Can Turkey Get Back on Track?

12 May 2024

Turkey has long been a classic boom-bust economy. Indeed, the volatility of Turkish GDP growth is higher than most comparable Emerging market and advanced economies (next Chart). In addition, while the global economy has experienced two episodes of negative GDP growth since 1980, Turkey has endured five recessions.

In my March 2021 blog “Turkey: Systemic Risk or One Bad Apple?”, I recommended investors abandon Turkish assets. Subsequently, the choas following the introduction of the “New Economic Model” in December 2021 rendered Turkey uninvestible for global asset managers.

However, recent events are raising hopes that Turkey is now getting back on track. In contrast to the inflationary government-spending spree prior to the 2023 Presidential election, newly-appointed Finance Minister Simsek implemented tough budget measures last Summer. And, he has promised additional efforts this year. Even more importantly, beginning last June, the central bank (TCMB) has raised interest rates from 8% to 50% to address the inflationary implications of the new model. Hopefully, these actions indicate Turkey has abandoned the misguided notion that high interest rates lead to rising inflation.

Optimists hope recent political events — e.g. the need for a second round of voting in the Presidential election, the AKP’s narrower Parliamentary majority, and the party’s poor results in recent municipal polls — has convinced President Erdogan’s government of the public’s desire for stability. Has Turkey turned a corner, and is the country getting back on track to achieve its enormous economic potential? Will the recent policy-induced boom end again in bust? Regaining credibility with global investors will take time. But, it’s probably time to begin giving Turkey another look.

Getting Back on Track: Regaining Credibility

Turkey has enormous economic potential. In fact, I had the audacity in 2003 to suggest Turkey might be the top Emerging market story of the next generation. Imagine the reaction I got from China, India, and Vietnam. However, economic reform aimed at EU membership led to a convergence of per capita GDP towards the OECD level between 2000 and 2015 (Chart above).

This achievement resulted from the abandonment of the previous economic model featuring high and volatile inflation, wage indexation, and lira weakness — sounds familiar (Chart above). The hard-won macro-policy credibility, which produced the low inflation of the Naughties, was the cornersone of the nation’s economic prosperity. As a result of the economic strategy of the past decade, however, the convergence of living standards has slowed, if not stalled. The challenge now facing the TCMB and Erdogan administration is to regain the now-lost credibility.

Turkey’s macroeconomic Achilles heel has long been its chronically bloated external financing requirement, which is dominated by the high level of short-term foreign debt (Chart above). If economic conditions are stable, as in the Naughties, these liabilities can be easily rolled over, and the exchange rate would remain relatively stable. However, as the recent lira collapse illustrates, without macro-economic credibility, Turkey’s low-level of FX reserves provides an insufficient buffer if international capital inflows dry up. The following Chart illustrates Turkey’s external vulnerability compared to other EM nations.

To put it in perspective, Turkey’s annual external financing need is a staggering $250 bn (25% of GDP) compared to central bank FX reserves of $60 billion. In recent years, the Erdogan government addressed this mismatch through regulations aimed at lowering the current account deficit, increasing the share of lira-denominated bank deposits (so-called “lira-isation”), and reducing reliance on unstable foreign capital inflows. To be fair, there were achievements. Overall, however, there’s now subsitute for macro-economic credibility, which the overall strategy squandered. After rising sharply in the Naughties, FX reserves have declined 40% during the past decade (next Chart). Indeed, the stockpile has continued to decline recently, even as sentiment regarding Turkey’s policy strategy has improved.

Reaching Its Potential: Reform=Convergence

Once the government restores macro-economic credibility and stability, Turkey would enjoy great potential. Indeed, as per capita GDP is only two-thirds the OECD average, a sustained commitment to reform could resume the earlier convergence of living standards. This will require Turkey building on its strengths, as well as addressing its micro-economic shortcomings.

