Patrick Wrigley in Istanbul -
In early December, in front of an annual gathering of young entrepreneurs and the US Vice President Joe Biden, Turkey's deputy prime minister for the economy, Ali Babacan, began lecturing the EU on its increasingly perilous debt crisis. "If they had a strong government like we have in Turkey, they would be able to solve their problems," he said.
Little more than a week later, at the World Policy Conference in Vienna, Turkish President Abdullah Gul also took up the theme. "At a time when euro member states are not able to abide by the criteria that they put for themselves, we are at the stage where we can meet those criteria," he said, adding that: European Union negligence... paved the way to the current difficult economic situation."
Such public utterances are becoming increasingly common among ruling Justice and Development Party (AKP) ministers, tapping into the public mood of schadenfreude at the EU's woes and consumer confidence in the stability and durability of the local economy.
While much of this is politics, reminding the electorate of the AKP's achievements and grandstanding in front of a population that has become increasingly disenchanted with the EU, such comments are not completely without foundation. Turkey's economy is expected to grow by 8% in 2011, according to the central bank, well above the estimated EU rate of 1.6% and, in all likelihood, second globally only to China. Furthermore, as Gul suggested, Turkey's fiscal housekeeping puts many within the Eurozone to shame. Turkey's budget deficit is currently at 2.5% of GDP, according to Gul, within the EU benchmark of 3% and significantly below countries such as Greece (10%) and Portugal. The AKP's nine-year stewardship of the Turkish economy has also brought public debt/GDP down from 74% in 2002 to 42% in 2010, significantly below EU countries such as Greece (143%), Italy (119%) and Portugal (93%).
Yet despite such achievements, the current indulgence in hubris could yet come back to haunt the government. Turkey's stellar growth has come at the cost of significant pressure on the country's balance of payments, with the current account deficit growing from 2.28% of GDP at the end of 2009 to an expected level of approximately 10% (approximately $79bn) at the end of 2011. This has been fuelled by rising energy imports, consumer spending and a dependence on intermediate imports to fuel production. The widening current account deficit and an overheating economy has also had a significant impact on the lira (which has lost nearly 20% of its value against the dollar in the first 11 months of this year) and seen inflation threaten to move back into double digits, with the expectation that it will end this year at 10%.
There is, thus, growing concern for the coming year.
Don't bank on it
With Europe experiencing its own difficulties, there is the likelihood of a sharp decrease in the external funds that finance the current account deficit. Although foreign direct investment (FDI) and long-term corporate borrowing has been increasing as a share of capital inflows, it still only accounted for 23.3% of the total on a yearly basis in October, suggesting that Turkey is unhealthily reliant on short-term debt.
The banking sector is likely to bear the brunt of this. According to Murat Ucer, a former advisor to the minister of the economy and the governor of the central bank, and currently advisor for GlobalSource Partners, "Regardless of how well the EU is fixed, the EU banking sector is going to have some damage from this, so there will be some restraint in credit facilities and Turkey's very much reliant on European banks. This is not just about deleveraging and paying back the [short-term external debt] stock, but we need fresh financing [as well] so this is one of the tricky things about this. It's not just about not losing the [short-term external debt] stock but getting new stock, so we are quite badly exposed to Europe."
Given this exposure and recent central bank measures, which included a rate hike on the overnight rate and an increase in bank reserve requirements, many analysts are revising their forecasts for the banking sector in 2012. The brokerage firm BGC Partners Istanbul is now forecasting 15% loan growth, a flat net interest margin, and fee income growth of 6%, translating into little or no growth in earnings in 2012.
Europe's woes are also likely to impact Turkey's export sector, imperiling further the current account balance. At the beginning of December, the minister of economy announced that Turkish exports reached $134bn for the last 12 months, the highest level since the foundation of the republic in 1923. However, given that the EU accounted for 46.3% of the country's exports in 2010, 2012 could be a much tougher year. "It wouldn't be surprising to see export growth year on year going down to high single digits," says Ucer. "We need considerably higher rates than this because of the current account deficit. Exports should be growing at least at 20% and imports should be coming down to 5-10%, then you can actually shrink the thing."
Pressure on the balance of payments is, therefore, likely to determine the outlook for 2012. There is general consensus that growth will slow significantly, but the more divisive question is whether Turkey can manufacture a soft landing. While the central bank is predicting GDP growth of 4%, a reduction in the current account deficit to 8% and a cooling of inflation to 5% in 2012, most international analysts are less positive. The most recent IMF Article IV consultation on Turkey released in early December, predicts GDP growth of just 2% for the year, with the current account deficit coming down to 8% of GDP and inflation to 6.5%. Goldman Sachs predicts that Turkey will experience a technical recession in late 2011 and early 2012, with 0.5% growth for the full calendar year.
Such pessimism is largely driven by the government's unorthodox and loose approach to monetary and fiscal policy. In terms of the former, Erdem Basci, the central bank governor appointed in April, has adopted an unorthodox monetary policy including cutting the benchmark one-week repo rate to an historic low of 5.75% in August, while more than doubling the overnight rate at which the central bank lends to banks to as high as 12.5% in October.
This interest rate corridor seems to have done little so far to slow growth, with third-quarter GDP growing at 8.2%, and the central bank shows little sign of amending its policy. Furthermore, according to Ucer, the policy is likely to have a detrimental impact on the markets. "If you want to price the yield curve, you want to know where you're heading. With the interest rate corridor you basically don't. What the central bank is remarkably missing is that their flexibility is the market's uncertainty," he says.
This has already had a visible impact on the benchmark bond yield, which now hovers around the 10.5% mark up from 9.62% in October before the central bank introduced its new policy. BGC Partners Istanbul has suggested that the yield could increase further, touching 12% in the next couple of months on the back of rising inflation, tighter lira liquidity and global deleveraging.
Continued instability in Europe and Turkey's current account position could well also dull investor appetite for Turkish equities. In 2011, there were significant sell-offs in Turkish equities in July, October and November, with the Istanbul Stock Exchange National 100 Index down 18.6% in the 12 months to December 2011.
On the fiscal side, the government also faces several challenges. The IMF Article IV note points out that the Fund's directors "emphasized in particular the need to restrain current spending, expand the tax base to ensure sustainable revenues, and strengthen the oversight of public-private partnerships." As such, the government will have to deal with the politically unpalatable prospect of cutting spending. Primary expenditures have increased from below 18% to 22% of GDP in the three years to the end of 2010, partially driven by transfers for social security and local government. These expenditures show little sign of slowing down with a year-on-year increase of 10.9% in the first half of 2011.
In the longer term, the government will need to address deficiencies in the tax system, broadening its base and improving revenues from income tax. It will also need to look at the structural problems in the current account deficit, including a high dependence on energy imports as well as a dependence on intermediate imports for production.
This suggests there are significant dangers ahead for the Turkish economy. While Ucer is largely behind the IMF prediction of 2% growth next year, he doesn't rule out a bleaker scenario. "We're going to continue looking good as long as revenues keep flowing, but we're going to look like the emperor with no clothes if revenues stop because primary expenditures are still growing, reasonably in line with nominal GDP... There is a distinct possibility of recession."
The 'R' word is not something the government has been contemplating. While it is far from a certainty, the confidence displayed by the likes of Gul and Babacan seems to be somewhat out of kilter with the prospects for 2012. Whether Turkey sinks into recession or not, 2012 is likely to be a much more somber year and the ruling AKP could face a rare test of its economic management credentials.
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