A country transformed: Growth is expected to continue at a measured pace

Undergoing a major transformation over the past decade, the Turkish economy is now the world’s 15th largest and the sixth largest in Europe, according to 2011 World Bank figures for GDP at purchasing power parity (PPP). The country has an estimated population of 74.7m, giving it the second-largest internal market in Europe, after Germany. Bordering that continent, as well as the Middle East and the Caucasus, and with a coastline on both the Mediterranean and Black Seas, Turkey also has a unique position in international trade. This gives it direct access to a variety of markets, while also making it a major transit route for many more.

A decade ago the economy had just been hit by a major financial crisis, which had seen the currency halve in value overnight, a string of high-street banks collapse and inflation reach around 100%. Back then, a series of unstable coalition governments presided over an economy that was still heavily state dominated; at the same time, despite its central economic role, the state also faced the problem of limited revenues, given the size of the unregistered or “grey” economy. Per capita income in 2001, when the crisis hit, was just $2905 at current prices, according to IMF figures – less than half that of Mexico. A decade later, things are very different. In 2011, Turkey’s per capita GDP stood at $10,576, a three-fold increase (and higher than that of Mexico).

FAST-PACED EXPANSION: In recent years, the state has withdrawn from many areas of the economy, while regulation and taxation have been strengthened. The current government of Prime Minister Recep Tayyip Erdoğan’s Justice and Development Party (AKP) has won three general elections in a row, all by a large margin. Inflation has been largely in single digits until recently, while the banking system emerged stronger than ever from 2001 and was able to withstand the global financial crisis far better than its European peers.

Indeed, in the first quarter of 2011, Turkey outpaced even China in terms of economic growth, recording a blistering 11.9% GDP expansion year-on-year (y-o-y) at current prices. This was the highest GDP growth in the world for a quarter where the Organisation for Economic Cooperation and Development’s average was 0.5%.

Yet despite this performance, there are some causes for concern, both in terms of its own structures and in external factors. The continued eurozone crisis and sluggish recovery elsewhere will likely have an impact, as Turkey is reliant on external sources for growth.

Nonetheless, the economy is expected to continue its expansion in 2012 – albeit at a more measured pace.

KEY PLAYERS: Turkey’s macroeconomic policy has been determined by the ruling AKP government since 2002, with the key institutions at the political level including the Office of the Prime Minister, with Erdoğan the current prime minister, Ali Babacan the deputy prime minister responsible for the economy and İbrahim Halil Çanakçı undersecretary of the treasury; the Ministry of Finance, with Mehmet Şimşek the current minister; and the Ministry of Economy, headed politically by Zafer Çağlayan. There are also ministries dedicated to development; energy and natural resources; food, agriculture and animal husbandry; science, industry and technology; and others all with important roles in policy-making and implementation. The Central Bank of the Republic of Turkey (CBRT), meanwhile, is independent of the government, with its primary objective maintaining price stability. Since 2005, its Monetary Policy Committee has held regular, scheduled meetings to announce policy decisions. For the banking sector, meanwhile, the Banking Regulation and Supervision Agency acts as its name suggests, while the Capital Markets Board oversees capital markets.

Turkey is also home to a number of economic associations, from chambers of commerce to trade unions.

Some of the well-known and influential today include the Turkish Business and Industry Association, the Union of Chambers and Commodity Exchanges of Turkey, the Independent Industrialists’ and Businessmen’s Association, and finally the Turkish Exporters Assembly.

INDICATORS: While the double-digit growth of first-quarter 2011 grabbed headlines, Turkey’s economy had begun picking up speed some time before. Indeed, 2010 saw a major recovery under way, after the effects of the global downturn sent the economy into a dive in 2009. Using the expenditure approach to calculation, in that year, GDP at constant prices shrank by 4.7% year-on-year (y-o-y), according to figures from the national statistical office, TurkStat. Yet by the third quarter of 2009, the economy had moved back into growth, expanding 6% after three quarters of successive shrinkage. Thus, as 2010 began, the economy was in recovery. GDP growth at constant prices was 9.2% over the year, with the first two quarters showing 12.6% and 10.4% expansion. Most analysts saw the main factor behind this as a series of major interest rate cuts. The CBRT knocked 10.25 percentage points off the rate between October 2008 and November 2009, with the overnight borrowing rate reaching 6.5% by the latter month. This stoked consumer and business spending, accelerating Turkey out of the downturn.

