WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

By Richard Grieveson

• The Turkish economy is on a tear, with growth hitting a multi-year year high in Q3.
• The economy has been pushed hard by the government, with external factors also contributing.
• Economic growth will slow from here, with base effects set to be less supportive, and fiscal policy less expansionary. Monetary tightening to support the lira and rein in inflation also looks likely.
• Turkey’s large external financing needs bring risks, and leave the economy vulnerable to either a more aggressive hike in US rates, or a deterioration in investor perceptions towards the country.

The Turkish economy is booming, with real GDP rising by 11.1% year on year in Q3, above the Reuters consensus estimate of 10%. This was the highest rate of growth for six years, and more than double the 5.1% posted in the previous three months. Household consumption rose by 11.7% year on year, while gross fixed capital formation (GFCF) increased by 12.4%. Exports were up by 17.2%, with imports rising by 14.5%. Government spending was 2.8% higher on the year.

While the rate of growth in Q3 was somewhat above expectations, the broad trend is not. Q3 growth was always likely to be flattered by the low base period (GDP contracted in Q3 2016). However, in addition, several key factors have combined to drive economic activity higher this year.

Domestic drivers

Three key domestic drivers of growth are visible:

1. Government investment. In the wake of the 2016 failed coup attempt, and the narrow victory in the constitutional referendum earlier this year, the Turkish government has ramped up capital spending in order to support the economy. Public capital spending rose by 29% year on year in January-October.
2. Credit guarantee fund (CGF). For similar reasons as above, the government has also introduced support for banking lending, in the shape of the CGF, worth around 8% of GDP. This has helped to support a rapid rise in bank lending; the volume of credit to the non-financial sector grew by over 20% year on year in January-November according to the central bank.
3. Tax breaks. The consumption tax on white goods was lowered to zero (from 6.7%), and the 18% VAT on furniture was lowered to 8%. Both will stop at the end of the year. These have had an important positive impact on retail spending, with volumes 2.4% higher in October than a year earlier.

The combined effect of these measures has been a boost to employment and rising consumer and business confidence.

External drivers

Growth is not only being supported by government policy. Exports have been important, reflecting primarily strong demand from key trading partners, including the EU. The ability to switch between markets to take advantage of demand hotspots—long a strength of the Turkish export sector—appears again to have been a factor. The collapse in the lira and consequent boost to external competitiveness has also likely played a role, although anecdotal evidence suggests that this has been less significant than rising external demand.

A partial recovering in the tourism sector has also played a role. Despite heightened perceptions of security risk, total tourism arrivals rose by 27.3% year on year in January-September. This growth was to a large extent driven by arrivals from Russia, which increased by a massive 729% year on year (this was a reflection in part of the very low base period).

However, arrivals from the EU are still falling, related to security risk and also possibly tensions between Turkey and the bloc. This is a problem because these visitors spend much more. Therefore, although total tourism numbers are up year on year, average spend per person in US$ fell by 10.1% year on year in H1 according to the central bank. Tourist numbers from the EU have been falling for some time – inflows from Germany (the most important source) peaked at 5.6m in 2015, before falling to 3.9m last year, and then were down a further 8% year on year in the first nine months of 2017.

Foreign credit inflows have also been very significant. Much of the funds for new lending have to come from abroad. The current account deficit widened by 27% year on year in January-September, to US$ 31.1bn. US$ 19.4bn of the financing for this—almost two thirds—came from net incurrence of portfolio investment liabilities via debt securities. Overall, net incurrence of portfolio investment liabilities (“hot money” inflows, across debt and equity) rose by 171% year on year in January-September to hit US$ 22.4bn.

Growth rate will slow from here

Some of the external drivers of growth are sustainable. Strong demand from the EU and other markets for exports will not disappear anytime soon; high frequency sentiment indicators suggest that growth in the bloc is set to strengthen further if anything. The lagged effects of the depreciation of the lira could also provide a boost to export competitiveness. Meanwhile, following the rapprochement between the two countries, tourism inflows from Russia will likely remain high, if for no other reason that the low costs (although strong growth in arrivals from higher-spending Western Europeans markets will be slower to materialise).

Domestically, there are greater challenges. The CGF is approaching its limit, and the government appears unlikely to extend it. Fiscal policy may also be tighter next year; the government does not appear to see tax breaks as a long-term strategy to boost the economy. Meanwhile recently consumer confidence has started to drop, and is approaching the low levels seen at the start of the year. Part of this may have to do with spiralling inflation (linked to lira depreciation), which is eating into real incomes.

Where are the risks?

Turkey’s booming economy has led to suggestions that major risks are emerging, and that the country is heading for a “hard landing”. The evidence for this is mixed.

There is no fiscal issue. It is true that the deficit is rising—the central government deficit almost tripled year on year in January-October—but it is still relatively contained. Public debt remains very low, reflecting tighter policy over the past ten years, and giving the government some room. The banking sector also appears stable (although current US investigations into several Turkish bankers related to avoidance of sanctions on Iran could affect this).

The obvious risks are external, and reflect Turkey’s large current account deficit and consequent hefty foreign currency (primarily US dollar) financing needs. We see two potential triggers of this risk. First, that the US Federal Reserve hikes interest rates more aggressively (something that has become more likely following strong US jobs data in recent days). Second, that foreign investors lose confidence in Turkey, for example owing to political developments.

The perceptions of international investors are already negative (strongly so in some cases); the three major ratings agencies have Turkey firmly in “junk” status. All eyes are now on the central bank, and much will depend on their next steps. The sharp weakening of the lira and further rise in inflation (which hit a 14-year high of almost 13% in November) may prompt a sharp hike in the policy rate (something that that market would like to see), although there are domestic political reasons for this not having been done, and these pressures will remain strong. The government is keen that job and wage growth remain strong in the run up to the 2019 elections. In the near term, the meeting of the central bank’s Monetary Policy Committee on December 14^th will be the next key event to watch.

Photo credit: Adam Reeder (CC BY-NC 2.0)