Economic woes cast shadow over Turkey's coming election

The Turkish economy is in a perilous state, in no small part due to the unorthodox economics that have dominated monetary policy in recent times.

The general consensus among economists is that the current path, which prioritises high public spending to support consumer demand, is unsustainable.

The economy’s already serious fragility was magnified in February by the devastating earthquake that struck central and southern regions. The human cost has been catastrophic. The economic cost will also be high.

The current state of the Turkish economy

One positive here is that, despite serious headwinds, the Turkish economy is still growing. In fact, it survived the Covid pandemic relatively well, with growth rebounding to 11.4% in 2021.

This peak was short-lived, however. Growth slid to 5.6% in 2022, and we expect it to fall significantly further, to 1.0%, this year.

Anaemic growth is still growth, and 1.0% doesn’t sound too far out of step with Europe as a whole. The problem for Turkey is that its entire focus has been on supporting an expanding economy, with growth promoted as the overarching goal of fiscal policy.

“This slowdown is happening despite an expansionary fiscal policy, with increased public investment and social spending measures to support private consumption” says Theo Smid, economist at Atradius. “These measures have included a minimum wage increase, a major social-housing project, credit subsidies and abolition of income tax on the minimum wage.”

The price of inflation

The problem for the next government is that high inflation and a weak lira have weighed heavily on consumer purchasing power, despite government handouts.

When your inflation rate hits 85% year-on-year, as it did last October and November, even generous public subsidies lose the power to support economic expansion. Consumers can pay less tax and still not have enough money to purchase anything but the most essential goods.

“Despite easing somewhat in recent months due to favourable base effects, inflation remains very high,” says Theo. “In April 2023 it was at 44% year-on-year. We forecast an average inflation of about 40% in 2023.”

Government policy is by no means the only cause of rampaging inflation. High global commodity prices are hitting Turkey just as they are everywhere else. But ultra-loose monetary policy and credit-driven growth are important factors.

And, while many central banks have been tackling inflation with interest rate hikes, Turkey has taken the opposite path. Since September 2021, the key central bank policy rate has been cut by 10.5%, to 8.5% in March this year.

The waning lira

The lira has been a major casualty of this policy stance, depreciating 34% against the US dollar since September 2021.

The bank’s attempts to prop up the currency have had limited effect. “The central bank attempts to manage pressure on the lira through capital controls and interventions on foreign exchange markets,” says Theo. “However, its ability to intervene in the currency market is constrained by a limited amount of foreign exchange reserves.”

With that in mind, we expect the lira to gradually depreciate against other major currencies in 2023-2024.

External pressures

On top of all this, exports are slowing down, with a predicted 0.8% contraction this year. In addition, the region affected by the February earthquake accounts for 9.3% of Turkey’s GDP. According to Oxford Economics, the disaster may hit GDP by 0.3 - 0.4%.

Given that, it’s hardly surprising that Turkey has high external financing needs, to cover debt repayments and bolster current accounts.  We expect this external financing need to leap from USD 245 billion in 2022 to USD 267 billion in 2023-24. That represents more than 30% of Turkey’s GDP.

“To meet its financing requirement, Turkey relies heavily on short-term borrowing, making it vulnerable to a balance-of-payments crisis in the coming years,” says Theo. Private businesses may face difficulties in servicing their high foreign currency debt overhang.

The state of Turkish industries: a mixed picture

Turkish businesses face headwinds in the form of high inflation, rising raw material and operating costs and limited access to finance. But some sectors remain robust.

Sector-wise, pharmaceuticals, food production and food retail are still doing well, and the export-oriented automotive sector is currently outperforming expectations. In the consumer durables retail industry, sales volumes also increased in 2022.

Importers have done relatively well so far in an environment in which exchange rate pressure allows them to sell imported goods in domestic markets at significant profit. But this may change if the value of the lira deteriorates further.

On the flipside, exporters are suffering from the same exchange rate pressures, alongside increased costs and slowdowns in target markets. The fact that exporters must convert up to 40% of their foreign currency export receipts into Turkish lira is also dragging profits down.

Credit risk is an issue for many companies, and is a particular concern in the construction sector. Companies are highly indebted and face increased borrowing costs. House building continues to decline in response to rising construction costs and companies’ reduced access to finance. On the consumer side, there are ongoing issues around access to mortgages, and that is also impacting demand.

The sector could receive a limited boost from reconstruction projects in the earthquake region, but strict rules may be set for companies looking to win contracts.

The earthquake also disrupted large parts of Turkey’s textile industry, which is heavily concentrated in the affected regions. With export volumes and values already on a downward trend, this was a severe blow.

What difference will the election make?

With all that in mind, the winners of the upcoming election will face a highly vulnerable economy and a series of policy dilemmas.

“We believe the current direction is unsustainable, and that the incoming administration will have to follow a more conventional path to get inflation under control and reduce Turkey’s external imbalances,” says Theo.

This means reduced government spending and, from the central bank, a more orthodox monetary policy aimed at stabilising the lira.

None of this will be easy, even if it is necessary. “The extent of economic challenges and depth of external vulnerabilities ensure that any pivot to more conventional policies will be a difficult and gradual process,” Theo adds.

“Hiking interest rates would be the first step towards getting inflation under control, bringing back investor confidence and rebuilding foreign exchange reserves.  But this could also spur the first annual contraction in economic activity since 2009.”

The Turkish economy is at a crossroads. To create stability, the next administration may need to take difficult and unpopular decisions around interest rates and public spending. Even if they do, the road to recovery is likely to be long and difficult.

Further detail on the state of the Turkish economy and its post-election outlook can be found in our Economic Research Note.