Kivanc Dundar in Istanbul -
Turkish GDP growth slowed markedly in the third quarter of 2014 amid weak consumption and investment, while exports and government expenditures were the main drivers. It is universally expected that the Central Bank of Turkey (CBT) will cut interest rates next year, as lower oil prices will help Turkey reduce its large current account deficit and inflation. But the prospects of higher US interest rates will haunt emerging markets, including Turkey, putting pressure on local currencies.
The main event of 2015 in Turkish politics will be the general election in June. President Recep Tayyip Erdogan wants to move Turkey to a formal presidential system – a move that would require a decisive election victory by his Justice and Development Party (AKP) to change the constitution. For this ambitious plan to materialise, Erdogan and the AKP will need strong GDP growth, while at the same time keep peace talks with the Kurdish militant group PKK on track at least until the elections. The government continues to keep pressure on opposition groups and promote a religious agenda in social life, which is keeping the country divided and polarised.
The Turkish economy has so far proved resilient to any global shocks, even though it has lost steam recently: the economy has grown on average 4.9% between 2003 and 2013, benefitting from a supportive international environment, and 6% since 2010. Like many economies in the world, it experienced a sharp contraction (4.8%) in 2009 in the midst of the Great Recession, as the International Monetary Fund (IMF) calls it, but the Turkish recovery was quick and strong, with the economy posting GDP growth rates of 9.2% and 8.8% in the following two years. Yet growth slipped again in 2013 to 2.1%. Average inflation has been 7.9% and the current account deficit has averaged at 7.5% of GDP between 2010 and 2013.
When the AKP came to power with a comfortable majority in parliament in 2002 after years of ineffective coalition governments, Turkey finally appeared on the radar screens of international investors, attracting substantial amount of funds, but also creating a fragile environment where cheap credit fuelled domestic demand, boosting growth. Turkey, thus, has become heavily dependent for its growth on foreign capital, which has been mainly in the form of volatile short-term inflows. Foreign direct investment (FDI) has remained low, covering only a fraction of its large current account deficit. Over the years, Turkey’s external imbalances have reached alarming levels, causing concern for investors.
The economy grew at an annualised pace of 2.7% in the first nine months of the year. After a surprisingly fast rate of 4.8% on year in the first quarter, GDP growth slowed to 2.2% in the second, reflecting ongoing geopolitical tensions, and more importantly sluggish demand from Europe, Turkey’s main export market. GDP contracted on a quarterly basis (-0.5% - calendar & seasonally adjusted) for the first time since the first quarter of 2012. And in the third quarter of 2014, GDP growth slowed further to 1.7% on year, sharply below the market forecast of 3%.
Households’ final consumption that accounts for 65% of GDP rose only 0.2% on year in the third quarter of 2014 and increased by a weak 1.3% on year in January-September. Private investments disappointed too; after contracting 3.5% on year in the second quarter, investments came to a virtual halt in the third quarter. Private demand started to decline in the first quarter as a result of monetary tightening and government measures aimed at curbing consumer borrowing.
Exports and public expenditures have been the main drivers behind GDP growth in the first nine months of 2014. Exports grew 8% on year in January-September, while public expenditures rose 6.6%, according to the statistics office TUIK’s latest GDP figures. Net exports’ contribution to GDP growth was 2.5 percentage points in the third quarter, versus private consumption’s paltry 0.1 percentage points. Government final consumption added another 0.6 percentage points to headline GDP growth in the third quarter.
Given the sluggish economic recovery in Europe, domestic demand should be the main driver of growth next year, according to some analysts. “We still look for the demand composition to change in favour of domestic demand in quarters to come, especially with the lagged impact of the loosening the Central Bank delivered in May-July period,” Yatirim Finansman Securities, a local brokerage house, said on December 10 in a research note on the third-quarter GDP data.
The key concern remains as self-induced tightening of financial conditions if the lira loses ground in tandem with the global uncertainties, Yatirim Finansman added.
Deutsche Bank has a similar view on growth dynamics next year. “Domestic demand is set to become the main driver of growth in 2015… private consumption will be supported by the credit impulse turning finally positive,” the bank said in a report in December.
