This paper aims to analyze current condition and outlook of Turkish economy in regard to private sector debt problem, macroeconomic policies of the government, transparency of the national accounts and US-Turkey relations.
Recession in the economy of Turkey started in the 3rd quarter of 2018. This ongoing recession is highly expected and long-delayed outcome of pro-growth policies of the ruling party since 2002. The major pillars of AKP’s pro-growth policies are mega projects constructed by private contractors and financed by the government, credit pumping via commercial banks and external funding of all financial system. This relatively had worked well until 2008 and maintained its resilience after the global financial crisis due to abundance of global liquidity. However, it relied on an assumption of external funding flows with reasonable cost conditions.
These policies became unsustainable, when leading central banks (ECB and Fed.) started to normalize their accommodative monetary policies. Cost of funding increased dramatically and rolling over current debt stock became more expensive. Thus, natural result of deterioration in global financial conditions was deceleration in the economic activity or growth with low quality meaning that growth at the expense of financial instability. Due to long years of election cycles starting from March 2014 to June 2018; second option was chosen and implemented.
Turkish economy continued to grow in this period and decoupled from its peers such as South Africa and Brazil. Policy choices of Erdogan worked very well to postpone the crisis, while extending its duration and making its solution more complicated. Therefore, recovery of the recession is slow and there is still no light on the far edge of the tunnel.
Private Sector Debt Problem
Underlying reason of recent economic crisis of Turkey is national debt problem. According to the latest figures published by Turkish Treasury, national debt is 447 billion dollars. Gross debt to GDP ratio is 61.8% which is the highest of all time. Major share of this debt stock (199 billion dollars) belongs to private sector. Total size of this debt peaked at 222 billion dollars in February 2018 and declined to 199 billion dollars in August 2019. While this deleveraging process in the last 1.5 years seemed to be positive in the first glance, it resulted in sharp decline in private sector investments (23.8% in the 2nd quarter of 2019 YoY). In other words, private enterprises had the dilemma of borrowing to invest more or paying back to downsize their operations. They chose the second option, and this led to the shrinkage of private investment. In case of the selection of the 1st option, loss of financial stability would be the likely result. Therefore, heavy debt stock of the non-financial private sector of Turkey leads to lower growth rate (or even recession) and financial instability (2013, 2016 and 2018), when funding becomes unavailable.
Impact of Economic Policies of the Government
Turkish Treasury and Central Bank (CBRT) were so active to tackle or at least delay the ongoing crisis. Both institutions implicitly implemented expansionary fiscal and monetary policies respectively. Even though they both claimed their commitment to the orthodox policies to maintain financial stability, application was much more different than this claim.
CBRT had maintained its high policy interest rate for a year, which is enough to normalize the currency shock, while ignoring determined action against inflation by easing its monetary stance. High interest rates prevented a sudden stop of capital inflows, where Turkey was about to fall into this hole in late summer of 2018. On the other hand, its credit stimulating policies caused to persistence of inflation. Annual inflation rate is relatively low, but price level is still too high. The main reason of this inconsistency is continuous price hikes with a declining rate. It should be kept in mind that inflation is not the price level, indeed it is the rate of increase in price level.
CBRT started to lower its policy interest rate very recently to stimulate credits to private companies. In addition to this policy; private banks are forced to keep credit taps open for the big conglomerates. Credit guaranteed fund became a major tool to inject cash for the SMEs, which are in need of working capital. State banks were used to promote loan growth and bear the risks of borrowers who are refused by the private banks. In summary, lowering borrowing costs and pushing credit to private sector are the major monetary policy targets of CBRT and BRSA, banking regulatory authority.
Turkish Treasury was also willing to promote growth and ready to implement heterodox fiscal policies. Although there has never been a written fiscal rule, non-interest surplus was informally targeted during the entire years of AKP government. In 2018, the government changed its decision and became more active in fiscal policy. Budget deficit became enormous and urged government to find new ways to balance it. Amnesty for repatriation of capital, zoning amnesty and paid military service had been enacted in 2018. 2019 is the year of more urgent and certainly creative ways of finding new sources to fill the gaps in the budget by policies such as transfer of cumulative capital reserve of central bank in terms of Turkish lira (corresponding to 8 billion dollars). In spite of these unconventional measures, budget deficit is still far beyond the revised targets.
In summary, both monetary and fiscal policies were actively used and became more expansionary. The critical questions are whether these policies are successful and sustainable. These policies were effective enough to postpone crisis as much as possible and alleviate the pains resulted from crisis. SME’s and big conglomerates are still functioning and banks are solvent. Government is able to pay its allowances to private contractors with some delay. Despite the decline in the approval rate of ruling party, loyal proponents of AKP still support the party.
