Turkey's economy grew strongly in the third quarter but the outlook has been clouded by Russian sanctions, which could worsen longstanding weaknesses.

Gross domestic product (GDP) grew by 4% year-on-year in the third quarter, up from 3.8% in the previous quarter, beating the market consensus forecast for a 2.8% expansion. On a seasonal and calendar-adjusted basis, growth was even stronger: output grew 1.3% from the previous quarter and 5.4% on the year.

However, following Turkey’s downing of a Russian bomber near the Syrian border on November 24, Russia has announced a raft of economic measures against Ankara, including restrictions on food imports and a ban on charter flights between the two countries.

This can hit the Turkish economy through the trade channel, and through the tourism channel, which looks even more troubling because tourism revenues are one of the main sources of hard currency helping Turkey finance its current account deficit.

Around 20% of Turkey's food industry exports went to Russia last year, generating $1.1bn in revenue. According to Turkey’s ministry of agriculture, the Russian sanctions could cost Turkish food exporters more than $760mn.

But, ironically the food ban could be beneficial for Turkish consumers as local companies have now turned to domestic markets to sell products that they cannot export to Russia. This may have a positive impact on Turkey’s inflation as the prices of some fresh fruits and vegetables have already started to decline. Consumer prices rose by 0.67% m/m in November, above the market consensus of a 0.46% rise. The annual CPI inflation rate quickened to 8.1% from 7.58% in October.

Consumption the driver

Deputy PM Mehmet Simsek, Turkey’s new economy tsar, says the Russian sanctions could cost Turkey as much as $9bn and shave 0.3%-0.4% off its GDP in a worst case scenario of “zero relations with Russia”.

EBRD economists calculate that persistent sanctions may reduce Turkey’s GDP growth in 2016 by 0.3 - 0.7 percentage points. Capital Economics estimates that the maximum losses from Russian sanctions to the Turkish economy would be around 0.5% of GDP a year.

Despite the ongoing problems and challenges, Turkish officials expect the economy to grow between 3.5% and 4% this year.

Data released by the statistics office TUIK on December 10 showed that the main driver of the better-than-expected GDP growth in the third quarter was consumption.

Households’ final consumption expenditures, which accounted for 64.7% of the country’s national income, increased by 3.4% year-on-year in the quarter, though it slowed from 5.5% in Q2. Household consumption added 2.2 percentage points to GDP growth.

Consumer confidence remained weak throughout the third quarter because of political uncertainties that emerged as a result of the inconclusive elections in June. But, consumer confidence rebounded sharply in November as the ruling Justice and Development Party (AKP) regained the parliamentary majority in a snap poll, ending months of political deadlock.

Government spending remained strong in the third quarter, rising 7.8% y/y, up from 7.2% y/y. This increase could be related to the election-related expenditures ahead of the November poll. Government spending added another 0.8 pp to the growth in Q3. Now with the elections cycle over, government expenditures may moderate in the coming periods.

Private sector investments disappointed. According to data of TUIK, private investments that rose by 11.3% y/y in the second quarter contracted by 0.7% y/y in Q3, subtracting 0.1 pp from the headline growth. This must be related to the pre-election uncertainties.

The contribution of exports, which declined by 0.6% y/y in Q3 versus the 1.9% y/y contraction in Q2, was 0.1 pp to economic growth. But, this still compares favourably with the -0.9 pp contribution of exports to GDP growth in the previous quarter.

The latest data from the Turkish Exporters’ Assembly (TIM) pointed to a continued weakness in export performance. Turkey’s exports plunged 10.5% y/y to $11.4bn in November, while the country’s 10-month exports fell by 8.6% y/y to $132bn.

If Russia extends the scope of its sanctions, Turkey’s losses, including export, tourism, shuttle trade and construction revenues, could amount to as much as $7.3bn in the next 12 months, and the current account deficit/GDP ratio would increase around 0.6-1 pp in 2016, said a report this month by Is Bank’s economic research department.

External rebalancing

The markets are also watching the current account deficit figures closely as the Russian crisis has the potential to worsen the external balance.

The latest data from the central bank for October was rather promising. Turkey posted a current account deficit of $133mn in the month versus $2.3bn deficit a year ago. Though this was the first deficit after surpluses of $180mn in August and $117mn in September, October’s shortfall was still below the market consensus of a deficit of $200mn, thanks to cheaper oil.

The 10-month current account deficit declined by 25% y/y to $25.4bn. The annualised deficit declined to $38.1bn, from $40.3bn in September.

Turkey, which spends around $50bn each year on energy imports, benefits from lower oil prices, which recently fell below $40. Turkey’s energy import bill shrank by 35% y/y to $2.8bn in October, and declined by 30.1% y/y to $32.2bn in the first 10 months of the year.

According to the current account data, the trade deficit shrank by 22% y/y to $39.4bn in January-October, with exports declining by 9% y/y and imports falling 13% y/y.

Net FDI inflows at $9.1bn corresponded to roughly 36% of the current account deficit in January-October. Net tourism revenues already fell by 12% y/y to $19.7bn in the first 10 months of the year.

Turkey has been one of the favourite destinations for Russian tourists. In 2014, 4.5mn Russian tourists visited Turkey, representing a 12% share in total foreign tourist visits to the country, second only to Germany. Even before the crisis, the number of Russian tourists had declined by 19% y/y to 3.5mn in the first 10 months of the year.

The central bank reported a net portfolio outflow of $11.6bn in January-October versus the $16bn inflow a year ago. It is still unclear how the US Federal Reserve’s policy normalisation, expected to begin this month, will affect capital flows to emerging markets.  Turkey, already seen as one of the most vulnerable markets to the move, could now be seen as even riskier because of the crisis in its relations with Russia.

“Downward pressure on the rating would arise from sustained further delays in implementing the structural reforms needed to reduce external imbalances and sustain economic, fiscal and institutional strength; and/or an increase in investor risk aversion which intensifies pressures on the country's external finances, thereby heightening the risk of a sudden and sustained halt in foreign capital flows,” said Moody’s on December 4 when it affirmed Turkey's Baa3 government debt and issuer ratings on December 4. Yet the rating agency maintained a negative outlook.

Revising up

The government targets a GDP growth of 3% for 2015, but in the first nine months, the Turkish economy expanded by 3.4% year-on-year.

Following the surprisingly strong Q3 GDP data, analysts are now busy revising their forecasts. “Based on the higher than expected third quarter realisation and higher foreign demand contribution to GDP, we revise up our end 2015 GDP growth estimate to 3.5% from previously reported 3.0%” said Deniz Invest, a local brokerage firm, in an emailed comment on December 10.

Is Investment has raised its GDP growth estimate for 2015 to 3.2% from a previous 2.8%, Muammer Komurcuoglu, an economist at the brokerage house, told Reuters.

For the final quarter, the assumption is that growth will remain elevated, at around the 4% level, said Tim Ash at Nomura International in a comment. “For the full year an outturn close/just under 4% now seems likely, which would be a significant achievement for the AKP government, after the 2.9% growth posted in 2014, and given the significant factors which buffeted the Turkish economy over the past year, particularly related to the political/security situation”.

Such an outcome would reflect one of Turkey’s underlying credit strengths – the durability and resilience of growth, said Ash.

“The sharp pick-up in Turkish GDP growth in Q3 may help to alleviate some of the political pressure on the central bank to keep policy loose. This reinforces our view that the central bank will raise interest rates at this month’s monetary policy committee meeting,” argued Capital Economics in a note published on December 10.