Growth, sustainability: wherein lies the future?
The Q1 GDP print was exactly as predicted – among other indicators - by a series of nowcasting exercises. It is basically due to January when the financial account posted $12.5 billion entry and when growth was widespread across sectors. The rest was – increasingly - ‘momentum only’. That is the story of Q1. Now we are in the midst of ‘momentum loss’. I would expect a cutback to 5.5 percent in Q2 and a very large downswing in Q2 – mainly, but not only, due to the negative base effect. Q4 is altogether another story. Its fate will depend on the course of actions to be taken at home as well as global tendencies. However, international financial factors will probably be unfavorable as the Fed balance sheet contracts at an increasing speed, the ECB is likely to follow suit and interest rates will continue to rise. In short, in H2 we are more likely to observe the formation of a secular downward trend than not, which 2019 will inherit. In 2019, a subpar ( below potential) growth is in the cards. There is more. All indicators increasingly point to a cooling off that can either take the form of a soft landing or a sudden stop.
Data and indicators
Consider the latest data briefly: Domestic consumption grew by 11 percent year-on-year and this is what we mean by “it was momentum”. Fixed capital investments followed suit with 9.7 percent growth. They are driven by private consumption growth. We should also note that the inventory cycle isn’t measured by the new chain index. However, the nominal GDP accounts point to a TRY 17.4 billion increase. Hence, stocks accumulate and in nominal terms they account for 12.7 percent of Q1 growth. Inventories piled up as matter of fact in Q1, a fact that is conducive to lower manufacturing industry production going forward – manufacturing GDP weight is 17.5 percent. We already see that in the April industrial production data. Direct public expenditures contributed much less because their growth rate is only 3.4 percent. Actually, the highest growth rates posted by the final consumption of the public sector read as 9 percent and 7.4 percent in Q1 2017 and Q4 2017 respectively. Hence, the public sector’s direct contribution to growth was high last year and in 2018 it looks like it has already run its course. Net exports contributed so negatively that this item has wiped out almost half of domestic consumption’s contribution. Private consumption has added 6.74 percentage points to growth whereas net exports have extracted 3.58 percentage points. Indeed, exports rose by 0.5 percent only whereas imports by 15.6 percent. This is the worst net exports’ performance in years. On the production side, we can immediately observe an indication of what we mean by ‘over-reliance on one factor’: construction investments increased by 12.28 percent while machinery and equipment by 7 percent. Because fixed capital formation in machinery and equipment was negative in H1 2017, the 2017 comparison is far worse. It is completely tilted toward consumption. This is indeed low-quality growth. It won’t last.
Why won’t it last? What are the indicators? First, growth is based on domestic demand and it is driven by credit. Credit is scarce, except public banks that are still lending at breakneck speed – 31.7 percent annualized from the weekly data of June 1 as opposed to 8.3 percent of private banks, a multiple of almost four. But it isn’t sustainable. Second, confidence is low. Third, costs are rising. As long as demand is strong, costs can be passed on to the final consumer, but even rampant inflation may not help sustain profits going forward. Fourth, there are already accumulated problems due to high indebtedness as testified by the latest restructuring and refinancing applications that add up to more than $25 billion – and large firms at that. Fifth, industrial production is set to slow down. Sixth, construction and real estate, which accounted for most of fixed capital formation over the last decade, is in the declining phase. Seventh, public spending has already been amply used, as a result of which the fiscal deficit more than doubled and can’t be expected to fuel demand as before. Eighth, net exports can only deduct from growth both because imports rise faster than exports and because terms of trade are unfavorable. Ninth, the exchange rate is still unstable and hard to predict. Tenth, so is the future path of inflation. A peak at around 14-15 percent is likely, but then who knows? Further exchange rate shocks and oil price rises could easily push the head-on CPI to above 15 percent. Finally, interest rates are also heading north. It is imaginable that up to half of the
top 500 firms 2018 bottom lines can be wiped out by the additional exchange rate and interest rate expenses triggered by events that took place in May-June.
