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WorldApril 30 2015

Turkey keeps calm amid surrounding chaos

While conflict and economic instability rage all around Turkey, the country is providing an oasis of calm, with an economy set to grow by 3% to 4% in 2015, and a young, educated population proving a draw for investors.
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Turkey keeps calm amid surrounding chaos

Turkey is surrounded by countries in turmoil. To the north there is civil war in Ukraine, while international sanctions against Russia, a major trading partner, have badly hit Turkey’s exports. To the east there is armed conflict in Syria and Iraq, with refugees spilling over the border. And to the west, the economic and political woes of Greece continue as it struggles to repay its debts.

The situation in Turkey is stable compared with what is happening around it. But there is still plenty of tension for thrill-seekers, as the momentum builds up to June's general election. Many fear that if the ruling Justice and Development Party (AKP) of president Recep Tayyip Erdoğan and prime minister Ahmet Davutoğlu is returned to power with a big enough majority, it will follow through with its plan to change the constitution and replace the parliamentary system with a more authoritarian presidential system that will further curb civil liberties and antagonise the West.

The good and bad news

Although Turkey’s economy is expected to grow by about 3% in 2015, compared with 2.9% in 2014, that is below the 4.1% expansion of 2013 and much lower than the average of 9% achieved in 2010 and 2011. The country's current account deficit is worryingly high, too, at about 5.8% of gross domestic product (GDP), and is expected to stay at this level throughout 2015 and 2016, despite the government’s attempts to reduce it. Annual inflation is also high, at about 7% to 8%.

That is the difficult news, but what of the good? There is plenty to be positive about. “One of the strengths of Turkey’s economy is its disciplined public sector, especially its public finances,” says Emre Inan, director, research and statistics, at the Banks Association of Turkey. “Another strength is its healthy banking sector, which is able to attract external funding and loans and has experienced management.

“Its biggest weakness is its dependence on foreign funds. The Turkish economy is operating a current account deficit of more than 5% of total GDP. It will probably decrease in 2015. But if the US Federal Reserve increases interest rates, this will negatively affect capital inflows to emerging markets, and Turkey needs foreign financing.”

Mr Inan predicts that inflation will fall from about 8% in April to about 7% by the end of 2015, thus failing to reach the government’s target of 5% by the year end. It is currently higher than expected because of the depreciation of the Turkish lira, and also because of high food prices due to bad weather this winter. But as those price hikes work their way through and raw material prices globally continue to fall, so will inflation.

With Greece as its next-door neighbour, what would happen if Greece defaulted on its loan repayments to the International Monetary Fund (IMF) or the eurozone states? “It wouldn’t affect us,” is Mr Inan’s straight answer. “[Greece is] not an important trade partner for Turkey. Our main trading partners are Germany, Iraq and Russia. There may be a slight contagion effect, but negative developments in our bigger trading partners would have a bigger impact.”

Strong headwinds

The European Bank of Reconstruction and Development (EBRD) forecasts that Turkey’s GDP will grow 3% this year, which is lower than the Central Bank of Turkey’s 4% forecast. “Lower oil prices will help growth in Turkey, but the potential to benefit from lower oil prices is limited because the central bank’s space to cut interest rates is limited by exchange rate pressures,” says Bojan Markovic, the EBRD’s lead regional economist in the country.

“There are some strong headwinds. The continuing weakness of external demand, especially in the eurozone, recession in Russia and geopolitical tensions in the Middle East are constraining Turkish export growth,” adds Mr Markovic. “Also, the euro-dollar developments are not helping, because Turkey’s capital flows depend mostly on dollars yet its trade flows depend mostly on euros. The dollar strengthening against the lira is reducing capital flows into Turkey, but if Turkey tries to defend the lira too much it may strengthen it against the euro, thus weighing on exports to Europe. That’s why we expect still relatively modest GDP growth.

“The current account deficit has fallen but it is still relatively large. Its refinancing is putting pressure on the exchange rate, and thus corporates that are exposed to exchange rate risk.”

On the plus side, says Mr Markovic, public finances are fairly stable, and public debt is low by international standards – at about 35% of GDP. “The banking sector is well capitalised with non-performing loans at about 3%, so there are some buffers that the country can use to stabilise the short-term pressures.”

In the long run, the story looks more positive. “This is a country with tremendous long-term potential to grow,” says Mr Markovic. “Population growth is high. The female participation rate in the economy is low at 30%, so the full potential of women in the workforce has yet to be tapped. This country has a lot of people with PhDs in engineering from the US, which is good for R&D.

“Whether this potential is realised will depend upon two key things. First, structural reforms are needed. After the general election we will have a four-year, election-free period; the ideal time for the new government to implement tough but necessary structural reforms.

“Second, it will depend on the ability of the country to improve its competitiveness in terms of innovation and corporate governance, and to stop competing mostly on low labour costs because per capita income in Turkey is reaching middle to high levels. If Turkey is to improve its competitiveness it should do so through improving the quality of its products, better corporate governance and more innovation.”