At constant prices, GDP for 2010 thus ended 8.9% up on 2009, with the final quarter seeing 9.2% growth. The headline first-quarter 2011 figure of 11% represented a continuation of an increasing trend. The second and third quarters of 2011 recorded 9.1% and 8.4% growth, respectively, with some analysts pointing to frontloading of projects during the first half of 2011 due to the June general elections as a further factor behind growth. Figures released at the beginning of April 2012 put growth at 5.2% for the fourth quarter of 2011, and according to TurkStat’s consolidated figures, annual growth for 2011 was 8.5% at constant prices. This brought total GDP at current prices to TL1.29trn (€550.33bn) for the year, equivalent to a per capita GDP of TL17,510 (€7441.75).

VALUE ADDED BY REGION: TurkStat figures show the vast majority of gross value added in Turkey has its origins in the western half of the country, with the Istanbul region itself accounting for 27-28% of the total between 2004 and 2008. The next largest contributor was the Aegean region, with 13.8%; then East Marmara with 12.8%; followed by Western Anatolia and the Mediterranean regions, with 10.9% and 10.4%, respectively. In the last few years there has, however, been the start of shift towards the so-called Anatolian tigers in the country’s east. While exports from companies outside Istanbul, Izmir and Ankara amounted to only 34% of total exports in 2008, by 2010 they had risen to 42.5%, according to figures from Turkey’s Foreign Economic Relations Board (DEİK).

Turkey’s trade relationships with its Middle Eastern neighbours underwent considerable improvement in the years 2008-11, particularly with Iraq, Egypt and Iran, as well as with Syria prior to the Arab Spring.

SECTOR FIGURES: Sector by sector, meanwhile, TurkStat figures show that the three largest contributors to GDP, using a production-based approach, were manufacturing, which contributed 16% in 2011; followed by transport, storage and communications, with 13.3%; and then wholesale and retail, with 11.75%.

Ownership and dwellings went from 11.3% to 10%, while agriculture, hunting, forestry and fisheries totalled 8.4% of GDP at current prices in 2010, with this falling to 8.12% in 2011. Meanwhile, real estate, renting and related business activity went from 4.8% to 4.73%. Public administration, defence and compulsory social security fell slightly from 4.2% to 4.06%, and the education sector stayed steady at about 3.3%. Construction’s contribution increased from 4.1% to 4.5%, while financial intermediation dipped from 3.7% to 3.15%. Electricity, gas and water contributed 2.1% to GDP in 2010 and 2.2% in 2011, while mining and quarrying was 1.4% and 1.49% . The rest was hotels and restaurants, health, social work, community activities and household staff.

In terms of growth rates, when looking at the supply-side, trade contributed 1.6 percentage points to the 9% GDP growth seen in 2010, and industry 3.1 points. Transport and communications contributed 1.5 points, construction and financial intermediation 0.9 points each, and agriculture 0.2 points. In terms of the demand side, private consumption contributed 4.7 points to the 9% GDP growth total, private investment 5.4 points, public consumption 0.2 points, public investment 0.6 points and net exports a negative 4.4 points.

The demand-side statistics show the private sector is now definitely the main contributor to growth. Looked at over time, private consumption and investment also show remarkable swings. In 2009, both were negative contributors to growth, as the global downturn bit, yet within 12 months they were on the other side of what many are coming to look at as a “V-shaped” recovery.

GDP growth is also a story of the importance of domestic consumption. TurkStat figures show that final consumption of resident and non-resident households on Turkish economic territory was 72.5% of GDP in 2010 and 71.5% in the second quarter of 2011. Indeed, domestic consumption has hovered around 70% for many years. Exports have thus also remained fairly constant from 2006 through mid-2011, varying between a low of 23.1% in the second quarter of 2011 and a high of 26.6% in the first quarter of 2009.

