Turkey: Ripe For Reform?

Postelection, Turkey needs to take tangible measures to restore economic stability and government credibility and strengthen domestic capital markets.

Recep Tayyip Erdogan’s combative decision to turn the March 31 local elections into a referendum on his presidency was always set to be a high-stakes move. Unsurprisingly, the campaign was bitter. The governing Justice and Development Party (AK Party) and its allies claimed Turkey’s very survival was at stake. It accused the secular Republican People’s Party (CHP) and its allies of being in thrall to foreign interests.

Nobody expected the whole electoral process to backfire so dramatically. Turkey’s main metropolitan centers, including Antalya, Adana and, significantly, the capital Ankara, fell to the opposition. Most poignant for Erdogan was losing his home city of Istanbul—where he started his career and which he used as a launchpad, as mayor, to break into national politics.

The political map of Turkey now shows similarities with that of the US, with the CHP—like US Democrats—holding the more-developed coastal areas, while the AK Party and allies—like the US GOP—reign supreme in the rural interior. Some 51% of voters supported the ruling AK Party coalition, versus around 38% who supported CHP. This suggests that although Erdogan remains by far the most powerful political figure in Turkey, the opposition is gaining traction.

How did this happen? Erdogan’s liberal critics voiced opposition to his growing authoritarianism and concern over his various spats with the EU and the US. Yet most of those who turned against Erdogan did so for a more mundane reason: the economy.

Turkey has yet to recover from the tumultuous days of last August, when a sudden tariff war with the US sent the Turkish lira into a tailspin—at one point losing 70% to hit 7.2 to the dollar, compared to a rate of 4 before the crisis. In mid-April, the lira was trading at around 5.4 lira to the US dollar, a drop of more than 20%. The impact on consumer and investor confidence has been dramatic, leading to GDP contracting 1.6% in the third quarter of 2018 and 2.4% in the final quarter of the year. Total growth for 2018 was 2.6%, the lowest since 2009, with unemployment reaching 13.5% by year-end, nearly four percentage points above year-end 2017.

Meanwhile, inflation has increased to about 20%, with consumers hit the hardest. To mitigate the pressure, the government has opened heavily subsidized food markets in the main cities. But such measures have been insufficient, with consumers and businesses also impacted by increasing interest rates.

Banks, which have seen an expansion in nonperforming loans (NPLs)—even though they remain low, at less than 4%—have become more risk-averse amid the drop in asset quality, and are poorly positioned to issue new loans. As confidence in the lira falls, dollarization has been rising. Foreign exchange (FX) deposits now make up nearly half of total deposits, compared with 30% at the end of 2010.

“Over the first two months of 2019, we saw a huge increase in demand for FX from local depositors: around $16 billion,” says Inan Demir, head of emerging Europe, the Middle East and Africa at Nomura Bank, adding that reserves at the Central Bank of the Republic of Turkey were initially unaffected. A further acceleration in demand over March, however, led to a drop in FX reserves; the central bank was obliged to launch countermeasures, which included restricting offshore lira liquidity in an effort to boost demand for the currency. “These moves raised concerns about CB transparency at a crucial time, with the worry it could have a negative impact on investor sentiment,” Demir notes.

Analysts at Moody’s Investors Service have added their own concerns, noting at the start of April that the erosion of the central bank’s foreign currency reserves is concerning and that recent apparent moves by the central bank to support the lira “pose renewed questions about transparency and independence.” These developments followed a period of reassuringly conventional central bank activity after it moved swiftly last September to boost its key interest rate 625 basis points, to 24%, to stem the lira’s decline.

Roger Kelly, the lead regional economist covering Turkey, Romania and Bulgaria at the European Bank for Reconstruction and Development (EBRD), says the broad policy response has been reassuring, despite some lingering doubts about the central bank’s independence. “The announcement last autumn of a new economic plan which involves better coordination of fiscal and monetary policy will also go some way toward establishing credibility,” he adds.

But most investors have been looking at the broader picture, which at first glance is not encouraging. “Indicators for first quarter 2019 do not point to a significant pick-up in activity, and for the full year, growth is likely to be negative,” says Demir. This is in line with many other forecasters, including Fitch Ratings, which in March lowered its 2019 forecast for GDP to decline 1.1%, against its earlier forecast of a 0.6% decline.

“This is a tough time for the economy, as the impact of the fall in the lira and much tighter policy settings continue to work through,” says Paul Gamble, head of emerging Europe at Fitch Ratings’Sovereign Ratings group in London. Gamble believes that the economy bottomed in the first quarter but that year-on-year growth will remain below potential next year. Inflation is expected to end 2019 in the double digits, albeit lower than where it is today.

This gloom is echoed by Lawrence Brainard of TS Lombard, an economic research house in London. In a recent note to clients, he argues that contrary to government claims, there is little evidence that the recession is bottoming out. He believes the economy faces an extended period of stagflation, compounded by a deteriorating fiscal picture, as expenditures continue to increase and revenues fail to pick up. He says the current fiscal deficit of 2.9% “understates the current fiscal shortfall.”

