Turkish Economy: A Primer

As the first quarter ends, the wave of optimism keeps Turkey currently in balance.

“Modern thievery,” is how Prime Minister Recep Tayyip Erdogan described interest rates and inflation during the press conference of introducing Turkish Lira’s new symbol in March. He added: “I find these interest rates too high. They must come down.” Since Erdogan’s command is considered pretty much law in Turkey, market participants interpreted these statements as very strong “policy guidance” for the Central Bank of Turkey (CBT). Under pressure from the government, CBT is expected to use any excuse to lower its multiple funding rates, or provide more liquidity to the banks.

Turkey has been experiencing a chronic high and unemployment. Yet 2011 witnessed an improvement. Turkey closed 2011 with an unemployment rate of 9.8% and net employment gains of roughly 1.5 million, much higher than expected. Employment is a lagging indicator of    growth, but leads consumption, justifying concerns that domestic demand could soon rise. However, the decisive data of March was the performance of manufacturing index (PMI), which came in at 49.6 in February, the first time it entered contraction territory since last August.

On the other hand, a US$7 billion trade deficit in January was surprisingly on the upside. Still, optimists found courage in the sharp decline of the non-energy portion. This was puzzling. It is yet to be clarified how the source of trade deficits is a determining factor, rather than the decifit in whole, unless one has very strong expectations that energy prices are set to moderate.

Coupled with rising oil prices, a surge in domestic demand is almost certain to cause inflation to overshoot market consensus of 7% by year-end 2012, as well as reversing the moderate trend of shrinkage in the current account deficit. Some market analysts, only a few, are pretty much alone in their assessment that a soft landing may not be forthcoming.

Consumer price index (CPI) for February was recorded at 0.56%, very close to the consensus. Given new signs that domestic demand may recuperate soon, higher oil prices and the increasing stickiness of current prices, its is believed that it will be very difficult for CPI to end the year at lower than 8%. The market consensus, meanwhile, is closer to 7%.

Turkish analysts are still extremely calm about the inflation outcome, a view shared by the CBT, which told them that it will tolerate further upward deviations from its 2012 target of 6.5% as long as these can be “explained by external factors.” The CBT’s last expectations surveys shows participants forecasting a 3.6% increase in GDP, which means there will be very little output gap. February cash budget data reveal non-interest expenditures rising by 10% for the month and 6% overall in 2012, meaning that from a domestic demand contribution viewpoint the budget remains strongly expansionary.

CBT’s Expectations Survey, revealed in March, showed that the sharp decrease in February core inflation indicators did not translate into lower 12- and 24-month forecasts. These fell by only 9 and 6 basis points, to 6.87% and 6.32%, respectively. More importantly, the participants hiked their current account deficit (CAD) estimates for year-end 2012 to $63.1 billion, up from $62.7 billion earlier in the month.

The Minister of Economy Zafer Caglayan told the press that oil prices at the current elevated levels could add another $10 billion to the annual trade deficit. Since the CAD is almost exclusively driven by trade developments, this may mean that 2012 CAD will end somewhere around $70–75 billion, or close to 10% of the expected 2012 GDP.

Some local economists express belief that the economic slowdown is temporary, but rebalancing is now in jeopardy. A correction in oil prices in the short run but predict a bull rally in Istanbul Stock Exchange (ISE) through 2012, driven by a stronger tone in the global demand and concerns about the Iran–US/Israel conflict mutating into military clashes.

With recent poll data indicating that consumer and business confidence is increasing again, and the Justice and Development Party (AKP) government talking up exceeding the 4% growth target, the only recourse is higher funding rates by the CBT. However, the central bank made it very clear that it will not respond to changes in domestic demand outlook, but is solely targeting the exchange rate. This is where the real dilemma starts. If the CBT only reacts to higher than forecast inflation and CAD when the currency tanks, then that is what investors will enforce on the exchange rate market.

S&P’s new index, points out to Turkey as the most vulnerable in Europe in case of credit crunches. Yet markets seem to have ignored this. The reason is that the Turkish investors unanimously believe that a good chunk of long-term refinancing operation (LTRO) money is destined for Turkey.

In a nutshell, if oil prices is not corrected sharply or the Turkish financial system is flooded by a surprising flow of hot money, one can expect that either rates will go up or the lira will have to lose strength again. This is not the kind of conundrum many investors wish to face going forward.

About Figen Şardağ

Banker, Financial Analyst