Goldman Sachs said on December 10 that: “As for 2015, we maintain our GDP growth forecast at 4%, underpinned mainly by disinflation, easier domestic financial conditions and a fall in energy prices.”
Public expenditures are likely to increase in the run-up to the June general election, providing further stimulus. But, Deniz Investment, another local brokerage house, has some doubts: “as financing conditions get tougher, it is hard to generate a private sector driven GDP growth in the near future, while looser monetary policy might somewhat help in the first quarter. Yet, this is likely to be short lived as FED’s normalization would lead to further pressure on exchange rates and deteriorate real sector confidence in the second half of next year.”
Risks for 2015 growth: geopolitics and export markets
In 2015 the growth outlook will be overshadowed by geopolitical risks and weak growth in Turkey’s main export markets, ie. Europe, Iraq and Russia, leaving domestic demand and public spending as the only elements supportive of growth.
There are also risks associated with the prospects of higher US interest rates, probably in the second half of the year, that analysts fear could trigger capital outflows from emerging markets, and possibly result in a sell-off of Turkish assets. Even just the Fed talk of tapering its quantative easing programme (QE) was enough to force the CBR to raise interest rates in January, but later it loosened policy, delivering a cumulative 175 basis points of cuts from May.
The CBR, under pressure from politicians, will probably have to lower interest rates next year to boost growth, while at the same time struggling to contain downward pressure on the local currency if potential risks from the Fed tapering materialise, a difficult task for policymakers at the CBR.
Turkey’s export markets
The European Commission slashed its forecasts for the Eurozone this year and next, citing waning consumer and business confidence, heightened geopolitical risks, and a deteriorating outlook for the global economy.
The Commission cut its growth forecast for 2014 to 0.8% from a previous 1.2% and reduced it for 2015 to 1.1% from a previous 1.7%. More than 40% of Turkey’s exports go to the EU. Russia, one of Turkey’s largest trading partners, has already lost billions of dollars in revenues as a result of the declining oil prices. The Russian economy, struggling also with the sanctions imposed by the West over Ukraine, is expected to slip into recession next year. This is bad news for Turkish exporters, the Turkish tourism industry in particular and for a number of Turkish construction firms doing business in Russia.
Furthermore Iraq, Turkey’s second largest export market, is fighting a nasty war against Islamic State militants that US Secretary of State John Kerry says could last years, crippling its economy. The civil war in Syria has the potential to engulf and destabilise the entire region. The oil-exporting Gulf states will also suffer from lower oil prices, adding more pressure on Turkish exports. The share of the Middle East in Turkey’s total exports is around 20% and shipments of goods to this region already fell 1% on year in the first ten months of the year.
Overall, foreign demand conditions will be less favourable next year. It is not clear how the adverse and positive effects of the declining oil prices will play out for Turkey, which imports nearly 90% of its energy, paying around $45bn-50bn each year for its energy bill and whose exports correspond to more than 25% of its GDP.
While the Fed ended its stimulus programme this year, the European Central Bank (ECB) is moving in the opposite direction and is expected to inject money into the markets next year through its own asset purchase programme. If extra money created by the ECB finds its way into emerging economies, Turkey, with its investment grade ratings, is likely to be one of the main beneficiaries of the ECB’s stimulus policies. “Turkey should also benefit from the inflow of Russian/Ukrainian/CIS flight capital, and also continued broader EM inflows as investors flock to invest somewhere – away from the CIS,” Tim Ash of Standard Bank commented on December 11.
Turkey’s central bank claims that it has a rich set of policy tools to use against an earlier-than-expected policy rate hike by the Fed. The overall impact of the global liquidity conditions next year on the Turkish economy is rather mixed and difficult to assess from today.
However, it is the general conviction that Turkey will post rather mediocre growth rates over the next two years. The IMF expects the Turkish economy to expand by 3% in 2015 and another 3% in 2016, while the OECD forecasts 3.0% and 3.2% growth rates, respectively. The government’s projections are more optimistic – 4% for 2015 and 5% 2016. But there is a bright spot here; each $10 drop in the oil price will boost Turkish GDP growth by 20bp to 30bp.