Pointing to the large off-balance-sheet liabilities associated with up to $60 billion in public-private partnership projects backed by the government’s Credit Guarantee Fund, he adds, “There are reasons to question whether official data provides an accurate picture of Turkey’s fiscal position.”

President Erdogan has gone out of his way to discourage the naysayers, and suggests that 2019 will turn out much better than many maintain. To be fair, there are signs that the economic contraction is bottoming out, with exports and tourism expected to have a bumper year on the back of a weaker lira and bolstered by an improved domestic security environment. The opening of the new Istanbul airport last October—Turkish Airlines moved all its operations there from Istanbul Atatürk Airport in early April this year—is also expected to bolster visitor numbers. The new airport is vast, with a current capacity of 90 million passengers a year, which will more than double to 200 million once the final phase of construction is finished in 2023. Flights will go to 350 destinations around the world.

Meanwhile, trade is doing well, with exporters in the manufacturing sector, in particular, taking advantage of the cheaper lira. Between January and March this year, the value of exports increased by more than 3.3% to reach $44.5 billion, the highest level ever, with imports down more than 21% to $50.5 billion.

The EBRD is among those who believe Turkey will experience some growth this year, although its current 1% forecast is well below the 4.2% forecast the bank made last May, before the currency crisis. “Exporters have the potential to be one of the bright spots in Turkey and we expect them to play an important role in any recovery later this year,” says Kelly.

As the dust settles from Turkey’s local elections, investors will be looking to Erdogan and his AK Party government to cool the heated political atmosphere and restore some order and predictability to the economy.

Turkey has had a turbulent few years, with the attempted August 2016 coup, subsequent far-reaching purges within the public and private sectors, some bitterly fought elections and numerous face-offs with countries it once counted among it closest allies. Now it has an unprecedented four-and-a-half-year window with no elections scheduled. Observers will be hoping the government presses ahead with its three-year reform program, the outlines of which were unveiled last year.

“[In the past], politics always got in the way,” argues Gamble. “Now investors are looking at an environment that should be conducive to the introduction of reforms that could improve the business environment and the domestic savings ratio.”

There is some solid ground to build on. Last year, Turkey improved its position by 17 in the World Bank’s Doing Business survey—to rank 43 out of 190 countries—having taken some key steps to improve the business environment, including reducing the amount of time needed to start a business.

Especially given Turkey’s travails, coupled with the general downturn in global investor sentiment, FDI has held up better than expected, with $13.2 billion invested last year, a 14% increase over 2017.

And according to the country’s Banking Regulation and Supervision Agency (BRSA), the bank sector has also remained in good shape. Total sector assets increased 19.4% year-on-year in January–February of this year to reach $743 billion, with net profits totaling $1.22 billion. Last year, net profits were up 10% and reached $10.6 billion.

This occurred despite the highly adverse impact the lira’s depreciation has had on foreign currency debt. In a report issued at the end of March, Fitch Ratings stressed the sector’s capital ratios and found that its profitability and capital buffers “still provide a significant cushion against a potential marked deterioration in asset quality,” although weaker banks “will breach minimum capital levels at lower levels of stress.” For these institutions, the EBRD’s offer in early April to help Turkey tackle an increase in nonperforming loans—which according to the BRSA reached 4.11% in February, up from 2.92% in February 2018—will provide solid reassurance.

Despite such bright spots, investors over the longer term will be looking for reassurance that Turkey is looking to stabilize the economy and reenergize reforms. The Turkish Industry and Business Association says priorities should be returning inflation to single figures, alongside strengthening institutions, improving transparency in the public sector and developing the insurance sector.

The EBRD’s Roger Kelly says Ankara should be focusing on a wide range of priorities: enhancing domestic energy security and sustainability (energy imports account for a large part of the current account deficit); boosting the quality of infrastructure, particularly municipal; and boosting competitiveness to help the economy avoid the middle-income trap.

The government should also, he says, look to boost inclusion and gender equality, taking into account the huge regional differences between western Turkey and areas in the east, particularly those far removed from the big cities.

“Turkey also needs to press ahead with strengthening domestic capital markets so locals are more easily able to borrow in lira. This is key to reducing dollarization,” Kelly says, adding that the high cost of borrowing in lira has been one of the major factors holding back domestic investment.

As growth slowly resumes, can Turkey look ahead with confidence? As long as something like the expected delivery of the SS-400 missile system from Moscow this summer doesn’t translate into another bruising deterioration in relations with Washington, which cost Turkey so much the last time, then the nation may be able to right the ship.

“Investors have seen a broad deterioration of the business environment—with the purge of the public sector spreading into the private—against a pretty poor macro backdrop, with policy uncertainty also a big concern,” says Gamble of Fitch Ratings. He believes that, regardless of what reforms the government promises, investors will be looking to see concrete action. “The key thing to watch for, as always, will be implementation.”