However, these policies almost reached to the upper limit of their effectiveness. Moreover, positive cycle of inflation rate and current account deficit will fade away in October 2019. There will be no more rate cut in the following months after October meeting without risking financial stability. Secondly, private banks strongly implement credit rationing and they resist to provide loans to SME’s despite the pressure of the BRSA. Thirdly, state banks are about to reach their upper limits for providing loans to entities whose loan applications rejected by the private financial institutions. Moreover, due to the borrowing strategy of the Turkish Treasury, 50% of the all internal debt stock of the government need to be rolled over in 2020.
Next year will be the most difficult year of both Turkish Treasury and private enterprises to roll over their loans and bonds. Bondholders and lenders will ask for an additional risk premium to their lending rates not only due to risk of rollover but also risk of default. To sum up, 2020 will be the year that Turkish government runs out efficiency and effectiveness of its economic policies. Debt rollover will be the toughest topic of the year. Only way out from this trap is chance of better global financial conditions. Major economies are at the edge of a recession and likely global monetary easing can be an opportunity to exit from the crisis. However, I strongly believe that negative impact of global recession will exceed the positive side effect of it, which is quantitative easing of leading central banks. The fundamental reason for this thought is skepticism of international investor to Erdogan.
Support of State to Private Companies
In the worst days of the global financial crisis of 2008, some of the international banks and giant manufacturing companies were bailed out or even acquired by the Western governments. Some of the experts put forth the same idea as a solution for the Turkish Treasury, in case large companies particularly in the strategic sectors bankrupt. There are different methods to implement this strategy, and each will be discussed one by one shortly.
The first method is use of state banks to inject working capital in return for shareholder’s equity as a collateral. This has been used for some of the construction and electricity energy companies recently. However, due to aggressive credit pumping policies of these banks last year, there is no big room for further acquisitions in case of default.
Another option is direct ownership of Turkish Treasury via expropriation. This is totally against the mentality of economic system AKP implemented in the last 17 years. This method was not used even in the case of Turk Telecom, in which holding company Oger Telecom defaulted its obligations to Turkish banks. Regardless of ideological approach or lack of funds of Turkish Treasury; this will probably not be the option exercised.
Third option is the transfer of bad loans of these companies to a special fund, in which government subsidizes via Treasury or TWF (Turkey Wealth Fund). This is more genuine approach and suitable for the ideological perspective of AKP. The main problem with this option is lack of funds. However, TWF is willing to borrow funds in international markets and necessary regulations have already been enacted to start this process.
There is still one question: will TWF be able to reach external funding? Yes, if it attaches required collateral to its bonds. Net asset value of TWF was expected to be about 40 billion dollars according to the unofficial predictions made last year. This figure was revised to 30 billion dollars this year due to loss of value of its subsidiaries after the currency shock. Largest asset in the basket is Ziraat Bank and its value is also controversial due to doubts on its loan portfolio quality.
If a new financial turmoil occurs, significant loss in the value of all these assets thus total portfolio size of TWF will realize. Therefore, TWF cannot be a perfect savior, but it still has non-negligible capacity to support economy by acquiring companies with financial difficulties. There is one more thing should not be ignored; Turkish Treasury will also compete with TWF for borrowing in international financial markets. Risk appetite of the global investors to Turkish assets is questionable and mostly depends on the global financial conditions as mentioned in the previous part.
Transparency of National Accounts and Statistics of Turkey
Turkstat is the responsible body for the compilation of data and publishing official statistics in Turkey. In addition to it, Treasury, CBRT, BRSA and CMB (Capital Markets Board) also publishes some stats mostly related to public finance and finance industry.
Since there is no alternative source of wide range of data to compile, these institutions publications assumed to be objective and independent. However, there are some issues, in which experts realized inconsistencies and discrepancies. Turkstat made some fundamental adjustments in the calculation of GDP in 2008 and 2016. According to the press release, these adjustments are compatible with the ones applied by Eurostat. The results of these two main adjustments were the computation of GDP of Turkey 18% and 31% larger respectively. High rates of positive adjustments in the developing world is not so extraordinary but timing of the second one led to high suspicion. It was published in the 3rd quarter of 2016, when failed military coup attempt caused to 1 quarter GDP contraction.
This is not the only case where experts become sceptic to the data provided by Turkstat. Inflation rate is the one in which not only academics but also public have high doubts on its objectivity. It is claimed that published figures and price hikes in the markets do not match each other. There are some convincing arguments of this discrepancy such as difference of consumption basket and location of accommodation. People living in the metropolitan cities and having higher income; are more severely affected than the ones living in rural areas from the price hikes. On the other hand, some discrepancies are beyond the level of these potential reasons.
