TURKEY

Will the shift to orthodox monetary policies last this time?

HIGH RISK for enterprise

Economic risk
Business environment risk
Political risk
Commercial risk
Financing risk

Economic risk
Business environment risk
Political risk
Commercial risk
Financing risk

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GDP	USD720.1bn (World ranking 19, World Bank 2020)
Population	82.33mn (World ranking 17, World Bank 2020)
Form of state	Republican Parliamentary Democracy
Head of government	Recep Tayyip ERDOGAN (President)
Next elections	2023, presidential and legislative

Important geostrategic position (that has historically always ensured aid when needed)
Adequate business environment (though deteriorating)
Potential as regional hub between Europe, MENA and Asia

Exchange rate vulnerability to domestic and external shocks
Economic policy responsiveness
History of persistently large current account deficits, largely financed through short-term external debt, which has risen to a very high level in the meantime
(External) debt refinancing risk of weaker companies and banks, exacerbated by the currency crisis in 2018-2019 and again by the Covid-19 crisis in 2020
Deep-rooted division in society between secularists and religious conservatives
Geopolitical risks

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The recovery hinges on external demand

Turkey is one of a few large economies that managed to grow in 2020. Real GDP expanded by +1.8% last year as economic activity rebounded strongly in Q3 from the coronavirus pandemic-triggered slump in Q2 and also held up relatively well in Q4 compared to most other European countries. Turkey did not experience such a strong second wave of Covid-19 infections as others did in Q4 and thus had less stringent lockdown measures in place. However, a low base also helped to avoid a full-year recession since the economy grew by just +0.9% in 2019 as a result of a prolonged home-made financial crisis that lasted over much of 2018-2019 and had hit consumer and capital spending particularly hard. Hence, domestic demand actually recovered somewhat in 2020 while external demand for Turkish goods (intermediate and consumption) and services (notably tourism) dropped sharply in the wake of Covid-19. A large positive contribution of inventories (+5.0pp) also helped to achieve the full-year expansion in 2020. It should also be noted that 2020 growth was quite unbalanced as very loose monetary policies led to a surge in private sector credit growth (which peaked at +43% y/y in October) and would likely have caused a full-blown balance-of-payments crisis if the monetary authority had not reversed its course in Q4.

Looking ahead, the shift to monetary tightening should result in a rebalancing of the economy and slower q/q growth in 2021. Monthly indicators for December for industrial production (+1.3% m/m) and retail sales (-4.2% m/m) indicate that economic activity lost momentum towards the end of last year. That said, advanced indicators point to some optimism at the start of 2021, with the manufacturing PMI of 51.7 in February indicating a modest improvement in the health of the production sectors and the Turkstat consumer confidence index at 84.5 points (vs. an average 81.0 in 2020) signaling a positive outlook for private consumption. The reopening of economies as Covid-19 vaccination programs are rolled out should support domestic and foreign demand from Q2 onwards, though we do not expect too much yet this year as sufficient provision and distribution of potential vaccines to the population will take time in many European countries. A continued relatively tight monetary policy stance by the Central Bank of Turkey (CBRT) should slow the recovery somewhat but will be counterbalanced by ongoing fiscal stimulus, which should mitigate pressures on individuals and corporates. Overall, we forecast real GDP to grow by around +6.6% in 2021 and +4% in 2022. That said, a possible third wave of infections in Turkey or Europe due to the spread of mutant variants poses a downside risk to our scenario, one that should not be neglected. Other downside risks include currency volatility, relatively high inflation and Turkey's fragile external position.

Economic policy dilemma

Monetary policy

In November 2020, the Monetary Policy Committee (MPC) of Turkey put on the emergency brake by rasing its key policy interest rate from 10.25% to 15.0%, reverting back to an orthodox monetary policy stance. It followed with a further rate hike to 17.0% in December 2020. Previously it had embarked on rapid monetary policy easing from mid-2019 to mid-2020, ostensibly in order to stimulate the faltering economy but disregarding anew rising consumer price inflation, which was higher than the policy rate in the first ten months of 2020. Financial markets did not appreciate this policy stance, reflected in rising bond yields and a sharp currency depreciation. The Turkish lira (TRY) lost -30% in value against the USD from the beginning of 2020 to early November. This was among the highest declines that major Emerging Markets (EMs) saw in 2020; moreover, it should be noted that the TRY fall occurred despite heavy intervention by the CBRT to bolster the currency. Combined with net capital outflows, this caused gross foreign exchange (FX) reserves to drop by -52% in the first nine months of 2020, further unnerving foreign investors. As it became increasingly clearer that the CBRT’s FX reserves were insufficient to defend the TRY for longer, the CBRT and the MPC eventually reverted to sharp monetary tightening, as we had predicted.

