Turkey Watch – On the eve of change

by: Nora Neuteboom

  • We expect 6.5% GDP growth yoy in 2017, despite political turbulence
  • Turkey is at a turning point: a higher Fed rate, higher energy prices and weak domestic economic structures will determine its direction in 2018
  • For 2018, we foresee slowing growth (4.5% yoy) and further lira depreciation
  • External financing problems to worsen in 2018
171215-Turkey-Watch.pdf (229 KB)

Political turbulence and economic problems in 2016 and 2017

In the past one and a half years, political instability went hand in hand with strong economic growth. The failed coup attempt in July 2016 marked the start of a period of uncertainty, with the constitutional reform referendum in April this year adding further tension. The lira spiralled downward, losing almost 17% against the euro in 2016. Inflation rose and rating agencies downgraded Turkey to junk status. Sudden economic contraction (-0.8% yoy in the third quarter of 2016) sparked brief fears of a severe economic crisis. The looming crisis was averted, however, thanks to the government’s extensive fiscal and monetary stimulus package combined with favourable external factors. Turkey depends strongly on foreign capital and this continued to flow into the country as interest rates in Europe and the US remained low in the past year. The Credit Guarantee Fund (CGF), set up by the government of Recep Tayyip Erdoğan, ensured that loans to small and medium-sized businesses did not stagnate. However, the lira slid further in 2017 and is currently trading at EUR/TRY 4.6 (USD/TRY 3.9). This weakening was partly attributable to the passive stance of the Turkish central bank (CBRT).[1] The CBRT’s current policy carries the stamp of the Erdoğan government, which is keen to prevent loans from becoming more expensive.

After regaining traction towards the end of the year, the Turkish economy ended 2016 with 3.3% yoy growth. A further acceleration followed in 2017, driven by the beneficial effects of the stimulus package, accelerating growth in the country’s most important export market (eurozone) and reviving tourism. We estimate growth at about 6.5% yoy. The economy is expected to cool in 2018 to 4.5% yoy as the effects of the stimulus package ebb away and the CGF funding will be virtually exhausted.

Relations with EU (and the Netherlands in particular) are at rock bottom…

Shortly after the attempted coup, President Erdoğan reproached European leaders for showing a lack of solidarity with Turkey. The mass suspensions and dismissals of civil servants, journalists and political opponents of the Erdoğan government caused outrage in many European countries. In the run-up to the referendum about the expansion of Erdoğan’s powers, the tensions between Turkey and the EU countries rose further. In March this year, the Netherlands withdrew the landing rights for the Turkish minister of Foreign Affairs, and the Minister of Family Affairs was refused entry to the Turkish Consulate in Rotterdam because she wanted to campaign for the referendum. In response, Turkey denied the Dutch ambassador re-entry to the country (this ban is still in place). Four months later, the Turkish vice prime minster was not welcome at a gathering to commemorate the failed coup. Meanwhile, this widening rift has brought the talks about Turkey’s accession to the European Union to a definite end. Judging from the budget debate in the Dutch House of Representatives, relations between the Netherlands and Turkey are unlikely to improve any time soon. Within the EU, the Netherlands advocated the suspension of the pre-accession assistance to Turkey and fully endorses the discontinuation of the accession negotiations. Nor do we expect Turkey to take the initiative for rapprochement as Erdoğan’s AK Party is exploiting the tense relations with the West to consolidate its domestic power base.

… but no official trade restrictions have been imposed

Despite repeated threats, Turkey has not yet imposed any official sanctions. We also consider this extremely unlikely as Turkey relies heavily on direct investments from the Netherlands and other European countries. If Turkey announces bilateral sanctions, the Netherlands will probably respond in a broader European context with countermeasures, which would be extremely damaging for the Turkish economy.