BALANCE OF TRADE: Historically, Turkey’s main trading partner has been Europe, and this is still very much the case. This link was further strengthened by the Customs Union with the EU which came into force on December 31, 1995, while Turkey’s efforts to join the EU have also led to a process of harmonisation between Turkish and EU economic and trading standards – a process still under way, although very little progress has been recorded of late, due to political obstacles, such as the Cyprus issue and opposition to Turkish EU membership from some key EU governments.

Figures from TurkStat for March 2012 showed exports to the EU decreased by 3.3% y-o-y. The proportion of EU countries was also down significantly, to 41.6% from 48.4% one year earlier. For the full-year period this figure stood at 46.3% in 2010 and 46.2% in 2011.

In 2011, according to TurkStat, Turkey’s total exports were $135bn, up from $114bn in 2010. The top destinations for exports in February 2012 were Germany, which took $1.08bn; Iraq, with $800m; the UK, with $795m; the US, with $533m; and France, with $533m.

In terms of the goods and services exported, the front-runner in March 2012 – and indeed, for many years now – was road vehicles. In March 2012, exports of these stood at $1.51bn. Road vehicles were followed by boilers, machinery and mechanical appliances at $1.1bn, and then iron and steel at $1.02bn. Electrical machinery and equipment was fourth at $917m, while pearls, precious stones, precious metals and related articles came in fifth with $830m.

Thus, exports are heavily oriented towards manufactured goods. Indeed, figures for the whole 12 months of 2009 show manufactured goods responsible for 93.4% of all exports, a figure falling to 92.6% in 2010 before rising back to 93.4% in 2011. Agriculture and forestry is the only other sector that makes it out of decimal places, proportionately, accounting for 4.3% in 2009 and 2010, and 3.8% in 2011.

On the imports side, 2009 saw Turkey bring in a total of $140.9bn, rising to $185.5bn in 2010 and $240.8bn in 2011. Thus, in 2009, exports covered 72.5% of imports, a figure falling to 61.4% in 2010 and 56% in 2011, demonstrating a growing trade deficit.

The main country importing to Turkey is Russia, which was responsible for $2.04bn in imports in March 2012. Following closely in second place was Germany, with some $2.02bn in March 2012, and then China, imports from which totalled $1.73bn during the same month. The EU as a whole also makes up a significant, albeit declining, share of the import total, accounting for 40.2% in 2009, 38.9% in 2010 and 37.8% in 2011.

The vast majority of the goods imported are intermediate goods, with these responsible for 70.6% of imports in 2009, 70.8% in 2010 and 71.9% in 2011. The next largest group is usually capital goods, with their share going from 15.2% in 2009 to 15.5% in 2010 and 2011. Consumption goods, meanwhile, went from 13.7% to 13.3% to 12.3% over the same three years.

LOOK OUT AHEAD: The pattern of exports and imports shows certain risks for the Turkish economy in the period ahead. First, there is the continued risk presented by the difficulties of the EU as it attempts to solve the eurozone crisis, while also suffering from sluggish growth and slow recovery. Indeed, three of the country’s leading export destinations – Germany, the UK and Italy – are all predicted to see low growth in 2012. A slowdown in Germany in particular would have major implications, with that country alone accounting for around 10% of Turkey’s exports and imports.

Yet some remain optimistic that slow growth and further belt-tightening in Europe may not be as bad for Turkish manufacturers as it first seems. “Some Turkish exporters have turned the crisis into an opportunity,” Burcu Ünüvar, the chief economist at İş Investment, told OBG. “As European households tighten their belts, they don’t buy the expensive new fridge, but the more modest one. Chances are, the latter was made in Turkey.”

At the same time, Turkish exporters are known for their resilience and adaptability. Many have sought out new markets in the Middle East, North Africa, Central Asia and East Asia. Indeed, in 2011, while Turkey had a $29bn trade deficit with the EU, it also had a $6bn surplus with the Islamic world.

