Turkey: Uncertainty giving way to growth Global Economic Outlook, Q3 2017

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Buoyed by two consecutive quarters of growth and a more stable political environment, things seem to be looking up for Turkey. Concerns, however, remain about a weak currency, higher inflation, and feeble investment. 

Introduction

In Turkey, the momentum of economic activity appears to be blowing away the clouds of uncertainty. After a shaky Q2 and Q3 2016, the past two quarters have reinforced confidence in the economy. Growth has picked up with households ramping up spending. Given a referendum in its favor and fiscal stimulus bearing fruit, the wind appears to be in favor of the government. Tourism appears to have bottomed out, with the number of foreign visitors going up year over year in April and May, breaking a trend of more than a year of decline.1 And exports have revived due to rising growth in key markets. There are concerns, however, about weak investment and its impact on long-term growth and productivity. Also, while reviving growth and central bank action have boosted the Turkish lira in recent months, much will depend on how the current account pans out and how much impact the present monetary stance has on denting inflation.

The economy gained momentum in Q1

Real GDP grew by 5.0 percent year over year in Q1 2017, gaining momentum after a 3.5 percent rise in Q4 2016. Households continue to show resilience, with spending increasing by 5.1 percent in Q1, although the fact that the figure is lower than the previous quarter’s rise (5.7 percent) shows that price pressures and high unemployment are weighing on consumer purchases—household spending remained flat on a quarter-over-quarter basis. Within household consumption, it was nondurable goods and services that mostly pushed up growth in Q1.2 Apart from household spending, there are two other expenditure categories that stand out for strong growth in Q1: government consumption and exports (figure 1).

High growth in government consumption in Q1 (9.4 percent) is not surprising given the fiscal stimulus to shore up the economy. Part of the stimulus in the form of tax discounts, and cheaper credit will continue to benefit households in the near term. Exports, benefitting from reviving demand in key markets such as the European Union, grew 10.6 percent in Q1, up from a 2.4 percent rise in the previous quarter. Investment, however, continues to remain subdued, with gross fixed capital formation growing just 2.2 percent in Q1. And within that, much of the growth came from construction, with investment in machinery and equipment declining for a third straight quarter (-10.1 percent).

Exports and government expenditure were the stand-outs in Q1 2017

Amid weakness, some green shoots for investment

Weak investment, especially in machinery and equipment (figure 2), is a worry for long-term productivity gains and, hence, potential GDP growth. According to Oxford Economics, total factor productivity growth is likely to fall to 0.6 percent per year during 2016–2025 from a 2.1 percent rise over 2006–2015.3 Nevertheless, there appears to be some green shoots for investment in the near term. Household demand is recovering, and growth in the European Union has been improving, albeit slowly. Arguably, the biggest relief for investment is an end to the political uncertainty that started with a failed coup in 2016 until a referendum this year. Business confidence is up as a result, with the real sector confidence index in June rising to its highest level since October 2014.4

Investment in machinery and equipment contracted in Q1 2017

In manufacturing, rising output and capacity utilization are good news for investment. Manufacturing output grew 7.1 percent year over year (seasonally and working-day adjusted) in April, the fastest pace of growth since August 2015. Capacity utilization (seasonally adjusted) is up slightly, from 77.7 percent in Q4 2016 to 78.8 percent in Q2 2017; capacity utilization growth was even better in investment goods over the above period.5 Interestingly, fiscal stimulus measures are more likely to aid residential investment than those in machinery and equipment. Building permits have been reviving since the latter part of 2016, and the pace of house price growth has edged down toward more sustainable levels.6

Households have something to look forward to

A key worry for households has been the weak labor market and high inflation. It’s no wonder, then, that consumers appear nervous: Consumer confidence fell in June after a slight increase in April and May.7 This is also evident in retail sales, with growth slowing to 0.1 percent month over month in April from healthy growth in the previous two months; year-over-year growth continues to be negative (figure 3). While a weak labor market has dented nominal wages, high inflation has pushed down real wages. Real earnings, for example, fell in Q1 relative to a year ago, according to the index of gross wages and salaries.8

Consumer confidence remains shaky, while retail sales are subdued

The good news, however, is that the labor market is reviving, and inflation is likely to have bottomed out as the lira starts strengthening. The unemployment rate, after peaking at 11.9 percent in December 2016, has dipped slightly this year (11.4 percent in March). Employment has also increased this year after a shaky 2016, with the participation rate edging up once again.9 Price pressures are also easing, with the growth in both energy and food prices—key drivers of inflation in recent times—slowing down in June, thereby bringing down headline inflation to 10.9 percent from a nearly nine-year peak of 11.9 percent in March.

CBT remains focused on the lira and inflation

The lira has been a key concern for the Central Bank of Turkey (CBT), with the currency losing about 23.7 percent of its value against the US dollar and 21.1 percent against the euro between the end of June 2016 and end of January 2017. A weaker lira, in turn, has contributed to higher inflation.10 The CBT’s response to the weakening lira as well as high prices has been to hike interest rates. While it raised the one-week repo rate in November 2016 by 50 basis points, its focus has been primarily on the late liquidity rate, a window by which it has channeled as much as 90 percent of credit to commercial lenders in recent times.11 Since October 2016, it has raised the rate by 300 basis points, with the latest rate hike coming in April.12

With the lira strengthening, it is likely that inflationary pressures will ease

The strategy seems to be working, with the lira up against the US dollar this year, although part of this could also be due to dollar weakening (figure 4). The tighter monetary stance has, however, not been able to stem credit growth much, although the month-over-month growth of domestic loans in lira fell to 2.1 percent in May from 4.1 percent in March. It is still too early to predict the outcome of the current monetary stance. While a return of assets back into Turkey will likely shore up the lira, the current account deficit will act in the opposite direction.13 For the CBT, its fight against inflation and the currency appreciation helps in getting back some credibility. Its use of the late liquidity rate for monetary tightening helps thwart political pressure to keep the policy rate low. Also, with the government focusing on getting growth back on track through stimulus in the near term, it helps that the CBT is not losing its focus on medium-term economic stability.