One bright spot is the return of tourists in 2017

In 2016, the number of foreign tourists slumped by 40% yoy in the high season. 2017 brought a strong recovery, though the total foreign tourist volume remained just below the 2015 average (see bottom left chart). The tourism revival is also visible in the recovery of income from services on the Turkish balance of payments. The return of the tourists is largely due to the improved relations between Russia and Turkey. In November 2015, the Turkish air force shot down a Russian fighter jet and Russia responded by banning its citizens from holidaying in Turkey. Just before that incident, the Russians made up the third-largest tourist flow, but their number plummeted more than 90% in 2016. When relations between the two countries improved in 2016, Russia lifted the sanctions and Russians flocked back to Turkey. European tourists, by contrast, are trickling back to Turkey in modest numbers, with the only increase coming from France (data until end of August). The Dutch are also staying away, with the European Travel Commission showing a decline of around 10% in the first 8 months of 2017. The absence of European tourists is partly compensated by a growing influx of visitors from Iran and the Gulf States.

Current account deficit rises further…

Turkey imported around USD188bn of goods and exported around USD128bn of goods in the first three quarters of 2017. This resulted in a current account deficit estimated between 4.5% and 5% of GDP in 2017. Turkey has a structural current account deficit, which has been rising since 2015. Clearly, the ‘cheap’ lira and tourism revival have not helped to reverse the growing balance of payments shortfall. The cheap lira should have dampened imports, but the volume data for this year provide no evidence of this. Despite the further currency depreciation in 2017 (around 30% in the past eleven months), Turkish import volumes rose sharply in the same period (by an estimated 7%). We expect the current account deficit to widen further in 2018 to USD 40 billion and to remain high as a percentage of GDP (around 4.5%).

… so maintaining inward investments is crucial for Turkey

The current account deficit is mainly financed with a mix of more volatile portfolio investment flows and loans from foreign banks. This makes Turkey vulnerable to investor sentiment: portfolio flows can be withdrawn at any time, for instance when investors fear a currency depreciation or see higher potential returns elsewhere. Foreign direct investments (FDI), by contrast, are more long-term and cannot be easily withdrawn in the short term.

The vulnerability of Turkey has increased in the past year, with the percentage of the current account deficit financed with short-term portfolio flows rising from around 22% in 2016 to about 70% in 2017 (Jan-Sep).[2] Only 30% of the deficit is financed with FDI. So far, Turkey has experienced no problems financing its external debts, though the financing costs have risen.

External factors on the eve of change

In 2017, the external factors (low ECB and Fed interest rates, low energy prices and accelerating growth in the eurozone) were still favourable, but this will presumably change in 2018. The main developments are as follows:

  • The Fed is ‘normalising’ its interest rate policy by restoring its interest rate to normal levels, while simultaneously reducing its balance sheet. On 13 December the Fed came through on a widely expected interest rate hike (25bp). We expect two more interest rate hikes in 2018. Turkey is traditionally sensitive to Fed rate hikes, which prompt investors to pull capital out of emerging markets.
  • Higher energy prices (our forecast: USD 75 /bbl 4Q2018) will drive up the current account deficit, with investors shifting their capital to countries that benefit from this development (energy-exporting countries such as Russia).
  • For 2018, we foresee a further acceleration in global economic growth (3.9% GDP growth against 3.7% in 2017) (See: Global Macro View – Will Goldilocks stay in 2018?). Turkey will benefit from this, but probably not as much as other emerging markets. Finally, the country has a large import component in its exports and is not a net commodity exporter. The above-trend growth in the eurozone last year was a positive surprise. We expect growth to remain at roughly the same level in 2018, at around 2.5% (in other words, no acceleration).

Domestic structures have not improved

In addition, we have to conclude that the economic structure in Turkey has not improved and, in certain respects, has actually deteriorated in recent years. Whilst other developing markets such as Russia and Brazil have managed to curb inflation, Turkey continues to contend with high inflation (hovering around 11% yoy). The November figure was higher than expected, 13% yoy, driven by food prices (which rose almost 16% yoy). The effects of the domestic stimulus policy will ebb away in 2018. The CGF, which accounted for around 1.5% GDP growth in 2017 according to estimates of the Institute of International Finance, is almost completely depleted. And the business climate has not improved either in recent years. This is reflected in the lower rankings on the Corruption Perception Index and Global Competitiveness Index.

