Turkey's economy is approaching a crossroads

Turkey's economy began 2021 under an umbrella of optimism.

An encouraging change to the economy team in November, interest rate increases, reform promises and declarations about Turkey returning to the Western orbit transformed the country’s capital markets into a magnet for foreign investors.

A slump in the Turkish lira ended and the currency has led emerging market gains this year, extending a rally since a record low in early November to 20 percent.

Many foreign financial institutions began to predict further gains for the currency as it neared a key level of 7 per dollar. Forecasts became increasingly optimistic, with estimates starting at below 7, then stretching to 6.5 and even 6.2.

In a dream scenario, some analysts have predicted economic growth of between 5 percent and 6 percent for this year, a normalisation of the loan market after 2020’s credit boom, a narrowing of $10-15 billion in the current account deficit, an increase in the central bank’s foreign exchange reserves, a move towards single-digit inflation, a decline in unemployment and a smaller budget deficit.

With monetary policy returning to orthodoxy under new central bank governor Naci Ağbal, the only obstacle that could stand in the way of res-establishing a sustainable path for the Turkish economy was President Recep Tayyip Erdoğan's exhaustion of patience with high interest rates. It was believed that Ağbal would convince him to remain on board.

Economic growth for Turkey in the last quarter of 2020 will be close to 8 percent and the annual increase in GDP for last year will be around 2.3 percent. The economic costs of achieving this high growth rate in a pandemic year were excessively high inflation, a widening current account deficit and a meltdown in the central bank’s foreign currency reserves.

But despite initial expectations, it appears that the rest of 2021 will not be so rosy despite some encouraging economic data for the first two months of the year.

Consumer price inflation (CPI) will likely increase to 16 percent or perhaps slightly higher in March-May. Even though fears of premature cuts to interest rates have subsided for now, current monetary policy is far from tight. It is insufficient to quickly bring down inflation to the central bank’s 5 percent target. Therefore economic growth will slow only gradually.

Preliminary data as of February points to an economic expansion of around 4 percent to 5 percent in the first quarter. Current central bank interest rates of 17 percent will only rebalance the economy from extremes rather than create the significant slowdown required to tame inflation. The average expectation among economists in for economic growth this year of 4.8 percent and year-end CPI of between 11 percent and 12 percent.

Then there are financial and economic pressures emanating from the outside world.

Year-end expectations for the price of Brent crude oil have marched higher and now stand at around $75 per barrel. Rising oil prices will create cost push inflation in Turkey and will feed into the current account deficit, given that Turkey imports nearly all the energy it consumes. With domestic demand slowing only gradually, the slowdown in import growth that some economists expect in 2021 appears difficult to achieve.

Meanwhile, tourism data for January shows that revenues will be low for the first half of 2021. The slow speed of the vaccination rollout both in Europe and in Turkey is likely to limit the growth in Turkey’s tourism revenues by some 40 percent compared with 2020. With economic growth and the increase in oil prices, the current account deficit to GDP ratio this year will not decline meaningfully from 2020’s 5.3 percent. Therefore, to avoid more losses for the lira this year, Turkey will need to attract high levels of foreign capital inflows to finance the revenue shortfall without pressuring the lira.

The U.S. Federal Reserve has announced that it will not react for the time being to rising U.S. bond yields and inflation and will not reduce its support for the markets. However, there are already expectations that the first signal of monetary tightening will come by the middle of 2022 and the first hike to interest rates in 2023. Whatever the Fed says, when U.S. CPI inflation rises to 2.2 percent, perhaps in May, regardless of whether it will be permanent or not, emerging market currencies will be hit, including the Turkish lira.

The positive effect of higher interest rates on capital inflows, seen in the November to February period, is waning. Given the policies of the AKP-MHP government, Turkey is not able to attract better quality foreign capital inflows beyond hot money. In an environment where locals continue to add to their foreign exchange holdings, a significant increase in the central bank’s reserves based solely on hot money flows is simply not on the cards. Pledges of economic reforms seem long forgotten. Instead, Turkey’s government appears focused on putting more pressure on its political opponents rather than transforming the economy.

Relative calm in foreign policy during January and February will not last long. Even though Erdoğan is making attempts to improve Turkey’s relations with the United States, his efforts will fail should he not totally abandon a defence policy dominated by the acquisition of Russian S-400 missiles. Other contentious issues such as U.S. legal proceedings against Turkey’s state-run Halkbank, U.S. support for Kurdish militants in Syria, and tensions with Cyprus and Greece over natural resources in the eastern Mediterranean will likely resurface one by one from the second quarter of the year.

Meanwhile, ongoing problems in the economy continue to weaken support for the AKP-MHP People's Alliance and have sparked a toughening in its political rhetoric. While this adds to political tensions in Turkey, it also prevents establishing a common ground for repairing relations with the United States and the European Union. 

It is unrealistic to expect that the lira will gain value permanently from current levels. On the contrary, one should expect it to gradually depreciate through the year based on macroeconomic and political developments. Whether the lira will merely weaken towards its so-called “fair value” of 7.5 per dollar or weaken to new record lows will depend on what the governing alliance decides to do to preserve its power and waning popularity.