Mina Toksoz
Associate Fellow, International Economics
Following the US Federal Reserve rate rise and amidst heightened regional conflict, 2016 holds more risks for the usually resilient Turkish economy.
A man rides on a ferry in Istanbul on 14 December 2015. Photo by Getty Images.A man rides on a ferry in Istanbul on 14 December 2015. Photo by Getty Images.

While the Turkish economy has defied previous dire warnings and shown resilience to external shocks, the coming year could be one of its most difficult yet. Growth will be more difficult to generate than in the past decade, requiring structural reforms and institutional strengthening. These are promised in the new programme from the ruling Justice and Development Party (AKP), but their implementation remains uncertain given the weak record of past AKP governments and the increased domestic and regional political challenges.

Not as fragile as some think

Since the global financial crisis, Turkey has had a series of external shocks, including the eurozone crisis, the strong performance of the US dollar and the waves of international capital flowing into and out of emerging markets. These have combined with regional crises that have disrupted trade and brought an influx of 2.5 million migrants adding to the already high domestic political pressures. The recent Russian sanctions, following an incident where Turkey shot down a Russian plane operating on the Syria/Turkey border, are likely to subtract another $4-7 billion from already weakened regional exports.

Turkey is seen as a ‘fragile market’, but despite these shocks and a large external financing gap of about 25 per cent of GDP, the Turkish economy has shown flexibility and resilience. This is due to several policy and structural strengths: a prudent fiscal policy, low public debt ratio of 35 per cent of GDP, a well-regulated and profitable banking sector, a diversified industrial base and exports and a large domestic market.

As a net oil importer, it also has a natural hedge to external shocks: when the global economy weakens, oil prices fall, reducing the energy import bill and offsetting the decline in exports. This has mostly driven the halving of the current account deficit to an estimated 4.9 per cent of GDP in 2015. Assuming oil prices remain low, a similar outcome is possible in 2016, supported by the more competitive lira that has begun the process of rebalancing of the economy away from imports towards domestic production and exports.

There are some weaknesses, notably the rapid increase in foreign currency corporate debt to 35 per cent of GDP. As US interest rates rise, some corporates will inevitably default - possibly those exposed to Russia. But the risk of widespread defaults is low as the debt is mostly long-term, hedged with corporate foreign exchange (FX) earnings, and mostly from Turkish banks.

Hence the Turkish economy is not an obvious candidate for a 1990s type of emerging market foreign payments crisis, where a plummeting currency and rising international interest rates render foreign-denominated debt suddenly unsustainable. The risks are more likely to arise from a prolonged low growth scenario given the difficult global environment, low national savings, foreign payments constraints and a weakening trend in institutions combined with possible further escalation of regional conflicts.

The need for structural reform and institutional strengthening

The new AKP government, led by Prime Minister Ahmet Davutoglu, has pledged structural reforms to address these long-term challenges. But the short-term aim of their 100-day ‘action programme’ is a burst of fiscal easing to boost growth. Election promises cover almost everyone in the country including rises to the minimum wage, student grants and soldiers’ pay; agricultural support; and financial assistance to small- and medium-sized business and start-ups. Given that fiscal discipline is one of the country’s strengths, this has raised concerns about their funding. There are also worries about the potential inflationary impact – especially since the central bank has struggled to contain inflation with political interference against a rise in the policy rate.

A post-election burst of activity in the construction sector reinforced by the restarting of mega-infrastructure projects will also contribute to growth. Assuming exports to the eurozone hold up, the estimated 3 per cent GDP growth in 2015 could reach 4 per cent in 2016, according to Economy Minister Mehmet Simsek. But risks include a sharper than expected rise in US Federal Reserve interest rates, a hike in oil prices or further escalation of the Syria conflict.

The AKP has a proven record of macro-policy flexibility in managing the economy through crises. But past policies were supported by declining interest rates and a stronger global economy. Today, high private-sector debt, inflation and lagging productivity signal the limits of macro-policy tinkering. The best defence against looming risks (besides reducing reliance on Russian gas imports and nuclear energy) are structural reforms to increase foreign and domestic investment – most of which are in the new government programme. These include a ‘reset’ in EU relations – including renegotiating the customs union to participate in TTIP – and democratic and business reforms. Business is also hoping for the strengthening of institutions (such as the procurement law) and the rule of law (including reform of the judiciary) to create a more level playing field.

The next general election is four years away, providing a window of opportunity for the prime minister to make good on his promises. But the AKP’s capacity or willingness to implement complex institutional reforms remains unproven. Meaningful measures to create a level playing field for investors would have to challenge the patronage-dependent government–business relations that provide a large electoral constituency for the AKP. Also the government agenda is already fully focused on the fragile regional security situation, constitutional changes (including President Recep Tayyip Erdogan’s controversial move towards a presidential system) and a restart of the difficult peace process with the Kurds.  It will take very strong political leadership to ensure that the country avoids being sucked into the Syria-Iraq vortex and the economy remains a priority.

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