Turkey: Political successes temper economic slowdown

Despite slowing growth and expectations of a widening current account deficit this year, investors do not appear to be shying away from the Turkish economy, particularly as the easing of political tensions is likely to yield an upgrade in the country’s investment ratings.

Economic growth slowed to 2.2% in 2012, a sharp decrease from the 8.5% and 9% recorded in 2011 and 2010, respectively. According to official figures released on April 1 by the Central Bank of Turkey (CBT), GDP grew by just 1.4% in the fourth quarter of 2012 – the lowest rate since 2009, and only slightly more than half the 2.7% that had been forecast.

The CBT had expressed a desire for a slowdown in growth, after the particularly rapid expansion in the two previous years incited fears that the economy was overheating through a combination of growth, high lending and an appreciating exchange rate, among other factors.

In late March 2013 the CBT tightened its policies further, slashing its overnight lending rate by one percentage point to 7.5%. Meanwhile, the bank held its borrowing and repo rates at 4.5% and 5.5%, respectively. It also raised the amount that lenders must provide to hold a portion of reserves in gold or foreign currencies, a move it predicted would drain $900m from the system. It also reduced lira funding to the market, slashing the maximum amount of liquidity it will provide at one-month repo auctions.

While these changes have indeed been engineered by the CBT, critics say the bank has gone too far in tightening liquidity, putting the economy in danger of being ground to a halt. According to Zafer Çağlayan, the minister of economy, such increased control is preventing the growth of domestic demand and putting the country out of sync with global markets.

"Unfortunately, one part of growth was missing. I believe that domestic demand needs to support growth as much as external demand,” he told The Wall Street Journal. “This growth figure shows that we stepped on the brakes too much.”

Additionally, the CBT announced on April 11 that the current account deficit had reached $10.9bn in the first two months of this year, a 9.6% increase over the same period in 2012. The deficit rose 20% in February, reaching $5.13bn after falling to the lowest level in more than two years in January, leading to expectations that the deficit will continue to widen this year. This came on the back of an increase in short-term foreign funding needs, which rose to $5.13bn in February 2013, a 21% year-on-year (y-o-y) increase.

Despite warnings from economists that Turkey cannot sustain external funding requirements in excess of 5% of its economy, investors seemed unconcerned about decreasing growth and an increasing deficit. This is largely due to speculation that ratings agency Moody’s will upgrade the country’s credit rating to investment grade this year – a status Turkey was awarded in November 2012 by Fitch Ratings.

The upgrade is likely due to Turkey’s recently improved political relations with both Israel and its domestic Kurdish population, moves that are expected to ease regional tensions. Indeed, Prime Minister Recep Tayyip Erdoğan’s government has recently begun negotiations to end the 30-year conflict with the Kurdistan Workers’ Party, which official estimates say has been responsible for more than 40,000 deaths and cost the country as much as $450bn.

According to Moody’s, defusing these tensions is likely to bring increased investment to the country. According to a report released on April 11, “The prospect of peace promises to boost investor confidence and improve southeastern Turkey’s attractiveness as a destination for foreign direct investment, which would deliver economic benefits and reduce Turkey’s external vulnerabilities, enhancing sovereign creditworthiness.”

The easing of tensions with Israel could also contribute to higher investor confidence. In late March Israeli Prime Minister Benjamin Netanyahu, in a phone call mediated by US President Barack Obama, formally apologised to Erdoğan for the Israeli raid of the passenger vessel Mavi Marmara in 2010 ¬– an incident that saw eight Turks and a ninth of Turkish origin killed when Israeli forces boarded the ship and five others in its flotilla to prevent the delivery of aid to Gaza.

The event has been a major source of contention between the two countries, causing Turkey to downgrade formal diplomatic relations with Israel and expel the Israeli ambassador from Ankara. Now, with Turkey’s calls for a formal apology answered, relations between the countries are expected to improve, lending greater stability to a region shaken by conflict in Syria and tensions with Iran.

Turkey’s increased focus on improving diplomatic relations in the region is undoubtedly a boon to its potential as an investment destination and will likely lead to increased investor confidence. However, the central bank will have to focus on stabilising the current account deficit and once again improving growth rates to ensure sustained investments in the Turkish economy.