Energy costs and current account deficit
The current account (CA) deficit has been the Turkish economy’s Achilles’ heel, financed mainly through volatile short-term capital inflows, leaving the country vulnerable to sudden shifts in international investor sentiment. The CA deficit, as large as 7.9% of GDP last year, is expected to shrink, but remain above 5% of national income this year, next and in 2016. The slower growth will help Turkey reduce its CA deficit, so will the declining oil prices. The price of Brent crude oil slid more than 40% since June, hitting a five-year low of $67 a barrel in the first half of December. It is calculated that every $10 drop in the oil price reduces Turkey’s current account deficit by $4.5bn. This is a significant figure for a country that spends $45bn-50bn each year on energy imports. Reflecting the effects of oil deflation, the CA shortfall narrowed 37% on year to $33.1bn in the first nine months of the year.
“The deficit countries, who were at risk because of shrinking dollar liquidity and higher rates, are now becoming the Lucky Five,” Turker Hamzaoglu, an economist at Merrill Lynch, was quoted by Bloomberg as saying on December 9.
Morgan Stanley coined the term “Fragile Five” last year for the economies (Turkey, South Africa, India, Indonesia and Brazil) with large CA deficits and a heavy reliance on foreign investment, which make them vulnerable to sudden reversal of capital flows.
Turkey’s CA shortfall could even fall below 4% of GDP next year if the price of oil averages around $80 per barrel, according to Finance Minister Mehmet Simsek. The country’s large CA deficit has been a key concern for investors, but now with oil prices falling, “Turkey would move back onto investors’ radar,” Simsek told Bloomberg on December 3.
Inflation and interest rates
Inflation has been a major bugbear this year, but there is optimism among analysts and policymakers. The decline in oil prices will definitely help the country reduce its stubbornly high inflation, currently hovering around double digits. Each $10 drop in the oil price shaves 40 basis points from headline inflation, according to Finance Minister Simsek.
Lower oil prices may be good news for Turkey, but there is another commodity giving the central bank a headache – food. Food inflation was 0.24% m/m in November, adding 0.4pp to headline CPI inflation. The annual food inflation was 14.37% in November versus 9.15% headline CPI inflation. The CBT blames supply problems, ie. drought, for food inflation, but believes food prices will fall significantly in 2015 even though it does not say how. The CBT has not reached a conclusion whether the sharp drop in agricultural output (4.9% on year in the third quarter and 3% in January-September) reflects a structural problem or is a temporary occurrence related to severe weather conditions this year.
In any case, inflation is expected to decline next year, mainly due to the base effect and favourable energy prices. The IMF reckons it will fall to 7.1% in 2015 from 9.0% in 2014, and further to 6.2% in 2016. The government forecasts annual inflation to be 9.4% at the end of this year, but its 2015 and 2016 projections are more optimistic – 6.3%, and 5%, respectively.
Because of the favourable mix of lower inflation and the ongoing external rebalancing resulting from favourable energy prices, the central bank will probably see some room for cutting interest rates. Many analysts expect a gradual easing. Investment bank Goldman Sachs, for example, believes the main rate will come down to 7.0% from the current 8.25%, while Deutsche Bank thinks there is only modest (75bp) and temporary scope to lower the one-week repo rate in the first half of 2015.
According to Goldman Sachs, its current forecasts (ie. somewhat late and gradual Fed rate hikes and formal QE from the ECB) suggest that Turkey’s central bank could find a window of opportunity to ease policy rates early next year, possibly sometime in late first quarter or early second.
JP Morgan said in a report on December 12 that, “it expects a cumulative 75bp in cuts (most probably a 50bp cut in February and a 25bp cut in March) in 1Q in the light of improving inflationary expectations and greater narrowing of the current-account balance. The exact magnitude of the cuts would depend on the global financial markets and especially on the magnitude of the worries over the start of Fed tapering.”
Local brokerage Deniz Yatirim, on the other hand, anticipates a 75bp cut in the first quarter, but expects the central bank to reverse its monetary policy stance by the fourth and increase the policy rate by 100bp to 8.5% by the end of next year. Odeabank’s chief economist, Inanc Sozer, told Reuters on December 10 that he expects the central bank to deliver a rate cut as early as December or in the first months of 2015, given the sluggish economy activity. Sozer anticipates at least a 100bp cut in the first half of next year. Similarly, Is Invest economist Muammer Komurcu believes the central bank is preparing itself for a rate cut in the first half of 2015.
