ISTANBUL BLOG: Better than expected Turkish growth raises concerns

ISTANBUL BLOG: Better than expected Turkish growth raises concerns
President Erdogan's government hopes to use mega infrastructure projects similar in scale to the Eurasia Tunnel – opened to traffic crossing the Bosphorous strait late last year – to give the economy a further boost.
By bne IntelliNews June 19, 2017

Turkey is accelerating away from the economic contraction it experienced in the third quarter of last year, but some analysts are sceptical that the growth trajectory has legs.

“Even the current growth boom, mostly driven by government spending and consumer expenditure, is not sustainable,” says Atilla Yesilada, an adviser at GlobalSource Partners.  “The treasury has already jacked up its net borrowing ratio over 100%, while consumer and corporate leverage is increasing alarmingly. Deposit rates have shot above 15%, rendering credit very expensive. The Turkish growth spurt will peter out at the latest by Q4 2017.”

The official GDP expansion of 5% y/y in Q1, which was also driven by net exports, represented the best performance since the second quarter of 2016’s 5.3% y/y and followed Q4 2016’s rebound of 3.5%. It has fuelled hopes that the country’s $857bn economy may be on the growth path again, having faltered following last summer’s attempt at overthrowing the government.

Thebetter-than-expected GDP data has been hailed by ministers as a sign of investors’ retained confidence in the economy and as an indication that the stimulus programme introduced following the failed coup is working.

The growth comes as a boost for President Recep Tayyip Erdogan, who on April 16 officially narrowly won the crucial referendum on expanding his powers under an executive presidency. His next target is a decisive victory in the 2019 general election.

Encouraged by the first-quarter figures, the government appears to believe that Turkey has put the major economic problems which surfaced last autumn behind it and that the strong growth trend will continue.

But analysts such as Yesilada continue to ask whether the government’s spending spree and consumer expenditure, which constituted the backbone of the economic rebound in Q1, will be sustainable in the longer run. They argue that the positive effects of the stimulus programme will eventually fade away, probably in the final quarter of 2017 or in early 2018.

Spending your way out of trouble

TUIK data on the new growth show that government spending increased by 9.4% y/y in Q1, while household consumption, which accounted for 60% of the country’s national income, was up 5.1% y/y thanks to tax cuts introduced on certain consumer goods, such as white goods.

Exports jumped 10.6% y/y due to stronger demand from Europe and imports edged up 0.8% y/y in the quarter, even though the lira weakened against the major currencies. But, worryingly, gross fixed capital formation increased by only 2.2% despite the Credit Guarantee Fund (CGF) scheme the government introduced in December last year to encourage investments. Machinery investments plunged 10% y/y in the quarter, deepening from the 0.4% y/y and 3.9% y/y contractions registered in Q3 and Q4 last year.

On the supply side, agricultural production rose by 3.2% y/y, while industrial and manufacturing output moved up by 5% y/y and 5.1% y/y, respectively. The construction sector expanded at 3.7% y/y while the services sector registered 5.2% y/y growth across January-March.

Meanwhile, as one of the side effects of the spike in government spending, Turkey’s budget deficit has widened. According to finance ministry data, the central government budget ran a deficit of TRY11.5bn in January-May versus the TRY9.07bn surplus in the same period of last year.

Analysts at the Institute of International Finance (IIF) and Citi are also cautious about growth prospects even though they admit that the country’s economic performance has been much stronger than they anticipated at the beginning of the year.

For instance, Ugras Utku and Yalcin Oney at the IIF argued in a June 12 report that the favourable impact of the CGF and the temporary tax cuts are expected to support the economy until the final quarter of this year. The IFF forecasts that Turkish economic growth will accelerate to 4.2% this year from last year’s 2.9%, but slow to 3.5% in 2018.

JP Morgan expects growth to remain relatively low at around 3% in the second quarter.  The investment bank, however, maintained its growth forecast for 2017 at 3.3% after the data release.

Similarly, Citi thinks that it would be difficult for policymakers to continue to provide “a similar kind of stimulus next year and thereafter without undermining market sentiment”.

According to Citi, the government should also focus on reducing inflation, which is harmful to growth, and “avoid a further increase in the share of construction in the economy”.

The government set up a sovereign wealth fund last year to finance mega infrastructure projects which it believes can fire up the economy. In an interview in April, PM Binali Yildirim vowed to keep pumping money into large construction projects to boost economic growth.

“All in all, while the Q1 GDP outturn is encouraging, a growth rate of about 3.5% per annum can no longer be taken for granted without tackling the noted structural challenges and buttressing macroeconomic stability,” Citi wrote in a report published on June 12.

Flying in the face of sceptical assessments of the economic outlook offered by several analysts, Deputy PM Mehmet Simsek suggested that leading indicators point to stronger economic growth in the second quarter than in the first. Development Minister Lutfi Elvan, meanwhile, sounded more upbeat on the growth outlook, arguing that 2017 GDP growth could exceed the 4.4% target.

