Turkey’s public finances are no longer the “pillar of strength” that they once were, Capital Economics has concluded.

 

“The debt-to-GDP ratio will continue to rise and, as investors demand a higher premium to hold Turkish sovereign debt, local currency bond yields will probably drift higher over the coming years,” Jason Tuvey, senior emerging markets economist at the economic research firm said in a June 5 note.

“We warned a couple of years ago that Turkey’s public finances would become a growing source of concern for investors and developments since then have only reinforced our view. Indeed, while President [Recep Tayyip] Erdogan’s government preached fiscal prudence in the New Economy Programme announced after the currency crisis in 2018, this has not materialised in practice,” said Tuvey.

“Admittedly, the headline budget figures show that the primary deficit (that is, excluding interest payments) is still relatively small at 0.6% of GDP. But this is flattered by the government’s tapping of the central bank’s profits which the Treasury records as a revenue, whereas the international convention is to register this as a form of budget financing,” he added.

Financial repression

With scope for meaningful fiscal consolidation limited, the consequences would likely be seen in sovereign debt and local currency bond yields and, while “all of this isn’t going to cause a major headache for policymakers” there were “already signs that they might resort to financial repression in order to keep a lid on borrowing costs”, Tuvey said.

Based on IMF definitions, Turkey’s primary deficit reached 3.3% of GDP in the 12 months to April, compared with a surplus of around 0.5% of GDP in 2015. The deterioration in the budget position is partly attributable to the effects of the recession that followed the August 2018 lira crisis as tax revenues declined and welfare spending increased. The coronavirus (COVID-19) crisis will put further pressure on the public finances.

“But that is by no means the only factor—after all, the IMF estimates that Turkey’s cyclically-adjusted primary balance has deteriorated by 4.5% of GDP since 2015,” observed Tuvey, adding: “The worsening of the budget position can also be pinned on the government’s repeated attempts to satisfy President Erdogan’s demands for faster growth. “Ahead of the numerous elections and referenda in recent years, the government has (unsurprisingly) pumped stimulus into the economy in a bid to boost support among the electorate. Crucially, this stimulus has not been withdrawn once the votes have passed.”

Tax cuts, wage bill

Erdogan gained direct control over the state budget following constitutional amendments that came into effect in 2018 making him executive president at the head of a presidential, rather than parliamentary, republic. Among items he has allowed to weigh on the fiscal balance are a range of temporary tax cuts implemented after the currency crisis that have been left in place and a steady rise in the public sector wage bill, partly reflecting wage indexation amid high inflation, as well as subsidies paid to companies for social security payments.

“Against this backdrop, the debt-to-GDP ratio has started to drift higher and we think that the effects of the current economic slump may push it up from 33% to around 40% by the end of this year,” said Tuvey. “While the debt ratio will still be relatively low, President Erdogan is unlikely to sanction the fiscal consolidation needed to stabilise the debt ratio. If anything, the budget position is likely to deteriorate further. Indeed, if the primary deficit were to widen to 5% of GDP, debt could reach 55% of GDP by 2025.”

An underappreciated risk is the build-up of contingent liabilities faced by the government, according to the Capital Economics report. Most of the liabilities are related to the government’s use of public-private partnerships (PPP), many of which include explicit minimum revenue guarantees as well as debt guarantees issued by the Treasury or other public institutions. In addition, there are aspects of PPP contracts that leave the government exposed to demand and exchange rate risks.

“Detailed information on PPP projects in Turkey is hard to come by, but figures from the World Bank show that total investments under such agreements amounted to $145bn (19% of GDP) by the end of 2019. Almost a third of PPP investment has been geared towards the construction of airports, including the new Istanbul Airport opened last year. Returns on these investments will suffer given the hit to the travel and tourism sectors from the coronavirus crisis, potentially causing contingent liabilities to come due,” Tuvey noted.

In addition, the government has underwritten bank loans using its Credit Guarantee Fund (KGF). The size of the KGF was recently doubled, from Turkish lira (TRY) 25bn ($3.7bn) to TRY50bn (1.3% of GDP) as part of the government’s response to the coronavirus crisis. “Given that there had already been a surge in credit before the coronavirus outbreak took hold, there is a risk that lending under the expanded KGF is of low quality,” Tuvey said.