Turkey: Trudging on in troubled times Global Economic Outlook, Q1 2017

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​Turkey has often used the advantage of its strategic location to build its economic stature. However, things did not go well for the country last year: strife at its borders, a failed coup, and terrorist attacks. But is the future really that bad for the Turkish economy?

Introduction

You may be forgiven for envying the Turkish economy. Nestled strategically between the East and the West, between commodity consumers and producers, and armed with rich heritage and natural beauty, Turkey has often drawn upon these benefits to advance steadily in economic stature. However, things did not go well for the country last year. As if strife across its borders and an influx of about 3 million refugees were not enough, a failed coup with its consequent uncertainty, a spat with Russia, and a host of terrorist attacks have weighed further on confidence among businesses, consumers, and tourists.1 Add to this slow growth in Turkey’s key export market, Europe, and a deteriorating current account funded by short-term capital inflows, and one may just believe that the economy is headed for a perfect storm. But are things really so bad for the Turkish economy? While there are dark clouds still hovering above, some of the political uncertainty will likely ease in the coming quarters. Also, with government finances in good shape, the economy will gain in the short to medium term from any fiscal stimulus. However, for long-term gains, policymakers have their task cut out in reforming the economy and injecting greater credibility in institutions, especially the central bank.

The economy contracted sharply in Q3 2016

Weighed down by a failed coup in July 2016 and its aftermath, the economy contracted 2.7 percent quarter over quarter in Q3 2016, the sharpest decline since Q1 2009 when the global economy went into a tailspin. Household consumption—a major source of growth for the Turkish economy in recent times—led the decline, contracting 2.6 percent. Ironically, this was the second quarterly contraction in 2016 (figure 1). While the failed coup dented consumer sentiment, a string of job suspensions in the public sector and other services by the authorities investigating complicity in the attempted coup likely impacted household spending in the quarter. Businesses were also affected by the sudden jolt in July, with gross fixed capital formation declining 1.7 percent in Q3 2016, the sharpest decline in about two years. And as Europe continued to lumber along and sanctions by Russia dented food exports, total exports fell 6.3 percent, the most in more than six years. Although the government did its part to counter the slowdown by pushing up spending, it was not enough to prevent a contraction.

Fall in household spending, investments, and exports dragged down GDP in Q3 2016

Although the government did its part to counter the slowdown by pushing up spending, it was not enough to prevent a contraction.

For consumers, the short-term scenario appears moribund

The fortunes of consumers haven’t improved since Q3 2016. Consumer pessimism, in fact, has increased, with the consumer sentiment index measured by the Central Bank of Turkey (CBT) continuing to slip further below 100, the level that separates optimism from pessimism; the number for December was the lowest in more than a year (figure 2).2 It’s no wonder then that retail sales volumes barely increased in November after declining for the previous two months. Households are also dealing with high inflation, which went up in December and has remained above the CBT’s target of 5.0 percent for quite some time now.3 High inflation, in turn, has dented real earnings, despite a sharp rise in minimum wages in early 2016.

Unfortunately, rising inflation and consumer pessimism have come at a time of growing joblessness: Between January and September last year, the unemployment rate went up to 11.3 percent from 10.1 percent. While slowing investment has dented employment, a drop in tourist numbers, owing to Russian sanctions, the failed coup, and rising terror attacks, has added to the misery, especially in the travel and hospitality industry. With total foreign tourist arrivals for 2016 barring December falling 30.9 percent year over year, it was no surprise that employment in accommodation and food services fell in Q2 (-12.7 percent) and Q3 (-11.5 percent) of last year.

Consumer confidence has slipped, as have retail sales volumes

Businesses have too much to deal with

The scenario for businesses is not pleasant either. Business confidence, for example, is subdued, with sentiment particularly down in retail and construction sectors, according to the components data of the Turkish Statistical Institute’s economic confidence index.4 This is also borne out in data for industrial production, which has been volatile for most of 2016. After contracting in Q2 and Q3 of last year, industrial output revived in October, only to falter again in November. Trends in manufacturing follow a similar trend as wider industrial output. In fact, real gross value added in manufacturing contracted for the first three quarters of 2016, with manufacturing output data until November hinting at a weak Q4 as well (figure 3).