Global risk appetite

According to Yesilada at GlobalSource Partners, global risk appetite is the biggest driver of economic optimism. The IIF expects portfolio inflows to emerging markets to hit a three-year high in 2017.

There has been an overall inflow of $3.06bn into Turkish government debt securities in the year to date while the total equities inflow tops $2.2bn, the central bank reported on June 15.

“The central bank still retains a pro-growth bias but a hawkish statement from the Fed FOMC [Federal Open Market Committee] and the decision by [opposition party] CHP chairman [Kemal] Kilicdaroglu to start a long protest march, which might be one of the factors that have modestly upset the currency market, forced its hand to remain tight,” Yesilada told bneIntellinews.

As universally expected, the central bank on June 15 left its policy rates unchanged.

The national lender kept its one-week repo (8%), overnight lending (9.25%) and borrowing (7.25%) rates on hold. The late liquidity window rate, which has been used by commercial banks for about 90% of recent funding, was maintained at 12.25%.

“The monetary policy is moderately tight but not tight enough to contain inflationary pressures, which are only moderating because of a stale TRY,” according to Yesilada.

“Current inflows are not sufficient to trigger further TRY appreciation, meaning that the central bank will have to keep the effective funding rate at 12% for the foreseeable future.”

The lira gained more than 3% against the dollar between May 18 and June 16.

Turkey’s annual inflation rate edged down to 11.72% in May from the near nine-year high of 11.87% recorded for April. The central bank said it believed inflation may have already peaked and will only fall from now on this year. Following its monetary policy committee meeting on June 15, the regulator vowed to keep monetary policy tight until there is a significant improvement in the inflation dynamics.

The central bank also appears to share politicians’ optimism that economic growth will further accelerate due to supportive measures and incentives provided by the government.

The government is encouraging local banks to support economic activity by offering cheaper loans. This is, however, widely seen as putting overt political pressure on the central bank to cut its rates, thus raising questions over whether it can retain its independence.

President Erdogan, who has declared himself “an enemy of interest rates”, on June 17 once again attacked high rates. “We will continue to intervene in interest rates,” he said. Erdogan was probably suggesting by that that he would continue to criticise the central bank’s policies.

“In an environment of high interest rates, investment will stop and no new jobs will be created,” he added.

The government is also anxious about unemployment. It has not fallen significantly despite the GDP expansions observed over two consecutive quarters. The ruling AKP wants to see higher growth and lower jobless rates before the 2019 election. That’s why it is asking the banks to pump more money into the economy through loans.

Nevertheless, as the latest GDP data demonstrated, consumer demand and public spending are functioning as the main drivers of economic growth, not private investment.

“Credit-driven growth booms are not desirable or sustainable, ask China,” observed Yesilada. 

He is also sceptical that growth is as robust as the state statistic agency has recorded. “First of all, there are serious errors in [state statistical institute] TUIK’s data collection and estimation methods which overstate growth. In my book, year-on-year growth is no more than 3.5%,” he told bneIntellinews.

JP Morgan calculates that the strength of domestic demand is such that it reduces the need for monetary easing and supports the case for a more cautious stance. The investment bank expects the central bank to start easing in December, in the absence of political pressure for lower rates.

According to Yesilada, the Turkish government and regulators need to be mindful of 2018, a year when the Fed is to initiate its balance sheet tapering, while the European Central Bank possibly ends bond purchases. These moves would significantly tighten global financial conditions.

But, Bulent Gedikli, one of Erdogan’s aides, disagrees with this caution. “Europe is awash with money. Foreign capital will keep flowing into Turkey, because for those funds there is nowhere else to go,” Gedikli told Aksam newspaper on June 14.

Political winds

The year to date has been difficult for Turkey. Ankara’s relations with the US are strained over Washington’s support for the Syrian Kurdish YPG militia and the arrest warrants lately issued for some of Erdogan’s security guards following the brawl that erupted outside the Turkish ambassador's residence last month during the Turkish president’s visit to Washington.

Moreover, the government is now deeply involved in the diplomatic crisis that has blown up between Qatar and several Gulf Cooperation Council (GCC) member states, led by Saudi Arabia and also supported by countries including Egypt. Another difficulty is that the Iraqi Kurds are preparing to hold a referendum on independence later this year, a move that could trigger tensions and hostilities across the region.

It is difficult to predict how all these conflicts will unfold and whether they will affect the Turkish economy. Investors fear that so many domestic tensions and geopolitical risks may distract the government from the urgent structural reforms which are required to address deep-rooted problems such as labour market rigidities and the current account deficit, and put the economy on a sustainable growth path.

Erdogan on June 17 shrugged off concerns over the heavy influence of domestic consumption in securing economic growth. “Strong domestic demand is only an indication of people’s trust in the country and its economy. All indicators point to a swift recovery”, he said. Declaring that “the worst is over for the economy”, Erdogan called on the rating agencies to upgrade Turkey’s credit ratings in light of the latest GDP data.