Three influential forces

Muhammet Mercan, senior vice-president and an economist at ING Bank Turkey, says that in 2014 Turkey was shaped by three major factors. “The first was the geopolitical developments in the region, the second was local political developments, and the third was the external market environment,” says Mr Mercan, who is also a lecturer on banking and finance at Istanbul Bilgi University. “This year these factors will continue to determine the country’s economic development," he adds.

Conflict in nearby countries last year had a negative impact on Turkey's external balances. “For example, Turkey’s exports to Iraq and Russia decreased due to the problems there,” says Mr Mercan. “After June 2014, when Islamic State increased tension in Iraq, our exports to Iraq contracted by more than 20% in the second half of the year. Our exports to Russia dropped by 15% in 2014.”

At home, between January and March the governing party put pressure on the Central Bank of Turkey to cut interest rates to support economic activity ahead of the election. “The election is important because the governing party wants to make a new constitution and establish a presidential system,” says Mr Mercan. “After the election, a new economic team will be appointed and this might be a source of uncertainty for a while.”

As for the external market environment, this will largely be determined by the US Federal Reserve’s expected decision to raise interest rates, which could weigh on already volatile capital flows to Turkey and other emerging markets. “Turkey’s financial indicators are sensitive to the Fed’s decisions,” says Mr Mercan. “After May 2013, since the start of the tapering of quantitative easing, we saw an impact on Turkey’s currency and interest rates.”

Meanwhile, the European Central Bank’s decision earlier this year to implement quantitative easing should work to the benefit of Turkey’s banking and corporate sector, which borrow from abroad. “The European banking system is the major financier of Turkey’s banks and corporates,” says Mr Mercan. “According to BIS data, close to 60% of our banks’ foreign liabilities are with European banks. For corporates the ratio is even higher. This might lead to further capital inflows to Turkey, which would be a plus.”

He adds the current account deficit, which between 2010 and 2013 averaged 7.5%, should continue to fall. “Last year it fell below 6%. This year we will probably see a further improvement because of the fall in oil prices. Turkey’s oil bill is about $50bn a year, which is about 6% of GDP. On the other hand, the benefit of lower oil prices could be tempered by lower demand for Turkish exports from oil-producing countries and the geopolitical backdrop,” says Mr Mercan.

Government economic plans

The Ministry of Development’s Medium Term Programme for 2015-17 outlines the government’s objectives:

• Real GDP growth, which was 4.1% in 2013, is forecast to be 4% in 2015, rising to 5% in 2017.

• GDP per capita, which was $10,807 in 2013, should increase to $10,936 in 2015 and $12,229 in 2017.

• Tourism income, which was $28bn in 2013, should rise to $31.5bn in 2015 and $35.5bn in 2017.

• The current account deficit, which was 7.9% of GDP in 2013, should fall to 5.5% in 2015 and 5.2% in 2017.

Erdem Başçı, the governor of the Central Bank of Turkey, told G20 finance ministers and central bank governors at the Turkish Presidency Conference in Istanbul in February about his plans to reduce the country’s inflation to 5% by the end of 2015. “The minimum inflation rate achieved in Turkey over the past 44 years was 6.2%,” he said. “Right now we are at 7.2%. So we have some distance to travel to reach 5%. Oil price falls are helping us, but the stronger dollar globally is not helping much, so we are monitoring the impact of these two variables on our inflation outlook,” he said.

However, these are external factors, he added. The main requirements for price stability are generated internally. “They are stable money growth and the stable circulation of money, which lead to stable output growth, and we should focus on those,” said Mr Başçı. “These conditions, driven by sustainable credit growth which favours production over consumption, are the main drivers of disinflation. External factors have temporary effects. They are one-time events. The main thing is money and credit change, internally. There we have hope.”

IMF view

Perhaps the last words should go to the IMF. “The Turkish economy registered a notable recovery in the wake of the global economic crisis and expanded by 5.5% on average between 2010 and 2014,” stated Ibrahim Canakci, the IMF’s executive director for Turkey, and Cem Gokcen, advisor to the executive director, in a Turkey staff report published in December 2014.

“Unlike the economic plague described as jobless recovery, buoyant growth in Turkey translated into 5.7 million new jobs since total employment dipped in 2009. A widening external deficit and inflationary pressures, however, have emerged as side effects of the recovery, driven by strong credit expansion and domestic absorption.”

The two officials conclude that the overall macroeconomic setting remains stable. “The electoral cycle will end in the first half of 2015, and no elections are scheduled to take place between mid-2015 and 2019, which will provide a window of opportunity for major structural reforms. Notwithstanding external shocks, the Turkish economy is on track to grow at a sustainable pace. Denting the external imbalance, maintaining price stability and upholding the reform momentum remain the overarching objectives,” they said.

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