The Turkish government has launched a bold stimulus programme aimed at lifting the economy out of its slump ahead of coming elections, but at what long-term cost to the nation’s finances? Tom Stevenson reports.

Turkey notes

The failed coup in Turkey in July 2016, which almost succeeded in ousting president Recep Tayyip Erdoğan’s government, left a harsh legacy on both the country’s politics and its economy. With a state of emergency in place, the government has doubled down on its strict security policies and Turkey as a whole remains shaken.

The coup attempt and Mr Erdoğan’s subsequent purges of the civil service, security services, media and business world caused the country's economy to contract in the third quarter of 2016 for first time since the global financial crisis.

By the end of 2016, unemployment had risen to 13%, and inflation hit a nine-year high in mid-2017. The Turkish lira has depreciated rapidly, the tourism sector has experienced a catastrophic decline, and foreign direct investment levels fell by 31% in 2016 alone. The big three rating agencies have all cut Turkish debt to junk status.

Surprise recovery

Yet despite 2016’s turmoil, Turkey’s economy is now showing surprising but undeniable signs of recovery. It grew by 5% in the first quarter of 2017, albeit from a low base, and Mr Erdoğan’s economic advisers are predicting gross domestic product (GDP) growth will total 4.5% for 2017 as a whole.

The stock market (at least according to its main index, the Istanbul 100) has undergone nothing short of a boom, with the index ascending to a value of 100,000 points for the first time in June. And while long-expected US Federal Reserve monetary policy tightening through 2018 may reduce global demand for emerging market assets, the Turkish lira’s depreciation has made stocks and bonds attractive compared with other emerging market financial assets.

During 2016, the Turkish economy may have gone down a volatile path but this year things appear to be getting back on track – and the reason is government intervention, according to Çağlan Mursaloğlu, deputy chief executive of İş Yatırım, the investment arm of Turkey’s İş Bank. “Rising terrorist activities and geopolitical risks, falling tourism revenues, the failed coup attempt and rating downgrades all weighed on markets, but we have seen a strong recovery in economic activity thanks to the stimulus packages,” she says.

Stimulus packages

In looking to address the crisis, the Turkish authorities moved to expand the Treasury’s credit guarantee fund under which it covers 7% of the loans extended by banks. In August 2016, they created a $200m sovereign wealth fund. As a result, Turkey is currently in the throes of a credit boom. According to some estimates, in total the government has precipitated a rush of as much as $50bn-worth of Turkish lira-denominated loans to almost 300,000 local businesses.

The government’s expansionary fiscal policies, along with the expectation of export growth, mean analysts are now forecasting a favourable macroeconomic outlook for 2017. A more active fiscal policy is, however, having an impact on the budget, with the deficit expected to widen over the remainder of the year to about 2% of GDP.

The impact of a growing deficit on the economy is still modest at this stage, says Ms Mursaloğlu. “The good news is Turkey’s public indebtedness is still well below that of its peers and the widening of the deficit is manageable. We do not expect any fat-tail risk from the budget dynamics,” she adds.

The government’s stimulus programme has been particularly beneficial for the country’s major banks, which suffered in the second-half slump of 2016. “Banks were the major laggards when Turkey underperformed its emerging peers last year,” says Ms Mursaloğlu. This year, the expansion to the government’s credit guarantee fund and a relaxation of capital adequacy ratio regulations boosted loan growth.

According to Ms Mursaloğlu, the risk of long-lasting negative impacts on the Turkish economy due to political upheavals has reduced, and markets have begun to recover, after the government won a hard-fought victory in a constitutional referendum in April referendum. “In our base-case scenario we expect the continuation of strong growth in the next couple years, which will be supported by expansionary fiscal policies,” she says. “Further measures might be on the cards depending on the pace of economic activity.”

Borrow and spend

Turkey has long depended on borrowing to fuel growth, and while faith in fiscal policy as a central tool of economic transformation currently appears to be paying off, there are lingering doubts as to how sustainable the project might be.

The government has borrowed so much in 2017 that it not only broke the budget deficit record in the first half of the year, but is already closing in on its legal borrowing limit. Now the cabinet is planning to change the law in order to allow it to raise the amount of debt the state can take on. “The borrowing limit for the current year is set by the budget law as the difference between forecasted total revenues and expenditures. That sets the ceiling for Treasury’s net borrowing,” says Haluk Burumcekci, an independent analyst and founder of Bürümcekçi Research and Consultancy.

Perhaps a bigger concern is what the borrowing is funding. Sceptics of the government’s loan guarantee programme claim the credit rush is merely supporting temporary consumption, rather than productive long-term investment in the real economy.

The impressive growth Turkey has experienced so far in 2017 has come primarily from private consumption and temporary tax cuts, says Ugras Ulku, deputy chief economist at the Institute of International Finance. He is sceptical that the health of the Turkish economy is being well served. 

“Those unsustainable measures to stimulate domestic spending are short-term phenomena that do little to address Turkey’s structural challenges,” says Mr Ulku. “With lagging productivity signalling the limits of macro-policy tinkering, accelerated reforms will be critical to boost Turkey’s potential growth funded by its own domestic savings and to reduce its external fragility.”

The tax cuts are set to be reversed in the final quarter of 2017, with social security premiums also poised to rise. As a result, Mr Ulku believes the government’s growth projections for the year are over-optimistic. “Renewed depreciation pressure on the lira, which is an important factor affecting inflation and financial stability in Turkey, could prompt the central bank to tighten its stance further,” he says. “The resulting higher interest rates to avoid significant depreciation pressures on the lira would weigh on domestic spending and economic activity.”

Mr Ulku says Turkey’s central bank will likely be forced to tighten its monetary stance in line with the expected Federal Reserve rate hikes through 2018. “That should slow real GDP growth to 3.5% in 2018, even though fiscal policy should remain broadly expansionary ahead of the presidential and parliamentary elections in 2019,” he adds.

Gearing up for elections

With near uniformity, analysts agree that in addition to a desire to be seen to have overcome the troubles of 2016, Turkey’s government has its eyes set on polls in 2019 in which Mr Erdogan will stand for re-election.

“The government’s pro-growth economic policy is motivated by a wish to change recent negative economic sentiments and by a desire for higher growth ahead of the coming elections,” says Burak Saltoglu, professor of economics at Istanbul’s Bogazici University. “But there are some side costs to the chosen policies and after 2019 those costs may slow down the economy,” he adds.

While a recovery of sorts is under way, the environment is far from rosy. The government’s purge of opposition groups continues, and $11bn in assets were seized by the state during investigations in 2016. The government has appointed administrators to run more than 900 companies that it believes were linked to the suspected coup plotters.

According to Mr Saltoglu, the experience of Turkish businesses and planners in crisis management, honed in the trying times of the recent past, has enabled the economy to survive the latest shocks. But there are still risks: the most prominent of them being the emergence of an over-leveraged economy after the 2019 elections.

“There are side effects to these financial and political shocks. Internal political conditions are now slightly more predictable, however the Turkish government has had its worst budgetary performance for many years,” he says. “It is never easy to predict global political risk in Turkey.”

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