A timely reaction by the central bank will be crucial in an uncertain and volatile global environment, because the pressure on the local currency will not disappear anytime soon. The central bank has been sending out the message that tight monetary policies will be maintained until it sees a significant improvement in its inflation outlook. But as the June parliamentary election approaches, the government could step up pressure on the bank for more aggressive rate cuts, which would undermine its credibility.
Investors will watch closely how the local currency, the lira, reacts as the Fed’s decisions continue to haunt emerging markets across the board.
On December 12, the lira hit 2.31 against the dollar, its weakest level since January ahead of the Fed meeting. “Lira suffered a bit of classic EM contagion, from big moves in oil, Russia, etc,” Tim Ash from Standard Chartered commented on the decline of the lira. “We are feeling decidedly nervous about the outlook for Emerging Markets in 2015, which in many respects feels similar to 1997-1998 in terms of the headwinds facing Emerging Markets… Risk aversion leaves the lira vulnerable to a reversal of short-term capital flows.”
Bernd Berg, an emerging-markets strategist at Societe Generale, was quoted by Bloomberg as saying on December 12 that he sees further pressure on the lira in the first half of 2015 ahead of an expected rate hike by the Fed. But JP Morgan argues that lower oil prices and the resulting fall in inflation will likely lead to an improvement in inflation expectations, while the sharp improvement in external balances and the start of quantitative easing by the ECB (sovereign QE expected in January) suggest that the pressure on the lira will be less than it initially expected.
On December 15, the lira, however, lost more of its value against the dollar, after President Erdogan lashed out at the EU for the bloc’s criticism of police raids on some media outlets and signalled more crackdowns could follow.
Following the elevation of Erdogan to the presidency in August in the country’s first direct presidential elections, some analysts had expected calm to return to the political arena, but they have been proved wrong. Erdogan has remained as polarizing and divisive as ever – which sets the scene for a hard-fought and bitter campaign for the general election in June.
The presidency in Turkey has been largely a ceremonial role with limited powers, but Erdogan has changed that; he appears on TV channels regularly, making comments on domestic and international issues, economic affairs, showing that he is the real boss, calling all the shots. It looks like executive powers are shifting, if not formally but de facto, from the government to Erdogan. The fFormer minister of transport, Binali Yildirim, said on December 11 that Erdogan would begin chairing cabinet meetings next year. According to article 104 of the constitution, the president can preside over the cabinet or call the cabinet to meet under his/her chairpersonship whenever he/she deems it necessary. During the presidential election campaign last summer, Erdogan said that if elected, he would use all the powers at his disposal given by the constitution, but would not snatch away the PM’s powers.
Erdogan wants to move Turkey to a formal presidential system after the June elections. But for this to happen, the ruling AKP needs a decisive victory in the parliamentary elections.
The AKP is still the strongest party and Erdogan is the most popular politician, yet it remains to be seen whether this combination will be enough this time to give the AKP the majority it craves in the next parliament to change the constitution. Erdogan will play all the cards he has in his hands to consolidate his supporter base, just as he did in the run-up to the presidential elections in 2015. His tactics, which has worked well with the AKP’s conservative base so far, involves making highly controversial statements, such as promoting teaching the Ottoman language at high schools or mandatory religious classes at elementary schools. He consolidates his support base by polarising the society.
Yet in another sign of Erdogan’s rising authoritarianism, on December 14 Turkish policed raided media outlets close to Erdogan’s foe, Fethullah Gulen. More than 20 people were arrested, including the editor-in-chief of Zaman newspaper, an executive of Samanyolu TV, and ex-police chiefs. Arrest warrants were issued on charges of founding and directing an armed terror organization, being a member of this organization, and engaging in forgery and slander, Hurriyet Daily News reported.
