Great expectations: Structural reforms key to regaining the economy’s positive trajectory

Throughout 2014 Turkey had to shoulder its fair share of international financial turbulence, especially in terms of currency volatility. However, despite investor concerns, the country has largely retained its appeal as a success story in the region with relatively sound long-term growth potential, provided the appropriate structural reforms are enacted.

The past decade has seen the economy thrive as Turkey took significant steps forward in its development. A young and growing population in a strategically important location have marked Turkey as a potential economic heavyweight. However, concerns remain over renewed political uncertainty and the private sector’s exposure to external debt.

Full Speed Ahead

The government has set an ambitious target of becoming one of the top-10 economies in the world by 2023, to coincide with the centenary of the founding of the Republic of Turkey. However, the optimism that gave birth to this goal has dimmed somewhat, as external factors have placed significant stress on the economy in recent months. While it is better positioned than a decade ago, the economy has also become more vulnerable and investors are beginning to question whether Turkey can keep pace with the growth trends of the past decade given its structural imbalances.

Since 1999 Turkey has recorded average annual growth of 3.9%, making it one of the best performing emerging markets. Growth fell below 3% in 2014, but there is potential for an uptick in 2015, with support coming from domestic investment and the prospect of modest growth in the eurozone.

Growth by Numbers

While construction has been a leading source of growth in recent years, recording double-digit growth in constant prices in 2010 and 2011, this slowed to 2.2% in 2014. According to the Turkish Statistical Institute (TurkStat), the largest contributors to the economy in 2014 were manufacturing, with a 15.8% share of GDP in current prices; wholesale and retail trade, with 12%; transport and storage, at 12%; and real estate activities, with 9.8%. As a whole, services accounted for 58.4% of GDP in constant prices in 2014, while industry contributed 28.7% and agriculture brought in the remaining 12.9%, TurkStat figures show.

Demographic Dividend

Turkey’s fundamentals bode well for strong economic growth. With a market of 77.7m people as of the end of 2014, nearly half of which are under the age of 30, there is room for rapid expansion. As the country faces a falling dependency ratio, which stood at around 50% in 2013, there will be less pressure on recurring government expenditure and a growing workforce to generate government revenues. Government policies on labour and education are likely to have a large impact on whether this potential is realised. Additionally, Turkey’s strategic trade location, within four hours’ flying distance of 1.5bn consumers, presents opportunities for export-led expansion and an attractive incentive for foreign direct investment.

Tracking Progress

Over the course of the last decade, these factors have worked in the country’s favour, as evidenced by a long run of sustained economic growth. Between 2003 and 2013 Turkey’s economy grew by a compound annual growth rate of 4.4%, according to data from TurkStat, making it one of the top performers in the G20. In 2010 and 2011 alone the country recorded 9.2% and 8.8% year-on-year (y-o-y) growth. Indeed, Turkey has experienced a decade of heady growth and development following the uncertainty of the 1990s, which were marked by coalition governments, an insurgent war in the east and the 2001 banking crisis.

State Measures

The ruling Justice and Development Party (AK Party) has not been shy about lauding its own achievements. In a November 2013 speech, Ali Babacan, deputy prime minister responsible for the economy, reported that Turkey had tripled its national income in the decade to 2013, surpassing $17,000 in per capita national income at purchasing power parity. In real terms, GDP rose by over 60%, while GDP per capita was up 40%.

The government has also been keen to stress its stewardship of public finances. During the height of the euro crisis at the end of 2011, for example, Turkey’s performance compared favourably with that of its European neighbours. Turkey’s budget deficit at the time stood at 2.5% of GDP, within the EU benchmark of 3% and well below that of its troubled European neighbour, Greece, at close to 10%. A decade of single party governments has also brought public debt under control. At nearly 80% of GDP in 2001, it fell to 36% by 2013, substantially below Greece (142.8%), Italy (119%) and Portugal (93%). By 2016, the World Bank predicts it will reach 33%.

Making the Grade

The country was rewarded for its course correction in 2013, when Moody’s Investors Service raised Turkey’s sovereign bond rating to investment grade, bumping it up from “Ba1” to “Baa3”, with a stable outlook. This gave Turkey the same credit rating as India, Spain and Columbia, bolstering hopes it would attract a wider investor base.