In addition to Iraq, the UAE, Iran, Saudi Arabia, Egypt and Azerbaijan are significant markets – even if political stability in the Middle East remains a concern. That said, worries about stability are not alien to certain nearby European countries either. Robert Yıldırım, the chairman of Yıldırım Holding, told OBG, “Industrialists and exporters need to make diversifying their international customer base a priority. New markets in Africa and Latin America, in particular, are going to be key.”

In sum, the widespread expectation is that external demand will be under pressure in 2012, with this having implications for exporters.

FOREIGN EXCHANGE: Perhaps even more significant though will be the exchange rate, with the Turkish lira depreciating 18% against the dollar during 2011. The start of 2012 saw major CBRT action to halt the slide, action that proved successful, with the general expectation that the lira will strengthen as 2012 plays out.

Figures also point the way to what many see as the most serious risk to Turkey’s economy going forwards – namely, the growing current account deficit (CAD). CBRT data showed that in 2011, the CAD had reached a record level – $77.8bn – which was 65.3% higher than it had been in 2010. This was equivalent to around 10% of the country’s GDP in 2011.

Kaan Başaran, the CEO of UniCredit Securities, told OBG, “If the world has changed, following the 2008-09 crisis, then our definition of ‘emerging market’ must also change. The ‘West-vs-rest’ economic paradigm is no longer useful. There are merely countries, clusters of problems and forms of interdependence. The current account problem needs to be considered in light of a great many more factors expanding the country’s reach of pursuit for capital beyond European markets.”

CAD TROUBLE: The declining ability of exports to cover imports demonstrated above – the main reason for the swelling CAD in 2011, according to the CBRT – is indicative of the nature of much of Turkish business and consumption, as well as of larger structural issues currently within the Turkish economy.

Structurally, companies are often highly dependent on imported materials – which they then use to assemble products – and on imported energy, as Turkey lacks significant oil and gas reserves of its own.

Meanwhile, more cyclically, economic growth – which clipped along at an average of 6.8% per annum from 2002 to 2007, before the global downturn, and has outperformed that rate since the end of 2009 – feeds demand for consumption and intermediate goods.

On the structural side, energy costs are dependent on a number of external factors. Oil prices, the standard measure, rose in 2011, with Brent crude averaging around $111 a barrel. Early 2012 also saw prices rise further, just under $120 a barrel in early May.

Thus, energy prices will likely continue to add to the import bill in 2012. At the same time, tackling the structural problem of reliance on imports of other materials is a difficult and long-term one.

Government officials are, of course, well aware of this and are trying with their long-term development plan – which runs through to the Turkish Republic’s 100th birthday in 2023 – to boost more value-added domestic industries (see analysis). In the near term though, the structural pattern is unlikely to see much change. On the cyclical side though, more immediate action can – and is – being taken.

High economic growth is being fuelled in large part by ever-higher domestic consumption, itself enabled by historically low real interest rates, an assertive and capable banking sector willing to loan – coupled with relatively low levels of existing leverage among households – and the availability of external financing.

The concern among many economists is that the latter part of that equation may be more uncertain in the year ahead, with potentially troubling consequences.

SAVINGS & LOANS: While Turkish households have relatively low levels of leverage, their savings ratios have also been fairly low. Indeed, historically, the banking system was often seen as highly unreliable, and many people kept their surplus funds in foreign exchange (FX), traditionally “under the mattress”.

“The low savings ratio is a deep-rooted problem,” said Yarkın Cebeci, executive director with JPM organ in Istanbul. “Historically, due to high inflation, people spent all they earned and thus now have few savings.”

In 2011 though, the ratio of household liabilities to GDP was around 17%, lower than in any European country and about a quarter the EU average. Nonetheless, the figure is rising fast. According to CBRT data, in 2010, credit growth was around 40%, and in 2011 around 42%. In the same years, most developed world economies saw zero or negative growth when it came to credit. At the same time, the ratio of deposit growth to GDP has been declining, down from around 9% at the end of 2010 to 6% by mid-2011, and dropping further to around 5% by the end of the third quarter of 2011.

The result of this is a savings gap, with gross national savings around 13% of GDP in 2011, down from about 23% in 1998 – illustrating the growing level of leveraging in the economy.

