Characterizing the Turkish economy: a portrait

Now that the CBRT policy rate has risen to 24 percent, almost fully accommodating what the market has already done, there are high hopes that the lira will stabilize. In fact, a 5.50USD/TRY rate towards the end of the year is in the cards. I offer two guidelines for this to happen. First, monetary policy is now aligned with the market, albeit with a considerable lag. Furthermore, this move implies that what is necessary can be accepted as such and policy authorities can act accordingly. This is the ‘signal effect’, so to speak. Second, one can read between the lines a certain rapprochement with the West, obviously a factor working in the right, i.e. from a currency viewpoint stabilization direction. Furthermore, I am not of the opinion that the lira deserves that kind of ‘undershooting’. It has depreciated a lot and the time is about to come for reposing at around a steady state. True, there are fundamental reasons for a depreciation but the speed with which it headed south can’t be exhaustively explained by fundamentals. Anyway, a steady state or rest point has to be attained, after which the TRY interest rate-inflation relationship could be rendered more transparent and the inflation problem could be addressed directly. After all, achieving a rest point would imply an end to the pass-through effect and will help inflation fall from the peak it is about to reach. Remember, inflation will be chiefly cost-pull after this point, and when the accumulated stress will pass on to the CPI from domestic producer prices, inflation will begin to fall automatically. It won’t fall to single-digits within a year or so, but it is likely to fall to low double-digits if only on account of the favorable base effects that might await in 2019. Because the exchange rate is the main culprit behind rising inflation, both inflation and inflation expectations will begin to drop if a temporary equilibrium or rest point is reached.

A portrait

However, just as the market risk isn’t the only risk the Turkish economy faces – it faces a ‘composite risk’ so to speak, market, credit, political etc. - a rate hike isn’t a panacea for addressing structural problems. From the corridor talks or preplay negotiations, I understand that the financial engineering part of any conceivable solution to the corporate FX debt problem is already under scrutiny. This is good news. However, there are other, more persistent issue at stake also.

For one, the Turkish economy looks like the U.S. economy in terms of its GDP composition: a persistent current account deficit, its insufficient level of savings etc., but less technology and capital formation levels, of course. Private consumption always hovers around 75 percent of GDP, the share of the public sector is about 15 percen, and gross fixed capital formation accounts for around 30 percent. If we look at it from a domestic demand/external demand dichotomy, domestic demand is almost everything from a net expenditure perspective, net external demand contributing negatively by 4.5 percent in 2017. Exports may go up from time to time, but so do imports because exports are dependent on imported inputs, and not only energy at that. Therefore, it is extremely difficult to engineer a switch, turn exports into an engine of growth and rebalance radically via this route. No, if one stifles domestic demand, growth turns into red. Hence, rebalancing ought to involve a rebalancing between domestic sources of growth such as rendering fixed capital formation (investments) the main demand item and curtailing household consumption a bit. Alternatively, public expenditures could be locked in a disciplinary box and the weights of public/private sources of demand could be modified. If the economy is set to grew at about its potential rate, i.e. 4.5-5 percent, then domestic demand, although reset and altered in its composition, will have to endure nonetheless.

Composition of demand

From the production viewpoint, there is a discrepancy. Construction accounts for 17.3 percent of GDP in terms of investments whereas machinery and equipment explains 10.5 percent. However, the share of construction in GDP from the production side is only 8.5 percent. True, there are forward and backward linkages and construction always has more weight in driving both growth and capital formation – and non-farm employment - but as the graphic depicts, it has risen to levels that suggest unbalanced growth at times. Over-reliance on construction and real estate development – and energy investments obviously - has taken its toll because these sectors don’t contribute much to technological innovation and exports. Any rebalancing needs to involve a setback in construction investments relatively speaking and an increase in industrial investments. Even so, the damage is done and the debt incurred by those sectors will have to be refinanced

and restructured via some kind of debt-equity swap mechanism as I suggested last week. There is no coming back to the boom phase of the construction cycle any time soon and the growth model of the old days now looks like, to play off Joyce, ‘a portrait of the business cycle as an old man.’