However, by April 2014 Moody’s revised the country’s outlook from stable to negative, citing greater external financing vulnerability due to lower global liquidity and domestic political uncertainty, as well as less optimistic near- and medium-term growth forecasts. Moody’s most recently upheld this position in April 2015. In terms of the banking sector, in March 2015 Moody’s also reaffirmed its negative outlook for the second year running, after putting 10 of its banks on notice for downgrades in early 2014 and lowering various ratings of 11 banks that June.

Standard and Poor’s (S&P) has been similarly bearish. As the only one of the big three credit ratings agencies not to grant Turkey investment-grade status, S&P has maintained a “BB+” rating with a negative outlook, the highest junk status. However, according to statements from Nihat Zeybekci, minister of economic affairs, the outcome of the June elections could have a positive impact on ratings.

Big Plans

Turkey’s track record over the last decade has encouraged the government to set highly ambitious growth targets for the country’s economy. Between 2014 and 2023 the government is working to boost GDP from around $800bn to $2trn; GDP per capita from $10,400 to $25,000; and total exports from $157.6bn to $500bn.

For some time analysts have warned that it will be difficult to replicate the performance of the past decade, and that such ambitious growth figures cannot be sustained with a burgeoning current account deficit (CAD) and the structural problems that created it. In January 2014 Sinan Ülgen, the director of the Istanbul-based, Centre for Economics and Foreign Policy Studies, told the press that Turkey’s growth model based on low global interest rates and large capital inflows was outdated. “For years, it has been clear that this model would come to an end the moment central banks, like the [US Federal Reserve], started raising interest rates again.”

Up & Away

Much of Turkey’s growth since 2008 has been based on domestic consumption, rapid credit expansion, and the construction and services sectors. This has led to rising energy and intermediate imports to fuel manufacturing and exports. While the loan-to-deposit ratio of the banking sector stood at 40% in 2003, from 2010 to end-2013 it grew from 88% to 114%, according to Moody’s. Although the sector’s 13.4% core tier-1 capital adequacy ratio insulates it from a certain degree of risk, banks are still exposed to market turbulence, especially with leverage rising from 8x to 9x since 2010.

Consumer debt has also increased, from 4.3% of household disposable income in 2002 to 55% by the end of 2013. Credit card debt alone rose by 22% in 2013 on the back of a 31% rise in 2012. Such consumer-led growth is unsustainable in the long run.

Structural Concerns

To achieve this kind of persistent growth again, Turkey needs to do more to tackle the problems of low-value production and pursue supply-side reforms that will lead to greater labour productivity and larger domestic savings. According to a report released by the Bah çeşehir University Centre for Economic and Social Research in August 2013, the country runs the near-term risk of falling into the middle income trap, as it continues to face a lack of sufficient labour productivity and a consequent inability to push up per capita income.

The events of 2014 highlighted the structural challenges and risks faced by the Turkish economy. Perceptions of political uncertainty have discouraged risk-averse investors and led to a flight to foreign exchange for domestic deposits. At the same time, external conditions, such as the US Federal Reserve’s decision to pull back on quantitative easing, coupled with the structural problems of Turkey’s chronic CAD, are putting substantial pressure on the country’s economy. The consequences of these trends – most notably a falling lira and creeping inflation – present a challenge to the strategy of growth at all costs.

Inflation concerns have been stoked by consecutive interest rate cuts in January and February 2015, on political pressure to boost domestic growth. Although inflation remains above the 5% target set by the Central Bank of the Republic of Turkey (TCMB), as of April 2015 the consumer price index had risen 7.91% y-o-y, compared to 9.38% one year prior. While lower oil prices are helping compensate for the inflationary pressure of the rate cuts, continuing depreciation of the lira is limiting this effect.

More Needed

The central crux for the country is that annual growth of 4% may not be enough to keep pace with population growth. “Turkey has a young population and it is growing, so a fast growth rate is crucial. If we grow 4-5% on average, it will not generate unemployment,” U ğur Küçük, senior economist at Garanti Bank, told OBG. “This is an assumption that is largely shared across the board, as well as by the central bank.”

However, with GDP growth of 2.9% in 2014, according to the IMF, the country’s unemployment rate increased from 9.6% at the end of 2013 to 11.3% as of January 2015. To both regain and sustain economic momentum, restructuring will need to be prioritised. In its medium term outlook, the government has conceded that a 5% growth rate in 2014 will not be possible. Instead, it is emphasising growth of 4%, a lower CAD and greater productivity.

The government is aware that it is in a difficult economic period, with US monetary policy and the EU’s halting recovery continuing to have an impact. Back in August 2013 Babacan told local press that, in light of Federal Reserve tapering, “It should not be surprising for Turkey to revise its growth rate below 4%… We set our annual exports target at $158m, but it looks difficult to reach this target as well.”