Building on Its Strengths

First of all, Turkey enjoys favourable demographics — a young, dynamic labour force. The median age is 33, and two-thirds of the population is working age, and only 10% is above 65. In addition, labour market participation and employment has been rising. The chart above illustrates the large contribution of population and job growth to Turkey’s past and future GDP growth. However, despite the recently favourable performance, Turkey’s employment rate remains low by international standards, especially amongst women (next Chart). Demographics, therefore, should contribute significantly to future GDP growth, especially if the participation of women is advanced further.

Meanwhile, if global trade tensions continue to increase, Turkey may benefit as European producers bring supply chains closer to home (“near-shoring”). There’s some evidence this may be happening. The rising share of Turkey’s imports from “other” countries (alternative low-cost destinations) could indicate Turkey’s role as a manufacturing hub is increasing (Chart below). To exploit this opportunity, Turkey must improve its attractiveness as a foreign direct investment destination, which remains low compared to other countries (following Chart).

Likewise, Turkey’s geography positions it to play a valuable role as a bridge between Europe, the dynamic Asian economies, and the Middle East. Indeed, the EU is Turkey’s largest trading partner (41% of exports), while another 25% of sales are destined to Middle Eastern countries. Of course, current regional tensions pose near-term risks. In addition, Turkey seeks to make the most of ongoing global geo-political tensions and economic fragmentation. For instance, the share of imports from Russia and China are rising, while the portion from the EU and USA is declining (chart above).

Addressing Weaknesses

Policies aimed at boosting labour supply, lifting productivity, and improving the business climate will be crucial to lifting living standards towards OECD levels. (I borrow from the OECD’s impressive analysis of needed reforms). Improving the business climate is vital to boosting both domestic and foreign investment. The following Chart indicates heavy regulation impedes Turkey’s dynamic private sector.

Encouraging greater female participation in the workforce would help ensure ample future labour supply (as would greater net immigration). Despite recent impressive improvements, the role of women still lags far behind other countries (next Chart). Moreover, the overall level of labour market restrictions is high by international standards; making it difficult for new entrants to the labour force to find employment. Likewise, these impediments sustain a large informal economy in which inequality is widespread, and pay is poor, especially for women.

As in other countries, Turkey faces the challenge of boosting flagging productivity growth. However, Turkey’s innovation performance is especially problematic (next Chart). In particular, the technology content of Turkish exports is particularly low; with sales abroad focusing on low value-added manufactured goods. As a result, Turkish workers are amongst the most vulnerable to automation and AI.

Turkey’s slow entry into the digital world contributes also to its poor productivity track record (next Chart).

Strategic Implications: Much to Play For

  • Turkish interest rates are near the peak. However, as inflation-adjusted yields are below other EM nations, the TCMB may need to hike another 500bp (Chart above). Stubbornly-high inflation will decline eventually towards 40% by the end of the year, and below 20% in 2025. Achieving these targets will prevent rate cuts until mid-2025.
  • Persistently high interest rates suggests that the current boom could lead to bust. Economic growth will slow towards 2-3% in 2024 and 2025. However, recession is avoidable. The low level of government debt provides scope to stimulate fiscal policy, if necessary (although this is not the government’s current plan).
  • I’m not convinced Turkey has turned the corner. The Erdogan government’s commitment to reform is not robust, and the TCMB’s credibility has been greatly compromised. Financial markets will be especially punishing of future policy reversals. But, if recession is avoided, Turkish equities are cheap. It may be worth beginning to give Turkey the benefit of the doubt.
  • The Turkish lira (TRY) is significantly undervalued, although the following Chart probably overstates the competitive windfall. While TRY has stabilised in recent months, I doubt the TCBM wants FX appreciation (even if it contributes to disinflation).
  • If Turkey really is getting back on track, the real exchange rate could appreciate 25-30%. However, this would primarily reflect Turkey’s high inflation rate compared to trading partners. Indeed, TRY’s nominal value may decline another 20-25% during the next 24 months. However, Turkish interest rates now appear to compensate for that risk. Perhaps it’s time to give Turkish bonds another look. Famous last words?