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Guldem Atabay
Dec 28 2018

Can hope return following Turkey’s dismal 2018?

2018 did not treat Turkey very well. Or perhaps Turkey did not treat 2018 as it should have done. Deterioration was tangible everywhere: from economics to politics and from freedom of speech to Turkey’s relations with the rest of the world.

With an expansion of 7.2 percent in GDP in the first quarter of 2018, what started as a year of “strong economic growth” and hope soon turned into an historic currency crisis that unfolded from May until late August. Inevitably, Turkey’s economy began falling victim to a much-warned-about “hard landing”. As of the third quarter, GDP growth stood at 1.6 percent with a very sharp recession expected to last through the rest of the year and beyond. If not “catastrophic”, the economic contraction and the reasons for this dismal economic performance will sadly have long-lasting spillover effects.

For the sake of a “snap” June 2018 presidential election – which President Recep Tayyip Erdoğan called to ensure he gained full control of the country -- the economic authorities ignored the realities of a changing global environment brought on by Fed rate hikes.

As the government pumped up domestic demand, the central bank was prevented from carrying out its duty of managing inflation expectations and dealing with higher price increases. Interest rates were kept low while state banks kept the loan taps open to stimulate the economy.

The Credit Guarantee Fund, created by the ruling Justice and Development Party (AKP) had guaranteed $129 billion of borrowing since the start of 2017, shifting domestic demand into full gear. Such careless steps had a devastating effect on Turkey’s macroeconomic balances, which were already fragile given its heavy dependence on external funding to fuel growth. Consequently, the current account deficit widened to 6.5 percent of GDP by the mid-summer due to an import boom.

What credible economists called “overheating” was rejected out of hand by the AKP’s economy team. The remaining credible names in the government’s economic management team had already been sidelined by the time Erdoğan took the stage in London on May 15 to declare to shocked investors that he would take more control of Turkey’s monetary policy.

Erdoğan repeated his incorrect assertion that high interest rates caused high inflation and announced that he would slash interest rates should he win June presidential elections.

The president chose to declare his misplaced intentions in perhaps the worst place he ever could – in the capital city of European finance and on Bloomberg, the world’s leading financial news channel. The impact of Moody’s downgrade of Turkish debt back in March, much berated by Erdoğan, paled in comparison to that of Erdoğan’s economic diatribe. He uttered these self-righteous comments when the Turkish lira was already down 14 percent against the dollar year-to-date, the central bank’s key interest rate was at 13.5 percent and consumer-price inflation was 11 percent.

On the same day Erdoğan spoke, Bloomberg wrote:

“The rapidity of the changes to Turkey’s economic and foreign policies have shaken investor confidence, which is critical because Turkey’s current-account deficit demands steady inflows from abroad.”

Thus, the spiral of loss of control over Turkey’s economy began.

Follow-up roadshows to London by then-Deputy Prime Minister Mehmet Simsek and the central bank governor largely failed to calm things down during the election countdown. As market uncertainty intensified, the president had effectively cornered himself with his strident words, meaning that the central bank was forced to step up with a policy rate hike of 300 basis points later in May to stop the bleeding. Another 125 basis-point increase was then required in early June just ahead of the most critical election in Turkey for decades.

The delayed rate hikes proved enough to stabilise the lira, at least for the time being. Erdoğan won the early elections of June 24, along with the enhanced presidential powers he so craved.  

Erdoğan’s victory had a temporary calming effect on Turkey’s financial markets. on the lira and the economy in general. Come July, the main focus was on the cabinet members he was to appoint; political figures that were meant to bring Turkey’s economy to safer shores. But Erdoğan appointed his son-in-law Berat Albayrak as minister responsible for both the Treasury and the Finance Ministry, amalgamating the two important institutions. The move was inevitably ill-received by financial markets.

By late July, emerging markets were already in turmoil. U.S. President Donald Trump had openly declared a trade war with China, Federal Reserve rate hikes were going at full throttle and Argentina was in crisis.

The second trigger for the lira’s devaluation had come with the announcement of the cabinet under the new presidential system. Yet, the worst was yet to hit Turkey’s fragile financial markets and economy. A virtual tsunami of lira weakness began in August as the U.S. administration imposed political sanctions on Ankara over the imprisonment of pastor Andrew Brunson.

What followed was a seemingly never-ending slide in the lira and, with it, mounting concerns about Turkey’s huge foreign debt obligations. Daily economic activity in the country froze as a waiting game ensued to see if Ankara would take the action required to steer Turkey away from impending financial ruin.

The Central Bank finally acted with a shock 625 basis point rate hike in September. Then the government announced a three-year “New Economy Plan” promising fiscal austerity for 2019 and beyond. Yet, what had more impact on investor sentiment towards Turkey, which had turned ever sourer, was a long overdue reaction from the political leadership. With Erdoğan’s reluctant blessing, the Turkish courts finally freed pastor Brunson in October. He was sent back to the United States the same day to be greeted triumphantly by Trump at the White House.

Yet, the damage to Turkey’s economy was already done.

In terms of lira stability, the final quarter of the year has proved more stable. Yet, losses of some 30 percent during 2018 were still painful in every respect. Turkey’s key macroeconomic indicators started to point to “stagflation” -- a rare economic happening in today’s world -- as consumer price inflation hit 25 percent, producer prices accelerated to 45 percent and other indictors showing a collapse in sentiment and a large economic contraction. Turkey’s current account deficit rapidly began shrinking; not as a by-product of a “rebalancing” process due to sensible economic policies taken by the government, who claimed that foreign investors were attacking Turkey though the lira. But rather because of a rapidly contracting economy that was surely in a “hard landing” due to policy mistakes.

What befell the Turkish economy in 2018 means we need to scrutinise events both on the political and macroeconomic fronts throughout 2019.

Perhaps only after the March 31 local elections might we see the government shifting away from its short-term, crisis management approach to adopt the measures needed to avoid long years of weak economic performance in Turkey. That misguided approach has been in place since May 2013, when the Fed first announced the all-important shift in its stance towards monetary tightening. Such a short-term approach by Ankara only creates new emergencies in the economy because it lacks coherence and a grander vision for macroeconomic policy.