Strong Current

The most significant obstacle to the long-term health of the economy is Turkey’s persistent CAD. Indeed, in the seven years to 2014, the CAD registered below 5% of GDP just once, in 2009. Although the figure decreased by nearly 30% in 2014, from $65bn in 2013 to $45.8bn, according to figures from the TCMB, this was primarily due to lower oil prices, which drove down the cost of energy imports. Weaker oil prices are expected to foster further improvements in the current account in 2015 (see Energy chapter). In relative terms, the IMF expects Turkey’s CAD to fall from 7.9% and 5.7% of GDP in 2013 and 2014, respectively, to 4.2% in 2015. However, as economic growth picks up to an estimated 3.9% in 2016, the CAD could increase to 4.8%.

Growing Pains

The high CAD in 2013, up 34.2% over 2012, was indicative of strong economic expansion that year, at 4.1%, compared to sluggish growth in 2012, when GDP rose by 2.1%, according to the IMF. While a higher CAD can signify growth, its persistence in Turkey underscores the need for restructuring. IMF staff estimates put the medium-term CAD at 5.5-6% of GDP based on current policies.

Turkey’s current account is particularly vulnerable as GDP grows, with the deficit swelling as the economy expands. Indeed, Turkey has become stuck in what the IMF terms “boom and bust cycles”, with growth being fuelled by imports and short-term capital flows. According to the IMF roughly 75% of the downward adjustment in the current account in 2012 came from a cyclical drop in imports and unusually large net exports of gold. It was also the result of a decline in investment rather than an increase in savings. The fund’s annual staff report on Turkey from 2014 notes, “The current account deficit remains 2.5-5% of GDP higher than warranted by fundamentals and optimal policy settings.”

Turkey’s reliance on imported energy is one of the main factors behind the deficit. Indeed, the country’s net energy import bill reached $55bn in 2014, with net energy imports accounting for 74% of energy use and 59% of electricity generation.

Taper Tantrum

Given the size of the CAD, the country is particularly vulnerable to any external shocks that could halt capital inflows, which are currently financing Turkey’s deficit. In the event of an abrupt and pronounced reversal of inflows, the economy would almost certainly face a rough and rapid adjustment leading to negative growth. Although analysts have warned of this scenario for years, a variety of internal and external factors gained pace in 2013, lending greater credence to risk assessments.

In May 2013 the US Federal Reserve announced that it might begin to wind down its large-scale asset purchases. The programme, enacted in response to the global financial crisis, has spurred lower US interest rates, bringing greater liquidity to emerging markets offering higher returns. The tapering, which began in December 2013, signals an eventual US interest rate hike, which is likely to have a negative impact on portfolio investment in emerging markets. However, weaker than expected job and inflation figures in March 2015 have fuelled expectations that the increase will not happen before September.

A reversal in investment flows is particularly troublesome for a country like Turkey, which has become so highly dependent on short-term capital inflows. However, according the IMF, low interest rates in the EU and Turkey’s investment-grade status could help to mitigate this effect, creating more of a “mixed” environment for capital flows. The Foreign Economic Relations Board (DE İK), having been restructured in September 2014, is focused on reaching the Vision 2023 targets of boosting exports to $500bn and the volume of foreign trade to $1trn. To this end, DE works with international organisations to bolster ties with the global business community and increase opportunities for domestic firms (see interview).

External Exposure

The more pressing concern for Turkey at present is the amount of foreign debt held that is set to mature in the near term. The short-term external debt stock on a remaining maturity basis, meaning debt that is set to mature within one year, stood at $164.9bn as of end-February 2015, up 26% since the end of 2011. The vast majority – over 85% – of this debt is held by the private sector, with more than two-thirds accounted for by banks. While this increases economic vulnerability and presents a long-term challenge to sustainable growth, the banking sector has had “no difficulty in rolling over its external borrowings and has adequate buffers against any [foreign exchange] liquidity shocks that may emanate from abroad”, according to the TCMB’s most recent Financial Stability Report from November 2014. Moody’s has echoed this view, noting that the country’s banks, corporates and public institutions alike have historically been able to roll over maturing debt even during times of crisis.

Currency Woes

The currency composition of Turkey’s short-term external debt stock is also noteworthy, particularly in light of recent depreciations in the lira. According to the TCMB, as of the end of February 2015, just 12.1% of all short-term external debt was denominated in lira, while more than half was in US dollars and nearly one-third was in euros.