Two cases mentioned above could not be directly examined by the experts since they do not have full access to the data compilation and data process methodologies. However, there was one another case where experts claimed obstruction and their findings verified their claim. Foreign exchange reserves of the CBRT were expected to sharply decline in March 2019 before local elections due to heavy foreign exchange sales of the state banks. Balance sheet of these banks were published weekly by BRSA and there was no permission to carry negative foreign exchange positions by these institutions due to related regulations.
Experts and academics tried to find the source of FX sales without a corresponding decline in CBRT reserves. CBRT made an announcement, which was obviously unsatisfying. Suspicions got bigger and currency traders started to significantly speculate against Turkish liras. After a sharp loss in the value of Turkish lira, CBRT had to make a second announcement confessing its borrowing of foreign exchanges from international banks without any briefing.
Current gross FX/ gold reserves of CBRT are 106 billion dollars. Net reserves are approximately 33 billion dollars. When other liabilities of CBRT (explained in the previous paragraph) is subtracted; on/ off balance net reserves are 20 billion dollars. This amount is far from covering short term (less than 1-year maturity) obligations of Turkey, which are 175 billion dollars. Therefore, high volatility in the value of Turkish lira cannot be mitigated by the use of foreign exchange sale of CBRT, if financial turmoil repeats next year. Furthermore, these funds cannot legally be transferred to Treasury or TWF to bailout distressed assets in the critical sectors such as construction and energy.
This third case clearly showed that Turkish officials are inclined to hide some data and news with or without the pressure of the top administration. On the other hand, it is not possible to clearly reveal any distortion of stats or fabrication of news by the government owing to lack of direct access to data compilation and process. When potential improper use of power during general and local elections are considered, it is so hard to say statistics provided by the Turkstat are impartial and compatible with international standards.
Potential Economic Impact of US Sanctions
Foreign relations of Turkey and US conflict in variety of areas. Procurement of S-400 missile system is the peak point of the tension in between two countries. There is a bipartisan support in the both sides of the US Congress and executive offices such as Department of State and Pentagon for economic sanctions to Turkey owing to purchase of the missile system. Likelihood of these sanctions should be examined by the experts of international security and relations. However, type of sanctions and their impacts are the subtopic of this article.
Sanctions implemented against Russia are named as CAATSA. Although Turkey is a member of NATO and ally of US, there is a risk of sanctions, which of the softer ones of CAATSA. Two major sanctions are exclusion from SWIFT system and hindering US companies and their international partners to invest in Turkish assets. These two would make devastating effect on the economy of Turkey. Turkey is heavily indebted to external bondholders and vast majority of the sources comes from US and its allies. Moreover, lack of access to the SWIFT will directly obstruct export and import of Turkey.
There are some other forms of sanctions targeting individuals and specific companies instead of entire country and nation. Restrictions on travelling to US and freezing funds held in US financial institutions for the individuals having participation in the S-400 deal, cash transfer and procurement are softer actions in CAATSA. These sanctions will increase country risk premium, thus cost of financing Turkish firms and state. Volatility in foreign exchange and bond markets will probably elevate. The key question is implementation of these softer articles of CAATSA will result in total collapse in Turkish economy or not. The answer is very unlikely. Despite the heavy debt stock, these softer articles do not have the power to paralyze economy of Turkey by themselves. However, softer acts can be fatal, when global financial conditions deteriorate for Turkey in the same period.
What to Expect in Turkish Economy in the Near Future
Difficulty to access external funding with reasonable costs is the major problem of Turkish economy due to large debt stock. 50% of the internal debt of the government must be rolled over in 2020. Furthermore, total size of the external debt with a maturity less than a year is 175 billion dollars. Because of these two reasons, the biggest challenge of Turkish economy in 2020 will be debt redemptions and rollovers. Unrolled redemptions will result in loss of economic activity and rolled ones will push interest rates and value of dollar exchange rate. This is an impasse and only chance to avoid solely depends on positive risk appetite of global investors.
Therefore, it would be wiser to call 2019 as a year of semi-recovery before the next shock, instead of a full recovery. SME’s and large holding companies will have more difficulty to reach funds to carry on their operations. Collapse of a major bank is not the base case, whereas it cannot be fully ruled out, if global recession strongly hits Turkey. Government was very active to postpone the crisis up to 2018 and used almost all sources to alleviate its pain on both entities and public in 2019. There is no more ammunition to fight against economic crisis in 2020. Magnitude of global recession and its positive side effects will be the main determinant of how good or bad Turkish economy will be.
Social and political impacts of economic crisis must be considered as well. Unemployment rate is the highest of all time and it will maintain this level next year. Government may try to lower real wages to make labor cost more reasonable to private sector. This will also lead to decline in purchasing power of the working class. Dissatisfaction of the mass society will continue to increase and decline in the approval rate of government will probably persists.
EPC | 17 Feb 2020
Mohamed Fayez Farahat | 13 Feb 2020