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Is Turkey really out of the woods?

The essential

After having narrowly escaped a balance of payments crisis last spring, there are questions surrounding the Turkish economy, not to mention the many (geo)political tensions.

Throughout this period, the currency has continued to experience strong downward pressures, leading to a surge in inflation. Recently, the markets seem to be recovering hope.

On some fronts, the news flow has improved. Inflation has fallen, the current account deficit has come down, FX reserves have stabilised and the bottom line is that the central bank kept its rates unchanged at its last monetary policy committee held on 16 January, calling into question possible doubts about its independence.

In addition, geopolitical risks, especially relations with the United States, seem to be easing.

However, for all that, is Turkey really out of the woods?

 

 

 

Flag-UK

 January 2019

 

 

 

 

Flag-FR

Janvier 2019

 

 

 

 

After having narrowly escaped a balance of payments crisis last spring, there are questions surrounding the Turkish economy, not to mention the many (geo)political tensions. Throughout this period, the currency has continued to experience strong downward pressures, leading to a surge in inflation. Recently, markets seem to be recovering hope. On some fronts, the news flow has improved. Inflation has fallen, the current account deficit has come down, FX reserves have stabilised, and the bottom line is that the central bank kept its rates unchanged at its last monetary policy committee held on 16 January, calling into question possible doubts about its independence. In addition, geopolitical risks, especially relations with the United States, seem to be easing. However, some risks, including the activity slowdown, the likely fiscal slippage and the existing uncertainties linked to Erdogan’s personality, are still there.

 

 

 

Inflation has diminished and monetary policy has kept a hawkish bias

- From a peak of 25.2% yoy in October, headline inflation fell to 20.3% in December.

Many factors are behind this decline, among which the massive tightening cycle adopted by the Central Bank of the Republic of Turkey (CBRT) that increased its rate by 1600 bp between May and September, i.e. from 8% to 24% (see chart 1). The implementation of a series of administrative price and tax cuts, the weakness of the economy, the rebound of the Turkish lira and the sharp fall in oil prices observed during the last quarter of 2018 have also played a key role.

The Government has announced that it will extend the tax cuts until the end of Q1 and the economy is continuing to contract. However, the recent increase observed in oil prices and the risks on the Turkish lira, related to geopolitical noise and policy mix uncertainty, would at least in the short-term limit a sharp decrease in inflation. Indeed, annual inflation should start to rise again and reach another peak in April of 22%. Inflation is here to stay for a while as reflected by inflation expectations that are still very high, at around 20% at the end of Q2 and 15% at the end of Q4. Considering the inflation outlook, we expect the CBRT to remain prudent and on hold until the end of Q2.

 

 

Improvements in inflation and
monetary policy may not be here
for long.

- The monetary policy committee remained cautious in its forward guidance

As expected, at its last monetary committee held on 16 January, the CBRT maintained its various policy rates unchanged and kept a very cautious forward guidance. In particular, the CBRT stated again that “if needed, further monetary tightening will be delivered”. It gave some hope to analysts and markets concerning the CBRT’s independence and decreased the probability of a premature rate cut at its next meeting on 6 March before local elections at the end of the month. We also think that Erdogan may have learnt from his experience last spring. He may have realised that he cannot manage without external funding and that depends on the monetary policy credibility. We expect him to use other measures to support the economy. However, regarding the uncertainty in Erdogan’s behaviour, we think that vigilance should prevail. We cannot totally count out pressure coming from him to cut rates before the local elections.

 

Current account turned positive and portfolio inflows have increased

- Current account turned positive in August

As expected, the current account deficit has narrowed hugely. On a monthly basis, the current account deficit has turned into a surplus since August (see chart 2). Lower oil prices and the sharp drop in imports have been the main drivers of this trend. The oil price outlook will remain a key factor in the current account trend in light of its impact on the country’s imports bill. If the current rebound in oil prices persists, it will have negative effects on the Turkish current account unless the Turkish lira appreciates sufficiently to offset them. Moreover, we do not expect the external environment to be supportive in Q1. We forecast a slowdown in global growth at the start of 2019 and a stabilisation after, so growth in Turkish exports may slow. It is also very important to note that the current account was still in surplus in November but lower than in October and that it may already have turned negative again.

- Portfolio inflows are positive and the fall in FX reserves seems to have paused

Portfolio inflows returned to positive in October. The CBRT’s decision to maintain the status quo at its last committee meeting held on 16 January will be helpful in  supporting portfolio inflows. In the absence of (geo) political noise and considering the lag in current account data released, we expect portfolio inflows to rise further over the coming months, at least until the next CBRT meeting on 6 March.

2019.02.01--Is-Turkey-really-out-of-the-woods-Fig.1

 

FX reserves have steadily decreased since the beginning of 2018 with an acceleration in June due to the provision by the CBRT of FX liquidity to the banking sector but also a sharp fall in banks’ deposits held with the CBRT. Since November, FX reserves have stabilised. Without additional harsh downward pressures on the Turkish lira, there is no reason for FX reserves to decline further.

 

 

Current account turned positive
in Q3 but it may already be back
to negative.

Real GDP growth decelerated abruptly in Q3 and high-frequency data are weak 

- The Q3 GDP figure released at 1.6% yoy, much lower than in Q2

After a robust growth rate in Q2 2018 (5.2% yoy), GDP rose by only 1.6% yoy in Q3. The main driver of growth was the trade sector on the back of a huge fall in imports (-16% yoy) and a rebound in exports (+13.6% yoy). Overall, the contribution of net exports to GDP growth represented 6.7pp.

