Turkish Economy in Review

Macroeconomics

Turkey has a broadly diversified economy with a main emphasis on Manufacturing and Retail Industries. Household Consumption is the main contributor to GDP with 69% pretense.

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Sources of growth have shifted since 2000. Over the 2002-2007 period, economic growth of 6.8% reflected the impact of the government’s fiscal consolidation agenda and structural reforms. The post-global financial crisis growth was largely driven by domestic demand and particularly consumption growth, with the later fueled by external global capital inflows. As a result of a slowdown in the growth of domestic demand and weaker investment climate, the GDP growth over the 2016-2019 is expected to average 2.7% compared to the 5.2% during 2010-2015. Unemployment is climbing gradually which puts more pressure on both Monetary and Fiscal policy stance.

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Savings have decreased in terms of GDP and now are significantly below peer levels. Downward trend largely reflects declining household savings rather than corporate savings, due to high inflationary expectations, a broadening of the social security system, and greater access to credit as a result of strong external capital flows. Lower domestic savings will add to countries need to borrow from abroad to finance its growth and increase current account Deficit.

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Manufacturing PMI has been decreasing from the end of 2015 with a slight up trend in the end of 2016. Industrial Production has been slightly more volatile this year. Retail Trade growth has been stagnating for the past few years with a continued decline in 2016.

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External Balance and Trade Position

Turkey’s government has been running Fiscal Deficit for years. In 2015 Deficit was brought below -1% mark which is forecasted to increase in 2016 and onwards.

General Government Debt has been declining while the share of foreign currency indexed debt has increased. Interest payments share in Gross Government Revenues also declined steadily to around 5.3% in 2016 from highs of 33% in 2004.

Total External Debt to GDP ratio accelerated from around 40% in 2012 to 55.5% in 2016. Share of Public as well as Private external debt remained flat during this time. Share of Short term external debt has increased showing risen demand for short-term foreign financing.

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Current Account Deficit has been shrinking gradually in the last three years due to the decline in commodity prices. As a matter of fact, imports have been more volatile over the years as the fluctuations in commodity prices increased.

Over the medium term, import growth is expected to outpace export growth, as a result of stronger domestic demand (stimulated by looser fiscal and monetary policies, as planned in the revised Medium Term Plan for 2017-2019) and rising commodity prices, while exports will likely remain dampened by security concerns and a shrinking tourism sector. Turkey is heavily dependent on its exports to Europe and Fuel exporting countries.

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Turkey runs a significant surplus in Services Trade thanks to the exports of Transport and Tourism. Steadily increasing number of tourists and income halved in 2016 with the drop in the number of tourist arrivals from Russia and European Union. Main influencing factor here was significant deterioration in political environment and stability.

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According to the OECD, the import content of Turkey’s exports more than doubled between 2000 and 2011, and 26% of total exports were imported as of 2011. This situation is reflected in Turkey’s low ranking on the World Economic Forum’s Global Competitiveness Report for reliance on imports (104/138).

In June 2012, the government enacted a new investment incentive program to encourage and develop the domestic manufacturing base, with a focus on the energy, mining, automotive and tourism sectors where the impact on the current account may be greatest. The scheme has the potential to not only reduce the need for Turkish exporters to import these types of goods over the medium term, but to also increase FDI inflows into these sectors and thus provide a much more stable source of current account financing.

The highest level of import dependency is in energy sector. The energy mix is dominated by natural gas which is mainly exported from Russia.

The government adopted an energy efficiency strategy to reduce the energy intrusiveness of the economy by 20% by 2023. The objective is for the country to become an energy corridor between Middle East and Europe. Additionally, Turkey has taken steps to liberalize its energy market to attract new investments, increase the share of renewables and addition of the nuclear power to the energy mix. Nevertheless, in mid-term Turkish current account balance will stay highly dependent on fuel prices.

For Turkey Capital and Financial Account Inflows were always a balancing factor against Current Account deficit. However, inflows in 2015 and 2016 were lower than the outflows from Trade balance causing External reserves to deplete.

Buoyant global demand for emerging market assets has allowed Turkey to finance its current account deficit with relative ease despite falling tourism revenue in recent months. However, it is reasonable now to expect Turkey’s ability to finance its CA deficit to come under increasing medium term pressure.

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The recent pickup in foreign flows into Turkey now is expected to reverse, causing inevitable market distress. Of $15.8 billion foreigners poured into the country in the first five months this year, only $2.3 billion were in net direct investments, down 50 percent from the same period a year earlier. The rest was inflows into its stocks and bonds, or so-called hot money, as well as other investments such as loans to banks and companies.

