Turkey Watch – Recovery to continue, but less vigorously

by: Peter de Bruin

In this publication: The recovery will continue but is set to moderate somewhat in 2016. This partly reflects payback from a strong 2015,… though political developments and security concerns post a risk. Central bank slowly but steadily lowering interest rates.

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Economy slowed modestly in Q1…

Following a very strong final quarter of last year in which the economy grew by 5.7% yoy, the Turkish economy slowed modestly in the first quarter. Growth fell to 4.8% in the second quarter. This still marks a very decent growth rate. The moderation in growth to a large extent reflects payback for the very strong growth rates seen earlier last year. In 2015, quarterly growth rates exceeded 1% in all four quarters. As a result, year-on-year growth accelerated from 2.5% in Q1 to 5.7% in Q4. Such a strong performance is most likely not sustainable for Turkey in the longer run.

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…and in April

Indeed, timelier data has continued to suggest that the economy is still losing a bit of pace. For instance, industrial production fell by 1.1% in month-on-month terms in April. As a result yearly gains in industrial production slowed from 3% to 0.7% in that month. Industrial production figures are notoriously volatile, so we need to be careful in drawing too strong conclusions from one monthly report. However, industrial production growth tends to move in tandem with GDP growth. The trend in production is thus an important figure to watch. We have also seen that Turkey’s tourist sector is going through a tough time. Russian tourists were already avoiding the country, as Russian sanctions are prohibiting them from visiting Turkey. But tourists from other countries are also shying away, as threats from terrorism have risen. As a result, in April of this year, almost 30% fewer tourists visited Turkey.

Political developments and security concerns post a risk

Although Turkey’s economy is, on balance, still performing well, we think that – apart from payback – part of the slowdown can be attributed to political developments and Turkey’s security concerns. Following the AKP’s win in the second round of elections in November, President Erdogan has continued with its push to change the role of the Presidency. Erdogan wants to move to a system of an executive Presidency in which the President holds more power than currently is the case. To attain his goal, Erdogan has forced Prime Minister Ahmet Davutoglu to resign. Granted, the new Prime Minister, Binali Yildirim, has soothed investors’ worries by retaining Mehmet Simsek as Deputy Prime Minister. Mehmet Simsek is perceived by financial markets as a proponent of economic reform. However, the new Prime Minister has expressed his support to overhaul the constitution. It is generally feared that this would put too much power in the hands of Erdogan and, as such, would erode the checks and balances in Turkey. In turn, such a move risks giving rise to civil unrest. In addition, security concerns have possibly also weighed on the economy. The AKP’s election outcome in November benefited from the resurgence of the conflict between Turkish security forces and Kurdish insurgents that drove nationalistic voters to the AKP. Meanwhile, there is also a threat of retaliatory attacks from the Islamic State.

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Current account deficit has moderated…

Political developments and security concerns risk that investors, at some point in time, could become cautious in investing in Turkey, in particular if the Fed restarts its tightening cycle. This is important as Turkey depends on international financing flows to finance its current account deficit. Admittedly, the country’s current account deficit has moderated, as the trade deficit has declined. This reflects that the Turkish lira has weakened over the past years supporting net trade, while a lower oil price has driven down import costs. But the 12m cumulative current account deficit still amounted to almost $29bn, or almost 4% of GDP in April. What is more, we expect the current account deficit to start widening again. The positive impact from the weakening of the lira should fade, while we see Brent oil prices rising to $55 per barrel at the end of this year. The latter implies that Turkey will face greater import costs. In addition, we think that the tourist sector will continue to remain in choppy waters this year, which should reduce the services surplus.

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…but has become more difficult to finance

In addition, the current account deficit has become more difficult to finance. While foreign direct investment has continued to flow into the country, portfolio inflows have receded recently. This helps to explain why Turkish FX reserves faced downward pressure between August 2014 and December 2015. That said, at $94.6bn in April, FX reserves are able to cover almost 5 months of imports, though the short-term external debt coverage ratio is less than one. Meanwhile, total external debt has risen modestly over the past few years and at 55% of GDP in 2015 remains manageable in GDP terms. However, the debt-to-export ratio is fairly high, with debt being twice as large as exports. What is more, Turkey has high private sector debt levels, mostly concentrated in its corporate sector. In addition, a large part of this debt is denominated in foreign currency. To some extent this is the result from corporates borrowing from abroad, but Turkey’s banks also grant foreign currency loans to Turkish firms. All this makes, Turkey’s corporate sector vulnerable to a weakening of the lira. In contrast, the government’s fiscal and debt metrics have remained healthy.

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Central bank policy becoming more accommodative…

While the Turkish lira seems to have stabilised after a period of sustained weakness, Turkey’s external financing risks could also increase because the central bank (CBRT) has started to cut interest rates. The central bank has had some room to loosen its policy stance. This is because inflation fell from 9.6% in January of this year to 6.6% in May on the back of plunging food prices. The fact that the Fed has, so far, not raised interest rates has also been helpful. In addition, Turkey’s central bank has only lowered one of its three policy rates. It has reduced the overnight lending rate by a total of 125bps since March. This rate marks the upper bound of the central bank’s interest rate corridor. In contrast, it has kept its other policy rates constant and liquidity conditions tight. As a result, the interbank rate has remained close to the upper bound of the interest rate corridor.

…but risks of overshooting

While we think that the CBRT will reduce its overnight rate one more time by 50bp, there is probably not much room to loosen policy further. For a start, Fed rate hikes are nearing. Our base case is that the Fed will only start to tighten again in 2017, but there is a risk of an earlier move. In addition, food price inflation has bottomed out, suggesting that inflation is likely to soon stop falling. Unfortunately, there is a risk that the CBRT overshoots its policy, in particular as it remains under relentless pressure from President Erdogan to ease policy further. Too loose a policy stance from the CBRT could risk another period of sharp lira weakness and may force the central bank to reverse course.

Growth to moderate, need to attract international investment remains a risk

Bringing everything together, we think that the recovery will continue, albeit with somewhat less pace. Average growth should slow from 4% in 2015 to around 3% this year. This mainly reflects the problems in Turkey’s tourism sector and other problems related to the country’s security concerns. On balance, we think that the negative effects stemming from these problems will outweigh the positive contribution from Turkey’s more expansionary monetary policy. As for the main risks, these are mostly related to Turkey’s current account deficit, as mentioned before. Both internal political and external geopolitical developments could prompt international investors to start hesitating to invest in Turkey. Faster-than-expected Fed rate hikes, and the possible adverse effects these can have on developing financial markets, is obviously also a risk.

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