The West expressed concern over the crackdown on Gulen-affiliated media. The EU's foreign policy chief, Federica Mogherini, said the police raids and arrests of a number of journalists and media representatives in Turkey are incompatible with the freedom of the press, which is a core principle of democracy. The US State Department’s spokesperson, Jen Psaki, said: “As Turkey’s friend and ally, the US urges the Turkish authorities to ensure their actions do not violate these core values and Turkey's own democratic foundations.”
Murat Yetkin, a prominent political analyst, wrote: “By claiming that the Gulenists, the CHP and the HDP are working hand in hand, [Prime Minister Ahmet] Davutoglu aims to consolidate his power base against a combined enemy, though it is getting harder for him to convince people both inside and outside Turkey that such a combination exists. That is why the latest move against the media is likely to complicate Turkish politics even further.”
The country remains polarised and tense. Yet any repetition of the June 2013 massive street protests looks unlikely: the opposition in parliament is fractured and ineffective, their leaders lack Erdogan’s charisma. Extra-parliamentary groups, ie. radical leftists, have not been able to organise mass protests on the scale of last year.
According to a public opinion poll, conducted by pollster SONAR in November, public support for the AKP dropped to 37.2%, below 40% for the first time in years. 27% of the respondents said they would vote for the secularist CHP and the nationalist MHP garnered a 17.1%. SONAR estimated public support for the main Kurdish party HDP at 6.7%. A vote below 40% would be a blow to the AKP, but it will still have a majority in parliament to form a government, though short of being able to change the constitution. Erdogan needs to broaden his supporter base if the AKP is really losing ground as the SONAR survey suggests. His likely target will be the nationalists, to whom he can appeal by sharpening his nationalist rhetoric – but only at the expense of alienating the Kurdish population.
Peace talks with Kurds
The violent street protests in October in Turkey’s Kurdish cities that left 40 people dead forced the government to revive the stalled peace talks with the militant PKK.
Thousands of people took to the streets to protest the government’s reluctance to help the Syrian Kurds fighting Islamic State militants in the town of Kobani, just a stone’s throw away from the Turkish border. The October protests showed not only that Kurds are running out of patience, but also the PKK’s jailed leader Abdullah Ocalan’s continued unquestioned authority among the Kurds. At the height of the protests, PM Davutoglu reportedly asked Ocalan to intervene; Ocalan told protesters to go home and the violence stopped immediately.
A settlement to end Turkey's decades-long Kurdish conflict could be reached within months if the government takes legislative steps, said Ocalan in December. Ocalan asked for legal guarantees for the peace process, otherwise he said the whole process would fail. Reportedly, Ocalan and state officials agreed to a detailed framework, drawn up by the PKK leader, but it has not been disclosed to the public yet. For his part, PM Davutoglu promised steps towards a peace deal by the June 2015 elections.
The Radikal newspaper reported on December 10 that the PKK’s senior field commanders in northern Iraq fully back Ocalan’s framework. The PKK will force a solution by the elections and Erdogan will need to strike a delicate balance between his Kurdish supporters and nationalists amongst the AKP support base.
Turmoil in Syria/Islamic State
While the turmoil in neighbouring Syria and Iraq risks spilling over into Turkey, Ankara has failed to reach an agreement with the US and EU on the conditions that would secure Turkey’s more active role in the fight against Islamic State.
There is a consensus between Turkey and the US on equipping and training moderate Syrian rebels, but Erdogan is strongly pushing for a no-fly zone and safe zone inside Syria. Erdogan believes the US-led coalition should also target Syrian President Bashar al-Assad. White House spokesman Josh Earnest told reporters in early December that Washington is open to discussing a range of options with Turkey, but that a no-fly zone over Syria is not on the table at this point.
UK Prime Minister David Cameron and EU foreign policy chief Mogherini visited Turkey in mid-December to discuss a common stance on Islamic State. Cameron’s visit focused mainly on preventing foreign jihadists from moving in and out of Iraq and Syria through Turkey. Cameron said the UK and Turkey were working hand in glove to prevent British jihadists returning home after fighting in Iraq and Syria. But Mogherini was more critical towards Ankara. The EU and Turkey have drifted apart on foreign policy and need greater alignment to tackle threats including Islamic State, Mogherini said.
Differences between Turkey and the West are obvious. The question is whether these differences will morph into something deeper and how Ankara will manage that situation.
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