Turkey: Can Damaged Credibility Be Restored?

15 March 2018

Turkey has a history of  “boom-bust” economic cycles.  And, while Turkey enjoyed an impressive 7% GDP gain in 2017, the telltale signs of overheating again have emerged.  In February 2018, for instance, inflation stood at 10.3% (granted, a bit lower than previous months), double the central bank’s (CBRT) 5% target.  And, core inflation is even higher, now running at 11.6%.  Likewise, the current account deficit ballooned to nearly 6% of GDP last year (compared to 3.8% in 2016) — January’s data suggests this trend is set to continue. With inflation persistently running well above the CBRT’s target, the credibility of its commitment to achieving lower inflation has been damaged significantly.  How can faith be restored? In both Brazil and South Africa —  markets often compared with Turkey — undervalued currencies rallied following improved economic/political performance. Can the hard-hit, undervalued Turkish lira (TRY) join this trend (top Chart)? Or, as global interest rates rise, will the “boom-bust” cycle be repeated?

Monetary and Fiscal Policies: Working at Cross Purposes

One of Turkey’s impressive achievements in recent years has been the huge improvement in its public finances.  Historically, Turkey ran large budget deficits, resulting in high levels of government debt. All that has changed.  While not too long ago  government debt/GDP was 80%, the ratio now stands at 30% (comparing favourable versus other EM nations).

However, following the slump in economic growth resulting from the 2016 coup, terrorist incidents, and pre-referendum uncertainty in 2017, the temptation to take advantage of the improved fiscal position proved irresistible.  As a result, the government implemented  measures to stimulate consumer spending, and especially aimed at boosting lending to encourage business investment. It worked! The following Chart highlights the surge in lending to both households and the business sector.

The composition of Turkey’s economic performance is  also revealing.  First of all, the fiscal stimulus appears to have added 2% to 2017 GDP growth.  Both the consumer, but particularly capital spending responded to the fiscal measures.  In addition to the signficant improvement in domestic spending, exports surged (after two poor years) in response to the strong global economy and TRY’s sharp depreciation.   The impressive export performance prevented an even larger  deterioration in the current account, even though imports accelerated in response to stronger domestic spending.

Some have suggested that the recent rise in Turkish inflation largely reflects the temporary impact from TRY’s sharp decline (much like in Mexico and Brazil, or the United Kingdom). To be sure, rising import prices have played a role, as illustrated in the sharp rise in core goods quotes (see next Chart).  However,  the acceleration in service sector inflation indicates that price pressures are broad-based, and will not be remedied quickly.

In addition to these cyclical considerations, structural features of the Turkish economy contribute to the tendency of Turkey’s current account to deteriorate sharply as domestic spending recovers.  First of all, Turkey has a chronically low savings rate. As the Chart illustrates, Turkey’s savings is low by comparison to other EM rivals, and the rate has been declining in recent years.

Not only does low savings lead to an excessive appetite for import spending as local demand expands, it also contributes to a low investment rate, which takes its toll on productivity in the export sector.  The following Charts indicate the low levels of Turkish productivity, and that efficiency gains have been particularly anemic following the Global Financial Crisis.

Correcting Turkey’s external/internal imbalances which are contributing to the tendency towards boom-bust cycles will require a combination of fiscal restraint, monetary vigilance, and structural policies aimed at boosting savings, investment, and productivity.  It is widely assumed that last year’s fiscal stimulus has run its course, growth will decelerate towards the long-term trend of 4-5%, and inflation will abate.  However, I worry that in the runup to the crucial November 2019 election (could be earlier), the government will continue to pull on the fiscal levers, and remain reluctant to address the economy’s more chronic weaknesses.  The responsibility for lowering inflation, therefore, will fall solely on the CBRT.  Despite maintaining a 5% inflation objective, the CBRT projects that CPI growth will remain at 7.9% and 6.5% at the end of 2018 and 2019 respectively.  I worry that pre-election price pressures will exceed even these unambitious targets.  CRBT credibility will not be restored quickly or easily.

External Financing Needs:  Living on Borrowed Time!

While cyclical overheating is troubling, Turkey’s fragile external financial position could become an even greater concern, especially as global interest rates rise.  While the Turkish government has succeeded in reducing its debt load, the same can not be said of the private sector.   As in other emerging market nations, Turkish banks and corporations have taken advantage of low interest rates to increase borrowing (see following Chart).

Moreover, two particular features of Turkey’s credit binge have left it particularly vulnerable.  First of all, much of the additional borrowing was from abroad.  As a result, external debt as a share of GDP is now 70% as opposed to 45% before the GFC.  which compares unfavourably to rivals Mexico, Brazil, and South Africa in the 35% to 45% range.  And, while the Turkish government succeeded in reducing its overall debt load , the share of Turkish domestic government  bonds that are linked to foreign currencies has risen substantially since the Crisis (from 25% to 40%, next Chart).  As a result,Turkey’s  overall FX-linked debt (public and private) is approaching 80% of GDP.

Even more worrisome is that much of Turkey’s external borrowing is of short-term maturity. The following Chart illustrates that both banks and corporates have gorged on low-cost, short-term foreign debt.  However, there are important differences. First of all, the FX exposure of banks appears well-hedged at least in theory, as they also lend in foreign currencies (usually to local corporations).  Corporates are not hedged.  Likewise, the Chart illustrates that banks are already attempting to curb their appetite for short-term  foreign liabilities.  Meanwhile, corporations continue to binge, adding another $12 billion in ST debt in 2017.

Under normal circumstances, even more large short-term external debt loads are not too worrisome, as liabilities can normally be rolled over, as Turkey  has managed relatively successfully so far.  However if creditors choose not to roll over  Turkey’s corporate liabilities — perhaps due to FX volatility or rising external interest rates — this sets the stage of boom turning into bust.

Moreover, the Figure above illustrates  exactly how vulnerable  Turkey would be to a reduction in the risk appetite in global markets — its entire stock of reserves could disappear in a couple of months!  To complicate life even further, Turkey is especially vulnerable to higher oil prices.  Likewise, Turkey’s current account is highly reliant on tourism (4% of GDP). Following the 2016 coup and terrorist incidents, for instance, these receipts declined $10 billion (over 1% of GDP).  Pre-election political uncertainty or the deepening Syrian crisis could scare off visitors, and add to Turkey’s external financing needs.

Strategic Implications
  • As I do not expect fiscal tightening before the 2019 election (more stimulus is the more likely outcome), inflation will remain above the CBRT’s unambitious targets.  As a result, additional rate hikes of at least 100bp will be needed to begin to restore the central bank’s credibility.
  • During the next 18 months, I expect US interest rates to rise up to 150bp.  Even the ECB will start to normailise policy.  Greater FX and overall market volatility will make it more difficult for Turkey to roll over its external debt if maturities are not lengthened.
  • Previously undervalued BRL and ZAR have rallied following improved economic and political prospects.  Likewise, TRY  now appears 10-15% undervalued (see Chart at the top of the blog).  TRY could rally if the CBRT can engineer a soft landing.  However, TRY is still 10-20% above levels encountered during previous cyclical “busts”.  The risk-reward, therefore, remains unfavorable, especially as I attach a higher likelihood to the boom-bust scenario compared to the soft landing.