The role of credits and public expenditures

Everything in terms of economic activity depends on debt, i.e. credit. It isn’t only the financial account that either covers the current account deficit or doesn’t cover it and we resort to reserves and net errors and omissions, it is also domestic credit. Nevertheless, domestic credit is also dependent on noncore liabilities, i.e. funds borrowed from abroad by banks, and any problem banks encounter in securing syndications will result in lower credit growth at home. Already, this is happening. With private bank lending – because domestic savings don’t suffice to fund significant loan growth - already negative if annualized from FX-adjusted 13-week moving average data (and with corporate lending coming to a halt also), a quick reversal of GDP growth rates can be expected, which many an investment house have factored in recently. Sustainable credit growth is a necessary condition for securing even trend/ potential growth. As such, banking activity doesn’t support even 4.5 percent growth. There, also, a ‘rest point’ should be found, a point after which – and after significant restructuring of already existing corporate debt incurred by banks - lending activity can pick up, albeit at a slower pace than before. Again, it isn’t the current account deficit alone that triggers the kind of slowdown we envisage currently. It is corporate FX debt mostly that remains the main culprit.

Growth: the latest data

Well, latest meaning latest past; so, it doesn’t mean much. How- ever, the data confirm our outlook. Beginning in February, capital inflows slowed down and in fact turned into outflows. Simultaneously, growth indicators displayed ‘momentum only’. In other words, the growth story came to an end, and it was basically the inertia or legacy that 2017 growth had transferred to 2018 that lasted a bit more. In Q2, this trend has become visible. Industry posted almost half of past growth and agricultural growth gave way to minus 1.5 percent - a contraction - in lieu of 7 percent (positive) growth in 2017. Industrial growth has receded to 5.1 percent in Q2, down from 9.8 percent in Q1 and 10.5 percent in Q4 2017. All confidence indices also fell in Q2, and there is no surprise there. Government consumption expenditures posted an 8.8 percent rise in Q2 after a 5.2 percent real increase in Q1. Public investments grew by 20.8 percent in real terms year-on-year in Q2. In Q1, the rate of increase vis-à-vis Q1 2017 was spectacular at 150.6 percent year-on-year. Hence, in H1 growth was fueled by government expenditures to the extent such expenditures could be stretched to contribute to GDP. After all, we are talking about 14.5 percent GDP share (of the public sector) that contributed 0.9 percentage points to growth in Q2. Net exports contributed negatively again. Quarter-on-quarter GDP slowed down by over 2 percent. Once more, loan growth led by public banks sustained private consumption demand that contributed 3.6 percentage points, and that is what explains Q2 growth mostly. All in all, all incentives have been used –and perhaps used up - in order to keep a relatively high growth rate ahead of the June 24 elections. The kind of growth we talk about can’t be repeated. Q2 will be the last of its kind, and even in 2019 it will be hard to replicate it, although there lie municipality elections ahead.

Two growth stories

Prof. Erinç Yeldan has hinted at the similarity between the U.S. and Turkey’s Q2 performances. Well, I am not so sure, although there are obvious resemblances. True, despite appearances, American growth, if measured year-onyear Q2 2017 to Q2 2018, is only 2.9 percent, lower than its trend growth of 3.3 percent and the lowest such growth since 2015. But still, it is due to corporate investments, services and energy mostly. Tax rebates and exemptions seem to have contributed a lot to corporate profits, i.e. EBITDAs translation to bottom lines at higher rates. As such, net profits grew by 6.6 percent, much more than GDP growth, PCE (personal consumption expenditures) growth or even turnover for some sectors. Still, American growth is widespread and we may not be anywhere near the end of the American business cycle yet. Hence, no good news for EMs can be derived from the findings reported by Yeldan as to the future path of Fed rates.

Soft landing and rebalancing Mark II

The rate hike was a good move in my opinion, but it will have to be shored up by the new medium-term program to be announced on September 20 and a lot more is to come. One such set of ideas is the SPV or ‘bad bank’ type of structure that might be established in order to clean bank balance sheets, render corporate debt an off-balance sheet item from the standpoint of banks, help the private sector to refinance and restructure its debt, and also help the public sector without incurring all the cost. Another set should involve expenditure cuts and a controlled drop in private consumption. It is falling anyway so the trick lies in softening it and controlling the speed of the fall. Another solution is the alignment or realignment with the West. Yet another one should involve the time of exit because rebalancing will take at least six quarters. Finally, exit from soft landing – if achieved - and rebalancing ought to be accompanied with a wholly different growth strategy.