Within key industrial groupings, the only positive is the rise in output of capital goods and durable consumer goods in the first two months of Q4 2016, although, even here, there is an evident decline in pace in November. While businesses have had to deal with slowing domestic household consumption and weak exports, they are also slowly contending with rising prices of inputs, given the global recovery in oil and metal prices last year. From a low of 1.6 percent in September, producer price inflation shot up to 9.9 percent in December of last year, thereby raising the cost of production for businesses in the country.

Manufacturing output was weak in 2016

CBT stuck between a rock and a hard place

The rise in producer and consumer prices in 2016 will be a worry for the CBT, which has often been under pressure from the government to ease monetary policy irrespective of economic conditions.5 For the CBT, apart from government pressure, there are opposing forces at work. While slowing economic growth ideally warrants a dose of monetary easing, the CBT’s hands appear tied by multiple factors. First, both headline and core inflation have been moving up. While headline inflation shot up to 8.6 percent in December from 7.0 percent in November—much above the CBT’s 5.0 percent target and its year-end forecast of 7.5—inflation for all items except energy and unprocessed food went up to 9.1 percent from 8.1 percent during this period.6 The surge in energy prices, in particular, is not surprising given the strong increase in global crude prices from the lows of January 2016—the price of Brent, for example, has gone up more than 100 percent since then.

Second, inflation is also facing pressure from a weak Turkish lira. Since December 31, 2015, the lira has lost about 25.0 percent against the US dollar (figure 4), with the dip accelerating since November 2016 as expectations of a faster interest rate hike by the US Federal Reserve in 2017 become stronger and short-term capital makes its way out of emerging markets. The lira’s decline is also a result of a deterioration in Turkey’s external balances: The current account deficit has been widening, reaching 6.2 percent of GDP in Q2 2016, with estimates by Oxford Economics putting the annual figure at 4.8 percent in 2016, up from 4.5 percent the year before.7

After an initial gain following the rate hike, the lira has continued its free fall, including a decline of more than 8 percent in the first two weeks of 2017.

Indeed, the CBT appears to be attempting to dent lira vulnerability and rising inflation by raising interest rates for the first time in three years in November 2016. But given the pressure the government has put on it, it is unlikely that the central bank is going to raise rates by more than 50 basis points this year; in its December 2016 meet, the CBT kept rates on hold. Not surprisingly, the slow progress of expected rate hikes due to pressure from the government, and hence weakening CBT credibility in financial markets, is putting further pressure on the lira. After an initial gain following the rate hike, the lira has continued its free fall, including a decline of more than 8 percent in the first two weeks of 2017.

The lira has weakened about 25 percent against the US dollar since the end of 2015

The way forward is reforms, not just fiscal stimulus

It is likely that, given subdued consumer and business spending, the government will take over the task of stimulating the economy. Already, the economic plan for 2017–19 includes a swathe of infrastructure-related investments, and the government has announced credit lines to small and medium enterprises.8 Encouragingly, the government has a healthy balance sheet to back its stimulus objectives. Central government debt as a share of GDP is low (28.8 percent in Q3 2016), while the average government budget deficit for the first three quarters of 2016 was below 1.0 percent of GDP.9

While the push to stimulate the economy is credible, what is lacking is a long-term reform plan to strengthen the country’s institutions and increase productivity. For example, the CBT’s independence has been much eroded in recent years by the government’s pressure to cut interest rates.10 That does not augur well for healthy macroeconomic policy. Productivity—both labor and total factor—on the other hand, is not likely to rise without investments and innovation. Output per person or labor productivity has actually fallen this year, while potential GDP growth, according to Oxford Economics, is likely to decline between 2015 and 2024 compared with the previous 10-year period.11 Without tackling productivity, growth will continue to be lower than what an economy with a strategic location and demographic gains would otherwise have achieved.