The CAD, fed by high imports, a substantial trade deficit and newly vulnerable to capital outflows, has had a sizable impact on the strength of the lira. The currency depreciated 28% against the dollar between May 2013 and the end of 2014, before falling by another 15% through to the end of April 2015.

The depreciation of the lira has also been exacerbated by risk-averse local actors. According to Ozer Balk ız, the director of economic research at the Independent Industrialists and Businessmen’s Association, “Turkey is a dollarised economy. When something bad happens, not only corporates, but also consumers go into foreign exchange.” Since mid-2013 many Turkish residents have been transferring their bank deposits into foreign currencies – namely euros, dollars and sterling – in an attempt to protect themselves from further currency volatility.

The instability of the lira has left the banking and business sector exposed to substantial risk, given the private sector’s share of foreign currency debt. According to Emre Sezan, head of equity research at İş Investment, private sector foreign currency net debt stands at 22% of GDP, and depreciation of the lira will necessarily increase the cost of servicing these loans. According to the TCMB’s November 2014 report, currency risk is comparably higher amongst electricity producing firms and real estate investment companies, as they generate less revenue in foreign currencies. However, non-performing loans have been stable thus far, at 2.6-2.7% since 2011.

The depreciation of the euro against the dollar has also had an effect on the corporate segment, with 45% of the country’s exports invoiced in euros, according to the World Bank. This in turn has made it more difficult for firms to finance dollar-denominated imports, though the impact on the wider economy has been negligible.

Domestic Demand

In general terms, the new regulations regarding consumer credit introduced in early 2014 could have a negative effect on domestic demand, though they are also likely to improve the consumer loan portfolios of banks. Domestic uncertainty ahead of the June 2015 general elections is also depressing demand. According to the World Bank’s April 2015 Regular Economic Note, consumer confidence is at its lowest level since March 2009, when the global economy was in the throes of the financial crisis. While major spending decisions by households and corporates are being put off until after the elections, the World Bank’s 3% GDP growth forecast for 2015 assumes that domestic demand will recover shortly thereafter.

Courting Confidence

In the short term, Moody’s outlook downgrade in April 2014, which it reaffirmed most recently in April 2015, is unlikely to have a dramatic impact. However, if Turkey were downgraded further, losing its investment grade status, the country could witness more serious capital outflows. According to Moody’s, while the country’s sovereign rating is unlikely to see any improvements in the near term, a move backwards in terms of public finances, heightened political instability or a deterioration in its external finances are all possible alert signals for a ratings downgrade.

Fortunately, the government has had few problems with its external financing needs. In April 2015 Turkey issued a $1.5bn dollar-denominated bond with a yield of 4.4% – some 250 basis points over comparable US Treasury bills, according to the Turkish Treasury. Combined with another $1.5bn issue in January, this sale marks $3bn out of the $4.5bn in planned issues for 2015. Oversubscribed by five times, the April sale signals continued interest in the country’s sovereign debt from international investors. Indeed, just 15% of the bonds were sold to domestic investors.

Measured Progress

Further improvements to Turkey’s external position could be in the offing. As of February 2015 the CAD was down by nearly 9% from $46.9bn in September 2014 to $42.8bn, driven by a $3.1bn drop in the energy deficit and a $2.1bn adjustment on higher gold exports. This represents a drop from 5.8% of GDP to 5.4% over the period.

Looking ahead, the depreciation of the lira should also have a positive impact on exports and the current account. Balk ız told OBG, “We do not want the lira to go to 2 [against the dollar] again, because it kills the competitiveness of Turkish exports. We see the effect of exports increasing. As developed countries show better performances, this is good for us. Also, it will be positive for the CAD.” Indeed, most predictions are for a further contraction of the CAD in 2015. According to the World Bank, weak oil prices could help cut it to 4.4% of GDP, which should help to reduce the country’s external financing burden from $220bn in 2014 to $200bn in 2015.

Outlook

While a reduction in external vulnerabilities is welcome in the short term, it belies persistent structural concerns. As it stands, the country remains reliant on domestic demand and a large CAD to reach its growth targets, generate sufficient employment or boost per capita income. In the long run, the country needs to address supply-side reforms such as labour market regulations and education.

While Turkey has recorded impressive growth in the past decade, it may have reached its limit without substantial structural overhauls of the economy. If the country can overcome the current investor uncertainty and improve productivity through much-needed reforms, the ambitious growth targets set by the government could eventually be reached.