The Road Ahead for the Turkish Economy: Will Words Turn into Action?

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Macroeconomist

Turkey has repeatedly been in the international spotlight in recent weeks, due to its involvement in the Nagorno-Karabakh conflict, its research operations in disputed waters of the Eastern Mediterranean, or President Erdogan's provocative rhetoric towards Emmanuel Macron. But this activity distracts from a worrying domestic economic and health context. Inflation is at its peak and the lira's exchange rate at its lowest, which led the president to dismiss the Central Bank's governor on November 7, while the Finance minister resigned a day later.

Murat Ucer, former IMF economist, as well as the co-founder of Turkey Data Monitor and a senior lecturer at Koç University’s Graduate School of Business, helps us understand this complex situation and what Turkey's next steps may be.

What Has Just Happened?

The Turkish economy has been on a downward trend for quite some time now, but this year has marked another inflection point, as things took a dramatic turn for the worse. In response to the Covid-driven recession in the second quarter of this year, Ankara, under the stewardship of the then-Minister of Treasury and Finance Berat Albayrak, has applied a massive amount of monetary stimulus, pushing real interest rates into negative territory and boosting loan growth, especially through the state banks, to unprecedented highs. There has also been budgetary support, but this has played a much more auxiliary role, with most support coming in the form of tax and social security premium deferrals, rather than direct income transfers. These, in turn, led to a massive drain in central bank reserves, as some of the excessive growth in the money supply simply "leaked out" through the balance of payments.

The numbers are truly staggering. By a rough estimate, Turkey has burnt some $80-90 billion worth of reserves this year alone, i.e., well over 10% of GDP, with the "short foreign currency position" of the CBRT slipping deeply into negative territory, to the tune of $50 billion, from around a positive $30 billion just two years ago. These reserves - without getting bogged down in the mechanics - have basically been used up for the financing of: 1) a large balance of payments deficit (comprised of a current account deficit and capital outflows), and 2) "dollarization", as residents, not finding enough of a return in lira-denominated assets, took refuge in foreign currency and gold as protection, from rising inflation and heightened currency volatility.

By a rough estimate, Turkey has burnt some $80-90 billion worth of reserves this year alone, i.e., well over 10% of GDP.

In the meantime, after a steep contraction in the second quarter, the economy has rebounded sharply in the third. It is now clear based on a myriad of high-frequency indicators (Q3 GDP data will be out on November 30), but the country is still facing markedly weakened policy buffers, double-digit inflation, a massive drop in the labor force (of about 1.5 million) and balance sheet damage to the nonfinancial corporate sector, still burdened by a large amount of debt, much of it in foreign currency.

Quite notably, yet perhaps not so surprisingly, the strong growth rebound did little in the way of improving public sentiment, which kept ranking the state of the economy as a top concern in the polls, even as Ankara, until recently, boasted of "V-shaped" recoveries and of outperforming its peers.

The unraveling of last week’s family and political drama that led to the resignation of Mr. Albayrak, the exact details of which we’ll probably never know, seems to have been triggered by President Erdogan finally grasping the gravity of the situation, thanks to a confluence of facts and happenstance.

Where Are We Coming From?

So, how did we get here, and where might we be heading? The first question has a relatively easy answer, over which there is even a consensus of sorts. After doing the right things, broadly speaking, for a relatively brief period of time, which goes as far back as to the first half of the 2000s, or basically AKP’s first term in power, the Turkish economy, like most emerging economies (EMs), has benefited greatly from the massive expansion of global liquidity after the Global Financial Crisis. This is also about when the Turkish economy became "addicted to credit", with the credit-to-GDP ratio of the nonfinancial corporate sector rising by some 30-40 percentage points - incidentally one of the fastest rates among EMs - which was channeled mainly to the financing of a construction boom. And all this has taken place against a backdrop of ever-weakening "institutions".

As this very "low-quality growth" began to peter out, Ankara, with its focus squarely and singularly placed on growth for, needless to say, political reasons, kept applying stimulus to get growth going. Meanwhile "imbalances" - read: inflation and current account deficit - remained too elevated for comfort. Growth has stayed relatively high throughout, but the frequency of boom-bust cycles increased in the meantime. Such was the case during 2017-2018 (thanks to the Credit Guarantee Fund scheme that overheated the economy) and then again in 2018-2019, with the recession triggered by the "Pastor Brunson Crisis" having quickly ended, thanks to stepped-up lending by state banks.

