Turkey: Forget the S-400; loose fiscal policy paves the path for doom
While the main focus in Turkey is waiting to see what sanctions the United States imposes as a result of Turkey’s acquisition of Russian S-400 missiles, loosening fiscal policy and the weak lira is likely to weigh down the economy.
Turkey’s freshly appointed central bank governor is gearing up to fulfil President Recep Tayyip Erdoğan’s demands for interest rate cuts, indicating a loose fiscal policy in the second half of the year that will spell renewed trouble for the economy.
The collapsing current account deficit in tandem with fading domestic demand might well postpone an August 2018-type currency meltdown, but with political risks also piling up, they might only delay it.
Fiscal deterioration: not a problem to get solved in the short-term
Erdoğan and his Justice and Development Party (AKP) were able to win elections between 2002 and 2018 owing to a great extent to strong GDP growth that helped the widening conservative middle class.
The first period, between 2002 and 2008, saw strong, but balanced growth thanks to a standby programme with the IMF that prioritised bringing down inflation and fiscal rationalisation that had kept Turkey from achieving its growth potential.
The second period, from 2008 to 2013, were years of cheap external liquidity that kept Turkey competing with China in terms of GDP growth. As growth reached almost 10 percent in some years, the overheating was cooled by an unorthodox monetary policy combined with a still intact fiscal discipline. But the start of tightening by the Fed in 2013 coincided with Erdoğan’s desire to consolidate power through an executive presidency.
The period between 2013 and 2018 was marked by an insistence on unorthodox monetary policy that kept price stability secondary to growth. Such policy mistakes fed inflation as fiscal discipline eroded.
While the value of the lira is the barometer of the economy for many in Turkey, when the current account deficit rises to unsustainable levels at around 7 to 9 percent of GDP is the best time for foreign investors to flee Turkish markets.
With Turkey’s fiscal deficit to GDP ratio at around 1 to 2 percent levels for more than a decade and public debt to GDP below 30 percent, the fiscal side of the story is often neglected, but it should not be.
The numbers can talk for themselves
With fiscal austerity in place between 2002 and 2008, Turkey’s primary surplus (revenues minus interest expenses) to GDP ratio hovered between 4.0 to 5.5 percent of GDP when the IMF programme based its measures on public sector transparency and accountability, as well as disinflation through central bank autonomy and inflation targeting.
When the IMF programme ended in late 2008, the financial crisis in developed nations sent some $12 billion across the globe and the AKP government of the time found room to reduce the primary surplus to GDP ratio down to the 1.5 to 1.9 percent range until 2013, which was enough to count as ongoing fiscal discipline. That was the time when the AKP found out how an elevated level of spending returned votes from supporters unified under a stronger style of leadership.
As global liquidity began moving away from emerging markets, the Turkish government began finding less room to maintain both fiscal discipline and spending. By the end of 2017, the primary surplus turned flat and an unorthodox loose monetary policy combined with a looser fiscal policy took its toll on inflation. Along with sustained above-potential growth to win votes, the rising current account deficit sank the lira last August and sent inflation to a 14-year peak of 25 percent in September.
Halfway through 2019, the background appears a little different following last year’s currency crisis. Inflation is down to 15.7 percent as the effects of last year’s currency shock are shrinking. As GDP growth turned into contraction and large losses for the AKP in local elections this year, Erdoğan is once again focused on growth to shore up his support.
While the central bank was forced to make a big, fat, orthodox rate hike last summer, Erdoğan’s remaining tools to tame economic contraction were on the fiscal side. The results are now tangible. Turkey posted a budget deficit of 78.6 billion lira ($14 billion) in the first half of 2019, a level it was only supposed to reach by the end of the year. While the government’s end of year primary balance target was a surplus of 36.7 billion lira ($6.4 billion), the first half performance points at a huge deficit of 27.8 billion lira ($5 billion), double that of last year.
Such poor performance comes both from contracting domestic demand and the government’s spending spree in the first half of 2019. The loss of Istanbul, Ankara and other big cities to the opposition in local elections, splits within the AKP and a KONDA poll that shows core AKP votes down to 28 percent all make it urgent for the president to bring growth back on track.
Erdoğan is likely ready to spend more on the fiscal side as is evident from a government bill that would transfer 40 billion lira from central bank emergency funds to the Treasury before the end of the year. The president is ready to cut the monetary policy rate aggressively as is indicated by his sacking of the central bank governor and appointment of a more pliant replacement. Make no mistake; the government will keep spending in the second half of the year.
The government can by law stretch the 2019 budget deficit to 90.4 billion lira from the initial estimate of 80.6 billion lira. The Treasury, run by Erdoğan’s son-in-law Berat Albayrak, has so far been borrowing heavily as shown by the 132 percent rollover ratio in the local market. Assuming the fiscal upper limits will be approved by parliament, the Treasury has 12 billion lira left to borrow from domestic auctions. Added the 40 billion lira to come from central bank resources, the end of year fiscal deficit is set to reach a sizeable 3.5 to 4 percent of GDP, almost double the 2018 level, based on a growth estimate of -2.8 percent for 2019.
If the United States is not bluffing with regard to S-400 related sanctions, a doubling of the fiscal deficit in terms of GDP and now increased monetary easing combine to indicate a sticky inflation rate of 15 percent. Turkey set to have a very difficult year ahead.