As of early March 2021, the TRY has regained half of the losses from 2020 but the damage has been done, especially because the currency also depreciated strongly in 2019 (-18%) and 2018 (-33%). The fall in FX reserves has come to a halt, but they remain at critically low levels.
Headline consumer price inflation rose to 15.0% y/y in early 2021, driven by rising energy prices and the previous currency depreciation. We expect inflation to remain elevated in H1 2021 before falling to around 11% at the end of the year. As a consequence, the MPC is likely to retain its tight policy stance for most of the year but may begin gradual easing in H2. Against this background, the TRY should remain relatively stable in 2021. That said, the downside risk to this outlook is that the CBRT and the MPC become complacent and repeat the old mistakes – shifting too early and too rapidly to monetary loosening amid gradually improving economic indicators – as has happened many times in the past.

Fiscal policy

Fiscal prudence, a policy anchor for many years in Turkey, had already weakened more recently and before Covid-19. After five years of annual fiscal deficits below -2% of GDP from 2011-2015, strong public spending growth, rising sovereign borrowing costs (downgrade to junk) and the impact of ongoing TRY depreciation on FX-denominated debt reversed the previously positive trend in fiscal indicators. The fiscal deficit increased to -2.3% of GDP in 2016 and further to -5.6% in 2019 (we use the IMF definition which gives higher ratios than the Turkish authorities’ definition). This visible loosening of fiscal policy contributed to the deterioration of confidence in economic policymaking and thus also to the crisis in 2018. Against this background, Turkey’s gross public debt edged up from 27% of GDP in 2015 to 33% in 2019.

In the context of the Covid-19 crisis, the Turkish government announced a fiscal stimulus package worth around 10% of GDP over two years or so. It may be expanded still. As a consequence, we estimate that the annual fiscal deficit widened to around -7% of GDP in 2020 and forecast it to remain large at close to -6% in 2021-2022. Total public debt is forecast to increase to around 45% by 2022. At first sight, such a ratio appears still moderate compared to peers. However, the sustained rise in the fiscal deficit and uncertainty over the possible scale of contingent liabilities and potential debt rollover pressures cause concerns about the country’s public finances. Contingent liabilities are mainly related to state-owned banks, which engaged in a major credit expansion in 2019-2020 to support growth. In contrast, private banks have cut back on their lending. Overall, the trajectory of the fiscal deficit and public debt requires a course correction in the medium-term. Otherwise, a renewed deterioration of investor confidence is possible, with potential adverse effects for external financing of the sovereign, banks and corporates, as well as for financial markets.

External position remains critical

External imbalances will narrow but remain elevated in 2021

Along with the recession in 2018-2019 came a sharp rebalancing in the tradable sector as nominal imports of goods and services collapsed due to the much increased import costs after the depreciation of the TRY. At the same time, nominal exports benefited from the more competitive currency. Exports of services also benefited from rising tourism as visitors enjoyed significantly more affordable holidays in Turkey. As a result, the annual current account balance shifted into a small surplus of +1.2% of GDP in 2019, after 17 years of (mostly) large deficits.

However, the rebalancing peaked in September 2019 when the rolling 12-month current account surplus reached +USD12bn (equivalent to almost +2% of GDP). Against the backdrop of rapid monetary easing and re-surging credit growth, the monthly current account has been back into deficit since December 2019. In 2020, nominal exports dropped by -18% (-USD43bn) as a result of reduced foreign demand for Turkish goods and services (notably tourism) in the wake of the global Covid-19 crisis. At the same time, imports remained broadly stable in USD terms. As a result, the current account posted a shortfall of -USD37bn in 2020 as a whole, equivalent to approximately -5.1% of GDP, the highest annual deficit ratio since 2013. Moreover, the financial account registered net short-term capital outflows of -USD10bn (-1.4% of GDP) in 2020. This combination of a current account deficit and net capital outflows confirms that a balance-of-payments crisis was underway in Turkey last year. Meanwhile, only 13% of the 2020 current account deficit was covered by net foreign direct investment (FDI) inflows which have a longer term nature.

For 2021, we expect a partial rebalancing. Exports should get a boost from Turkey’s increased competitiveness owing to the weaker TRY (as compared to the average exchange rate in 2019-2020) while import growth should be curtailed by the weaker currency and slowing credit expansion due to the tighter monetary policy. We forecast annual current account deficits of around -3% of GDP in 2021-2022. However, net FDI inflows will remain modest, as they have been over the past two decades. Whether or not the capital outflows from 2020 can be reverted in 2021 depends on investor sentiment towards both Emerging Markets in general amid the ongoing pandemic as well as towards Turkish politics and policies in the coming year.