At the end, as the consensus more or less had it, the Turkish economy has become a ticking time bomb, with no endgame in sight.

It is against this fragile backdrop that the Covid-19 shock struck. As noted in the introduction, Ankara responded with a huge amount of monetary stimulus. This has basically backfired, as inter alia evidenced by an ever-weakening currency, the size of the reserves that had to be burnt along the way, a pure exodus of portfolio investors from Turkish assets and an elevated country risk premium to markedly above peers. That the stimulus would backfire should hardly be taken as a surprise, however, given the very low credibility of the central bank and/or a very weak policy framework more generally, characterized by extreme coercion and discretion. Ankara has kept arguing otherwise until recently, but no one quite bought into this rosy narrative. At the end, as the consensus more or less had it, the Turkish economy has become a ticking time bomb, with no endgame in sight.

Where do we go from here?

So, what happens now after the sackings and resignations? The good news is that the change in economic management that took place over the past week is quite a significant and positive affair. After all, Mr. Albayrak, according to some credible accounts, was being groomed by President Erdogan as his political heir. His sudden departure attests to Mr. Erdogan’s pragmatism as well as his survival instinct. Under the circumstances, hee probably saw that his chances of being reelected in 2023, the year of the next combined presidential and parliamentary elections, were becoming grim. The new appointments, Messrs. Naci Agbal and Lutfi Elvan as the CBRT Governor and the Treasury and Finance Minister, respectively, are also quite positive, given that both gentlemen are sensible people with technocratic backgrounds. Finally, Mr. Erdogan himself also seems willing to usher in a new era, and to be prepared to "swallow the bitter pill".

Turkey basically needs a very comprehensive program - ideally with external funding, because reserve replenishment and bank recapping will be costly - backed by President Erdogan himself.

The bad news is that the damage by now is colossal, in this author’s view, and thus the "to-do list" to fix it, is just too daunting. Now add on top of this another Covid-19 resurgence, which, unfortunately, was fully underway as we were writing these lines, notwithstanding much misreporting and opacity around the true state of affairs. According to the latest reports from the Ministry of Health, diagnosed daily cases have exceeded 3300, while true "case" numbers, including the asymptomatic ones, are likely in the tens of thousands.

All this is a little too much to walk alone, even for a formidable and still popular politician such as Mr. Erdogan. The rate hike that the market has been focusing on is crucial and necessary for sure, but is most probably not sufficient. Much more is needed to restore investor confidence and reverse trend "dollarization". Keeping our focus on the economic sphere alone, these would include, inter alia:

A new 2021 Budget and a medium-term fiscal consolidation plan that puts public debt on a sustainable path and takes a hard look at the contingent liabilities.
A plan to repair the CBRT balance sheet and build reserves.
Making disinflation an absolute priority (by dropping, once and for all, awkward theories on the interest rate-inflation nexus).
Proper stress-testing of banks to have an understanding of the size of the "hole" in bank balance sheets (and indirectly, in corporate sector balance sheets).
Last but certainly not least, institutional rehabilitation, starting with Turkstat, the Statistics Office.

What all this means is that Turkey basically needs a very comprehensive program - ideally with external funding, because reserve replenishment and bank recapping will be costly - backed by President Erdogan himself. Yes, you guessed it, this is another way of saying that Turkey needs a fully-fledged IMF program...

How likely is it though, for Mr. Erdogan to call in the IMF and eventually sign up for a program? Well, it sure is more likely now than a week ago, but it still is highly unlikely. The problem is that for the first time in years, "muddling-through" does not seem to be an option, certainly not through 2023, and the proverbial "fork on the road", seems to have come closer than ever. The new economic management team has a daunting task ahead of it, to first convince itself, and then Mr. Erdogan of the fact that there is no easy way out of the current malaise, and that Mr. Erdogan should be more open to the prospect of an IMF program - a dialogue that can start with Turkey showing a willingness to tap into the Rapid Financing Instrument, with a view to, who knows, turning it into a fully-fledged IMF program.

We all forget these things, but there was a time that Turkey did have an IMF program, looked to the EU as the "anchor", tried to rebuild its institutions, and did extremely well as a result, with the economy achieving "high-quality" growth that averaged over 7% p.a., boosted by a surge in "total factor productivity", and accompanied by a visible improvement in income equality. Maybe it is time to remind Mr. Erdogan that the last IMF program, while not conceived, has certainly matured under his watch, and that it was him who collected all the fruits of it...

Copyright: Yasin AKGUL / AFP