak and fragmented opposition. Other political risks stem from the Kurdish issue (although the situation has improved under AKP governments) and from neighbouring Syria and Iraq.

Risks to the outlook

In our view, the main risk to the outlook relates to a faster-than-expected monetary tightening in the US or other factors that would trigger a sharp turnaround in market sentiment, which would affect Turkey given its still high external deficits. Such a correction could also trigger an unorderly deleveraging impacting the banking sector and spilling over to the real economy. Turkey has experienced a credit boom in recent years, despite the recent slowdown. Hence, overall leverage in the system has risen sharply in recent years, although the credit/GDP ratio still remains low compared to for instance China and other emerging Asian countries. Other downside risks stem would for instance stem from a sharp deterioration of the security situation in Iraq (with ISIS gaining ground) and other parts of the Middle East. Exports to Iraq (Turkey’s second export destination) dropped by around 20% in June. Moreover, Iraq is an important transit route for Turkish exports to the Gulf. Obviously, a flaring-up of domestic political unrest or a politicisation of macro economic management harming Turkey’s long-term growth potential and external robustness would also form important downside risks.


To conclude

So far, we have kept our 2014 growth forecast at 3% (with market consensus moving towards our forecast in recent months). We see both upward potential to our forecast (given resilient growth in Q1), but also downside risks. For 2015, we expect annual growth to reach 4%. Turkey will remain a country with a high growth potential, but also subject to volatility given its external and political vulnerabilities.