Will capital inflows help again?
How was growth possible in the first place? Both because banks and corporates could successfully tap fixed income markets at low cost for years and portfolio inflows endured. On more than one occasion there were signs indicating a reversal of the flow of funds but it didn’t exactly happen. However, the situation has finally changed. As time went by, because nothing fundamental has changed, it has been possible to keep the momentum but only at the long-run cost of rendering the fundamental outlook more bleak.
The question is: will fundamentals weigh this time around more than capital inflows, albeit short-term because there have been extended periods of cheap and ample money around, first with the global savings glut, then with capital pouring in the EMs after Lehman, secular stagnation and all that? Whatever textbook wrongs you did, they weren’t punished because dollar liquidity acted as sin eater. Is it finally over? Well, the answer is ‘yes’ I suppose. As the Fed has begun to scale down its balance sheet, the question of the impact of this move has come to the forefront. It is also not exactly simultaneous with the rate hikes but at least they overlap. We also see a retreat from EMs, which has reached $13 billion in May alone. There may be caveats to that, but certainly Turkey isn’t an attractor of overseas funds out of a shallow pool these days.
What are the fundamental approaches to the ongoing malaise?
Now, there may be more fundamental approaches to what is going on. One approach would consist of an inference one could make out of the production function. We know that unless total factor productivity doesn’t help significantly, over-reliance on a classical factor – such as capital - will end up with falling marginal productivity. Depending on the curvature of the production function – its degree and kind of concavity - sooner or later decreasing returns loom large on the horizon. In this particular case, too much reliance on a single factor means over-investment in construction. FDIs have been low, less than two percent of GDP over the last decade. There is virtually no innovation and the high-tech component of exports is always less than three percent. There are no efficiency gains and total factor productivity doesn’t help. Nevertheless, is all this because of the choice of the growth model? The simple story that tells us thus can’t pass for an over-arching explanation: “there were billions of dollars on the sidewalk because there was a global savings glut first and then money at almost zero cost because of the Great Financial Crisis, and a small open economy has collected the money, accumulated debt, invested in buildings and such, and distributed rents through quasi-fiscal devices and such – so the incumbent party always wins.” It isn’t that simple.
There is another fundamental approach, a message conveyed by neoclassical/neo-institutional political economics. It stresses the importance of institutions. The novelty in the recent works of Acemoglu & Robinson, for instance, compared to their older papers, lies in the proposition that geography, political legacy, and history are conditioning variables only. They don’t reduce the set of possibilities to a single point. Various outcomes based on similar backdrops have been possible according as the society/state mix and this very mix can be conducive to either extractive or inclusive institutions, weak states or despotic states and suchlike. Admittedly, there are cases when the dead hand of the past weighs far too heavily on current generations so ‘Prometheus can’t be unbound’. There are also cases when there is enough degree of freedom so the game admits a solution leading to a ‘good’ equilibrium. In the face of deteriorating governance/institutional strength indicators, rule of law, freedom of press, accountability and all that, it may be the case that the malaise is more deeply entrenched into the society/state mix than imagined before.
A high growth print isn’t necessarily a good omen, especially if it is driven by high-powered incentives, if it is based on credit, if it generates a high current account deficit and worsens the FX debt burden, if many large firms tend to restructure their debts and if momentum is lost. The first two quarters will look good still and the H1 GDP growth will be in the vicinity of 6.5 percent. However, the second half will tell an entirely different story. Overall, achieving a 4.7-5.2 percent yearly growth is possible.
Nonetheless, 2019 relies on weak fundamentals. The automatic correction will drive the growth engine to work in a relaxed mood. Will automatic correction be enough to restore fiscal, financial and trade balances? Is it plausible to imagine that the same mechanism and the same external conditions that kept good business going on can be repeated? No, and the result is likely to be a secular fall in the potential growth rate. Add to this the additional burden of high interest rates and the so much depreciated Lira, less earnings, a much lower bottom line etc. As we’ve said before: A fully worked out new plan of action is warranted.