At this point, some demographic factors highlight the conundrum, too. With a growing population (around 1.35% growth in 2011 according to TurkStat) the economy needs GDP growth of about 4% to create enough jobs, and an investment rate of 22-23% of GDP, according to predictions by many analysts.

Although the relationship between savings and investment is a complex one, most economists agree that this means there is a major need for external savings to keep the Turkish economy growing. The CAD is the result of this mismatch, with future economic growth highly dependent on the continued availability of foreign financing for the country.

FOREIGN DIRECT INVESTMENT: Foreign direct investment (FDI) flows for Turkey have seen spectacular growth in recent years. Between 1980 and 1999, total realised FDI stood at just $12.5bn, according to figures released by the Treasury. Indeed, yearly averages of around $1bn continued until around 2005, when they jumped to $10bn, doubling the next year to $20.2bn and peaking at $22bn in 2007. The global downturn then took its toll, yet by 2010 they were back up to $8.9bn and in 2011 were $15.9bn, according to the CBRT.

“Turkey’s geography is serving it well, with European, Russian and Gulf investment growing,” Başaran told OBG. “The country has every single ingredient necessary for a decade of economic growth.” In the JanuaryDecember 2011 period, Turkey recorded an as-yet unexplained $13bn net inflow in “net errors and omissions” in its balance sheet. Theories on this money’s origin include repatriated household capital to unofficial Middle Eastern money in flight from the Arab Spring.

There are also major programmes of quantitative easing ongoing in Western economies, with part of the European Central Bank (ECB) issuances also seen as potentially ending up in Turkey. Historically though, larger Turkish companies have seldom had difficulty rolling over their debts – even when the recent global crisis was at its peak. This is especially significant at the moment, as private sector debt – particularly that of the non-banking segment – is much larger than that existing in the public sector.

Still, there is room for improvement. “Turkey is missing out on some big projects because there is insufficient inventive to invest in greenfield projects at the moment,” Yıldırım told OBG. “Better support for locals to move to global-standard corporate structures, and better auditing and control systems, would help build confidence for those bearing FDI.”

FISCAL REBALANCING: Indeed, Turkey’s fiscal policy has been a tight one for many years, with the exception of the 2008-09 crisis, when the budget deficit jumped. According to Ministry of Finance figures, the deficit has been in decline since – at 3.6% of GDP in 2010 and an estimated -1.5% in 2011.

A small primary surplus has emerged, of 0.8% in 2010 and an estimated 2.2% in 2011. Data for January 2012 showed the budget with a monthly surplus of TL1.7bn (€722.5m), 73% higher y-o-y. The primary surplus was at TL7.1bn (€3bn), 48% higher and around a quarter of the target that had been set for the entire year. Helping with this has been an expansion in tax revenues, which accounted for 83.5% of total state revenue in January 2012. Higher levels of consumption have boosted indirect tax collection – the main tax revenue component in Turkey, at 69% of the tax total in 2011– while there has also been an improvement in direct tax collection due to more efficient tax office activities bringing more of the grey economy under scrutiny.

At the same time, the government has raised revenues from sales of state enterprises in past years, with plans to sell deforested public land, real estate and introduce payment schemes in military service in the period ahead (see analysis).

Government fiscal policy is currently being conducted in the context of a series of medium-term programmes, the current one running from 2010 to 2012 and the next 2012-14. There is also the 9th Development Plan, 2007-13, while the government also has longer-term plans through to 2023 (see analysis).

HOT MONEY, INTEREST RATES & INFLATION: Faced with growing credit extension domestically and a surge in short-term foreign capital inflows after the onset of the downturn in 2008-2009 and following its exit strategy from a period of crisis management to overcome the immediate effects of the global downturn, in November 2010 the CBRT began a campaign to both reduce banks’ lending abilities and deter “hot money”, which had been causing currency appreciation.

This produced what many saw as an unconventional policy in which banks’ reserve requirement ratios (RRRs) were increased, while the difference between lending and borrowing rates was deliberately expanded, a policy known as the interest rate corridor.

This was aimed at increasing the maturity of deposits, a goal which was partly achieved – as CBRT data showed average Turkish lira deposits rising in maturity from 45.1 days in June 2010 to 62.6 days a year later.

