Turkey: current economic model stores up imbalances, increases cost of disorderly adjustment
By Levon Kameryan, Associate Director, Sovereign Ratings
We have revised down our GDP growth forecast for Turkey (B-/Negative) to 5.3% from 5.8% in 2022 and to 3% from 3.5% in 2023 as economic imbalances pile up. There is a risk of an even sharper slowdown unless the government returns to more sustainable economic policies.
The next government after elections due in 2023 will inherit an even shakier set of economic fundamentals than the ones today’s policy makers are grappling with, complicating any new effort to stabilise the Turkish economy.
Aggregate supply in Turkey has failed to catch up with aggregate demand for a long time despite ultra-loose monetary policy in stark contrast with the tightening by other G20 central banks. Companies have run down inventories since Q4 2020 due to strong consumption and exports – two main drivers of economic growth in Turkey. The negative contribution of inventories to growth reached around -10pps in Q2 2022 (Figure 1). Industrial production grew by only 0.9% in August from the same month a year ago, down from 3.2% in July and 9.2% in Q2.
Figure 1. Stock shock: inventory depletion holds back Turkey’s economy
Contributions to real GDP growth (percentage points, year-on-year)
Source: Turkstat, Scope Ratings
The data are yet more evidence that the country’s growth model is not sustainable with such high inflation and downward pressure on the exchange rate. Either currency depreciation worsens to a point that the Turkish central bank is forced to raise interest rates to relieve pressure on the lira and restrain inflation. Or the government resumes with restricting the economy's access to foreign currency while forcing the de-dollarisation of domestic deposits.
Monetary policy reset is improbable before election
The first option entails a reset in monetary policy, which is highly unlikely, at least before the next elections scheduled to take place by June 2023. President Recep Tayyip Erdoğan is behind potential presidential candidates of the main opposition Republican People’s Party in opinion polls. This provides an incentive for Erdoğan to double down on current economic policy given the damage to his credibility that a U-turn might inflict, even with annual inflation running at 85.5% in October.
The government will continue to prioritise near-term growth with loose economic policies, including a likely pre-election spending spree, while obtaining hard currency from domestic banks, exporters as well as international allies. This includes potential dollar-denominated Islamic bond issuance, currency swap deals with allied central banks and closer cooperation with Russia – all of which involve varying degrees of geopolitical, economic and financial trade-offs.
The longer the current expansion continues, the greater the cost of the future correction in aggregate demand – through substantial economic slowdown and severe balance-of-payments adjustment.
Current account deficit widens sharply
We estimate Turkey will run a current-account deficit of around USD 40bn, equivalent to 4.5% of GDP, over the next 12 months, up from a deficit of USD 13.9bn (1.7% of GDP) in 2021, due to a higher energy bill, continued credit stimulus and an expected decline in export revenues because of the economic slowdown in Europe. This is putting significant pressure on the lira and already depleted central-bank reserves. Net central-bank reserves, corrected for short-term FX swap liabilities with domestic banks, are near record low of negative USD 59.7bn in September 2022 compared with positive USD 18.5bn at end-2019.
Without rate hikes, the next government’s response could include additional capital controls to help finance these wide external deficits.
Turkey raised USD 1.5bn on Tuesday in a dollar denominated international bond due 2028, showing that investor sentiment towards emerging markets has improved slightly, though the yield of 10% shows how the outlook for Turkey remains challenging.
Turkish banks have been pressed by the central bank to buy more government debt to ease pre-election spending costs, so yields on 10-year lira bonds had dropped artificially to below 12% at the beginning of November from over 25% in March – the lowest since January 2020. Foreign investors have been exiting Turkish domestic markets for years over concerns about the unorthodox policies, with foreign holdings of domestic government debt falling to USD 1.5bn in Q2 2022, down from a peak of USD 64.9bn in Q1 2013. A rise in interest rates after scheduled elections would therefore damage domestic bank balance sheets.
For now, current domestic political decisions driving policy makers’ approaches to inflation continue to increase the risk of another currency crisis and more financial-market instability, exacerbated by uncertainty surrounding post-election economic policy and its implications for capital flows.