This makes Turkey more sensitive to external shocks…

A weaker economic structure combined with tightening Western central banks and higher energy and commodity prices is a toxic cocktail for investments in Turkey. Added to this, the recent downgrades to junk status by the external rating agencies, make Turkey considerably more vulnerable to external shocks, such as an unexpected Fed rate hike, diplomatic rows and natural disasters. This sensitivity is also reflected in the volatility of the lira, which has shown a structural increase since August. That is worrying, because volatility usually emerges suddenly (in response to a political event or economic data) and then rapidly recedes. Investor nervousness once again became visible when the court case against the Turkish gold trader Zarrab of Halkbank started in September. Zarrab was accused of deliberately circumventing the sanctions against Iran. Since then, the lira has lost some 15% of its value (against the dollar) and yields on ten-year government bonds briefly jumped above 13%.

… but the central bank can partly stem the tide on 14 December

The CBRT is behind the cycle and has kept interest rates low. The market widely expected a significant interest rate hike on 14 December (at least 100bp), however, the central bank once again failed to sufficiently act. The central bank bumped up its lending rate by half a percentage to 12.75%. In a statement, the central bank acknowledged that the elevated levels of inflation led to the hike and that tight stance in monetary policy will be maintained until inflation outlook displays improvements. However, the discussion is whether this stance is ‘tight’ enough, as real interest rates are practically negative.

Not surprisingly, the lira fell against the dollar, while the yield on the 10y government bond rose 13 basis points to 11.96 on 14 December. We believe that the pressure for the central bank to hike will continue throughout 2018, as inflation pressures will not substantially ease. If the central bank continues its wait-and-see policy and merely signals its willingness to act in the event of negative inflation and lira developments, the currency will come under mounting pressure and, hence, so will the external debt obligations. In that scenario it is not inconceivable that the Turkish central bank may roll out the big gun in 2018 and suddenly hike with a significant amount. A similar situation occurred in 2014 when the Fed triggered a taper tantrum (soaring interest rates due to the announced unwinding of quantitative easing), thereby putting pressure on several emerging market currencies, including the Turkish Lira. On that occasion, the CBRT unexpectedly raised its interest rate by 550 bp, after previously maintaining a dovish stance.

Our baseline scenario assumes a gradual increase in the average interest rate in 2018, but a sudden steep hike is not off the table. In line with the increased sensitivity to external shocks, we expect the lira to remain volatile. The lira will presumably weaken further in 2018, breaking through the USD/TRY 4 barrier (our Q4 2018 forecast: USD/TRY 4.20 and USD/TRY 4.83). The economy will cool to 4.5% in 2018. Though not part of our baseline scenario, the risk of a balance of payments crisis has increased.

Turkey’s growth contraction in 2016 has mild impact on Netherlands

From 2010 to 2016, the value of Dutch exports to Turkey grew 6% annually on average, which is on the low side compared to other emerging markets. Export growth to China, for instance, averaged 10% annually in the same period. Whilst China may be an exceptional case, export growth to countries like Poland, Morocco, Czech Republic and Romania was also higher than to Turkey. This is surprising, because the Turkish economy grew faster than these economies. The main reason was the ‘bad’ 2016 year, when Dutch exports to Turkey contracted 2.3% annualised, whereas exports to other emerging markets actually grew strongly.

The explanation lies in the macro economic situation in Turkey (as described above). In 2017, the Turkish economy expanded again and Dutch exports to Turkey followed suit. In Jan-Aug 2017, total exports ran to EUR 3.9 billion, compared to EUR 3.3 billion in the same period in 2016 (up 18%). All in all, therefore, Dutch exports were largely unaffected by the weak lira, partly because Dutch exports are relatively price inelastic (machinery and means of transportation and chemical products).

[1] Various measures were taken to steer the currency market (including changes to the Reserves Option Mechanism coefficients and auctioning of non-deliverable forward contracts), but the CBRT omitted to significantly raise its key policy rate (current weighted average base rate: 12.25%, while inflation is hovering around 11%).
[2] According to the Institute of International Finance, the short-term financial investment flows have accelerated from USD 7 billion in 2016 to USD 17.6 billion in 2017 (Jan-Sep).