Yet credit continued to expand into 2011, despite the weighted average RRR rising from 5.5% in September 2010 to a high of 13.3% in April-May 2011.

LENDING & BORROWING: The difference between lending and borrowing rates also widened, with borrowing as low as 1.5% from December 2010 to July 2011, while lending stayed at 9%. The interest rate corridor, while controversial, did lead to depreciation in the lira though, as hot money was deterred.

Yet this depreciation was perhaps greater than intended, with the lira losing 18% of its value against the dollar over the course of 2011. By the end of the year and into 2012, the CBRT was conducting major operations to prop up the currency by selling FX. By the end of 2011, the interest rate corridor was between 5.75% and 12.5%, too, with frequent adjustments by the CBRT, which essentially set the rate according to daily circumstances.

UNCERTAINTY IN THE MARKET: This created uncertainty, if not a little confusion in the market. The CBRT set the higher-end rate more frequently during later 2011 too, while undermining the significance of the policy rate. This continued until a policy reversal in January 2012 saw the CBRT opt for a rate that was closer to the lower end of the band. This rate cut probably had more impact on the defence of the lira than FX sales did. The lira began appreciating again in early 2012, rallying 7% by mid-February. The CBRT, which had seen a major reduction in its FX reserves due to this defence of the lira, was thus able to begin focusing on rebuilding its dollar stocks in late February 2012, as the lira appreciated, and this should continue during the year.

Banks, meanwhile, began hiking their bond issuances, as the deposits-to-loans ratios worsened, with data provided by Bloomberg for the first six weeks of 2012 showing $4bn in issuances by Turkish banks, four times that of the same period of 2011.

With credit expansion and lira depreciation in 2011, an old Turkish bugbear had also returned to the scene – inflation. The extent of this was unexpected, as the global slowdown had been widely anticipated to see imported inflation under control.

The CBRT, which operates a system of inflation targeting, had predicted the year-end 2011 consumer price index to stand at 5.5%, yet the eventual figure was 10.45%. Other culprits blamed by the government included rising food costs and more taxes being placed on tobacco products and alcohol.

OUTLOOK: Turkey’s economy faces a number of challenges in 2012. These include finding the external financing for the CAD, bringing down inflation, ensuring a stable lira, checking credit growth, and maintaining the levels of GDP expansion and job creation that are necessary for its youthful population. All of this will be undertaken in an uncertain global environment.

Most analysts have therefore seen 2012 as likely to be a year of slower growth than 2011; the government forecasts 4% GDP expansion, with the IMF going for 2.2% and a Bloomberg poll of economists finding an average of 2.7%. Indeed, some agencies have even predicted negative growth, although based on figures available in early 2012 this seems unlikely.

The GDP slowdown will have some potential upsides. Amongst other things, it should be helpful in shrinking the CAD and bringing down inflation, which the CBRT is now targeting much more aggressively.

Some unexpectedly good industrial production figures for December 2011 (up 3.7%, y-o-y) also give some hope, when combined with similar figures in Europe, that the economy is still basically strong. Indeed, in February 2012, Goldman Sachs revised up its forecast for GDP growth from 0.8% to 2.5%.

Meanwhile, “Turkey attracted around $11bn of FDI in 2011,” said Güldem Atabay, the director-economist for UniCredit in Istanbul, “which can be replicated in 2012. Indeed, around $20bn a year is quite sustainable.” If so, financing the CAD may not end up being such an uphill struggle after all.

With a strong note of caution, given external uncertainties – particularly in the eurozone – it may be then that Turkey’s growth will remain on the higher side of predictions in 2012, while declines regarding the CAD may end up being on the lower side of predictions.

The first half though is widely expected to see a significant drop in the CAD and growth, while the second half of 2012 may see a rapid re-expansion. In the longer term, Turkey’s economy will also be addressing the structural issues behind its dependence on imported intermediary goods and external financing through its medium- and long-term development plans.

The destination that the Turkish economy is headed to seems to be clear. The speed with which it is reached, however, may vary considerably in the coming period.