The sharp decline in FX reserves is very worrisome

Gross FX reserves reached a peak of USD114bn at end-2013. Ever since, they have been on a volatile downward path, mainly owing to frequent FX market interventions by the CBRT to stabilize the exchange rate of the TRY, as well as occasional capital outflows. At the end of 2019, reserves stood at USD79bn. Then they dropped by -52% to just USD38bn in September 2020 due to capital outflows and CBRT intervention in the wake of the Covid-19 crisis. Following the sharp monetary tightening in Q4 2020, reserves recovered modestly to USD43bn in January 2021. Yet, at this level they are covering less than three months of imports or, in other terms, less than 30% of the external debt payments falling due in the next 12 months (> four months and >125% are assessed as comfortable, respectively). Even more worrisome, net FX reserves (this excludes all FX deposits parked at the CBRT by local banks) dropped from a peak of USD70bn in 2011 to an estimated USD20bn at the end of 2020. Overall, the CBRT’s FX reserves are way too low to defend the TRY if needed. Should serious financial market turbulence re-occur in the near term, the CBRT may at some point need to revert to capital controls in order to defend the TRY or release the currency into free fall.

Corporate debt and non-payment risk will remain high

The total debt of non-financial corporations (NFCs) in Turkey declined from a peak of USD570bn in Q1 2018 to USD437bn in Q4 2020, thanks to the deleveraging in the wake of the 2018 domestic financial crisis and the 2020 Covid-19 crisis. However, it has increased from 69% of GDP in Q1 2018 to 76% in Q4 2020 because nominal GDP in USD has declined due to the massive currency depreciation over the past three years. Somewhat improved, though still worrisome, the FX-denominated debt of NFCs in Turkey fell to 34% in relation to GDP at end-2020 (from a peak of 46% in Q3 2018) and to 45% as a share of total NFC debt (from 59% in Q3 2018). Refinancing that FX-denominated debt will remain challenging as NFC balance sheets have been stressed by the TRY depreciation, volatile interest rates and low growth, while investor confidence has remained weak.

There are clear signals that non-payment risk in Turkey has been on the rise. For example, the average days sales outstanding (DSO) increased from 65 days in 2007 to 82 days in 2017 before falling back slightly to 76 days in 2019. This was well above the global average (64 days in 2019, nearly unchanged over the past decade) and has put Turkey among the countries with the longest DSO. Another signal is the share of non-performing loans (NPLs) in total loans, which has increased from a recent low of 2.8% in May 2018 to 4.1% in December 2020. Most of those NPLs are to Turkey’s ailing energy and construction sectors. Combining this with the worrisome corporate debt position of Turkish NFCs, we conclude that corporate non-payment risk will remain on the cards in the next two years. We forecast an increase in business insolvencies by a cumulative +17% in 2021-2022, after a +12% rise in 2020. - March 2021

Trade structure by destination/origin

(% of total, 2020)

Exports	Rank	Imports
Germany 9.5%	1	11.2% China
United Kingdom 6.7%	2	10.5% Germany
United States 6.0%	3	8.6% Russia
Iraq 5.4%	4	5.6% United States
Italy 4.8%	5	4.5% Italy

Trade structure by product

(% of total, 2020)

Exports	Rank	Imports
Road vehicles 15.2%	1	11.4% Gold, non-monetary (excluding gold ores and concentrates)
Articles of apparel & clothing accessories 9.2%	2	6.7% Road vehicles
Textile yarn and related products 8.8%	3	5.8% Iron and steel
Iron and steel 6.9%	4	5.5% Electrical machinery, apparatus and appliances, n.e.s.
Electrical machinery, apparatus and appliances, n.e.s. 5.8%	5	4.8% Other industrial machinery and parts

The payment behavior of domestic firms has a significant margin for improvement and normal payment terms seem excessive. In fact, as a result of the trend in long payment duration, the value of unpaid receivables has grown considerably in recent years.

Low
Medium
Sensitive
High

Payments
Court proceedings
Insolvency proceedings

Payments
Court proceedings
Insolvency proceedings

Domestic courts lack independence, the rule of law perception is moderate, and the chances of obtaining payment through legal action are lower than through strong pre-legal negotiation efforts.

Debt renegotiation proceedings before the courts are not generalized and when it comes to insolvency issues, liquidation remains the default proceeding even though liquidation sales rarely yield efficient results and may not be in the creditors’ best interest.