We have been calling for a recession in Turkey in 2019 since at least September 2018. Q3’s GDP figure gave some support to our view in two ways. First, it shows that growth has substantially decelerated. Second, its composition indicates that the domestic drivers of growth are clearly in difficulty: household consumption decelerated to 1.1% yoy from 6.4% in Q2 and private investment fell by 3.8% yoy. Moreover, while the economic sentiment index, services sector index and retail sales confidence index recovered in December, consumer- and constructionsector confidence indices were still deteriorating. The economic sentiment index, which is global, has certainly improved but it is far below its three-year average. Our forecast of a contraction of the Turkish economy is clearly below consensus (+0.4%) but seems in line with the IMF that mentioned in the last update of the WEO “a large projected contraction in 2019 in Turkey, amid policy tightening and adjustment to more restrictive external financing conditions”.

- High-frequency data point to a sharp deterioration in activity in Q4

Turning to high-frequency data, they show that the deterioration of activity accelerated through Q4 (see chart 3). Car sales dropped by 55% yoy in Q4. Imports  fell by more than 20% yoy. The Manufacturing PMI has been in contraction territory for almost 10 months and hit a low in December at 43. Industrial output and retail sales contracted by 6% yoy in October-November. The manufacturing sector’s capacity utilisation rate shrank to 74% in December (3pp below its three-year average). The unemployment rate increased from 9.5% to 12% in six months. Total credit to domestic borrowers peaked at 35% in August and then declined to 15% yoy. Consumers loans dropped from 20% to less than 5% on the same period.

2019.02.01--Is-Turkey-really-out-of-the-woods-Fig.2

 

There is little support for
a recovery of the economy.

All indicators are calling for a sharp drop in the Turkish economy. Considering both external and internal drivers, we do not see any room for a sound recovery. We already mentioned earlier in the text that the external environment is not favourable. The probability that the contribution of net exports to GDP growth will decline is very high. On the domestic side, tighter financial conditions, high inflation and an increase in the unemployment rate would drag down both consumption and investment. We do not think that the fiscal stimulus would be large enough to offset these negative trends at least before H2 2019.

The evolution of the fiscal
account may be the next source
of concern for markets.

The risk of fiscal slippage has increased

- The most recent data pointed to a higher YTD fiscal deficit in December 2018 than in December 2017.

Public debt that is below 35% of GDP is not a source of concern. However, fiscal slippage and a higher-than-expected fiscal deficit could put pressure on the Turkish lira and limit CBRT’s room for manoeuvre to ease its monetary policy. The Government committed to fiscal consolidation of 1% of GDP for 2019 but we do not believe it will achieve this target. The latest data pointed to a YTD fiscal deficit of TKY 72bn in December 2018 (i.e. +TKY 25 bn compared to December 2017). This deficit is in line with the Government’s target but higher than in 2017 (see chart 4).

Both sides of the balance, revenues and expenditures, are behind the rise in the public deficit. On one hand, revenues have fallen sharply on the back of the negative impact of the tax cuts, the postponement of the energy price adjustments and the deceleration of the economy. On the other hand, expenditures have increased more intensively than during the same period last year due to the implementation of a series of populist measures.

2019.02.01--Is-Turkey-really-out-of-the-woods-Fig.3

 

- On the fiscal side, things may get worse in the run-up to elections

While for the time being things do not appear dramatic, the trends in expenditures and revenues in Q4 2018 and the possibility these negative trends may continue and get worse are worrisome. The Government has already announced the extension of the VAT cuts on durables and vehicles until 1 April and the minimum wage increased by 25% starting from 1 January. The rise in debt servicing costs, due to the depreciation of the Turkish lira and higher borrowing costs will also drag down the fiscal side, in addition to the fact that the risk that Erdogan will announce additional populist measures to reinforce activity before the elections is substantial. In an environment where we expect real growth to decline, we forecast a deficit slightly above 2% of GDP for the end of 2018 and around 3.5% of GDP in 2019.

Is Turkey really out of the woods?

In terms of inflation, monetary policy and balance of payments, compared to three months ago, we can say that things have improved. Nevertheless, we must remain vigilant. Uncertainties are still high and the observed improvements are fragile. In terms of activity and public finances, compared to three months ago, the situation has worsened and the outlook remains very challenging.

Even though the political noise is softening, further downward pressures on the currency that could exacerbate the current economic slowdown cannot be counted out. Uncertainty on the monetary side has decreased but on the fiscal side, the opposite is true. Moreover, even though the banking sector is deleveraging and the capital adequacy ratio has sharply rebounded, some negative news such as a sharp increase in non-performing loan ratios could also weigh on markets’ perception.

When answering the question “is Turkey really out of the woods”, we would be inclined to say no. Concerning the possibility that Erdogan will reach out to the IMF for a rescue package, one has to be prudent here again. First, it is still a rumour. Second, regarding Erdogan’s anti-IMF rhetoric, it seems unrealistic at least until the elections. After the elections, everything will depend on the outcome. If Erdogan loses some ground and his political position is weakened, we may consider the possibility that he will change his communication and ask for an IMF rescue package. But we are not there yet.

2019.02.01--Is-Turkey-really-out-of-the-woods-Fig.4

The trend in fiscal balance may be
the next source of concern for
markets.

HERVE Karine , PhD, Senior Economist
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