The rally in Turkish assets has come amid a slowing of inflation and easing of global liquidity that’s supported the currency and allowed the central bank to lower the overnight-lending rate by 175 basis points this year.

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Uncertainty threatens to unravel gains that have made Turkey one of the biggest beneficiaries of the global clamor for risk as central banks pump cash into the biggest economies. The Borsa Istanbul Index has climbed 15 percent this year, while the yield on Turkish five-year local bonds has dropped more than every other emerging-market nation except Brazil. The country’s five-year credit default swaps fell to the lowest in a year July but increased afterward due to Political uncertainties that surround the country.

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Banking Sector

Core Tier 1 ratio (13.8%) has fallen in the recent years as a result of rapid loan growth and upward revision of certain risk weights which outpaced the banking system capital growth. The ratio is expected to fall further due to moderate loan growth, weak internal capital generation and lira depreciation.

Reliance of Turkish banks on capital market funding increased in the past years. Turkey’s low domestic savings rate of around 16% of GDP means that lira deposits grew slower than the credit demand resulting in system wide loan-to-deposit ratio increasing to 120.7% at the end of first half of 2016 from 88.5% at the end of 2010. Short-term borrowing makes up a huge portion of wholesale funding which increases refinancing risks.

Exposure to foreign currency denominated external debt is a key risk for the banking sector. Should banks lose market access, they should be able to raise sufficient foreign currency liquidity at least to service their foreign debt liabilities up to a year. Turkish banking sector has significant FX reserves held at the central bank which is sufficient to repay 100% of the USD 70 billion contractually due within 12 months.

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Any growth is expected to occur in local currency lending as banks try to limit their foreign currency exposure. The growth focus is likely to be on corporate and larger commercial segments and the retail sector, as opposed to SME, which is most sensitive to weakening operating environment.

32% of total loans are foreign currency denominated, and its NPL outperforms the overall NPL of the sector, due to the fact that foreign currency loans are concentrated in prime corporate segment where borrowers are more diversified, and the loans are typically long-term and have amortizing repayment schedules. Tourism lending is small and therefore seems manageable, and energy sector risk is mitigated by exposure to renewable energy projects, which are eligible for a government guaranteed floor price set in foreign currency.

Profitability will deteriorate given rising funding costs and higher cost of external borrowing due to increased country risk. ROE boosted in 2016 due to increase in average loan yield, lower FX-swap costs and one-off items, but loan impairment charges remained and are expected to remain high in 2017.

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Monetary Policy 

The global uncertainty may intensify the negative impact of the current risks in domestic politics. Last 50bp increase in 1 Week Repo rate coming after hovering down the Overnight Lending Rate in the first half of 2016 from 10.75 to 8.50 and narrowing the gap between Lending and Borrowing rate was meant as a signal to market that CBT can be flexible to support TRY. However, it does not change the mid-term easing policy stance. Erdogan expressed multiple times his support for lower rates to stimulate the economy and the Central Bank, whose independence has come under question after Chetinkaya came to power, will remain under pressure to maintain an accommodative policy stance (ie, tolerate FX weakness and look-through inflation) as risks to domestic growth increase (internal and external).

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According to Barclays research, higher political uncertainty and an accommodative monetary policy stance to weigh on TRY; implying a steep rates curve and wider credit spreads as the risk-premia of Turkish assets is likely to re-price higher.

Moreover, the likely depressed mood and a rise in risk perceptions of local investors in the aftermath of the recent events would add to the pressure on the local assets, particularly the TRY given retail investors’ exposure (c. USD 100bn in total in USD and EUR retail accounts).

Slower growth in the medium term owing to a combination of negative growth spill-overs from Europe (post Brexit) and the detrimental impact of intensifying terror on confidence and tourism. Against this backdrop, the CBT (Central Bank of Turkey) would maintain its accommodative policy stance, tolerating TRY weakness and looking through inflation. Recent developments are unlikely to change the CBT’s policy stance; at most, it as increasing the likelihood of a delay in normalization and no cuts or smaller cuts (Barclays Research).

Perceptions of rising political/geopolitical risks could also increase dollarization.

In the medium-term, prolonged period of increased uncertainty could take a toll on sentiment, on the other hand, and lead real money investors to reduce their exposure to Turkish assets that have been outperforming EM peers as of this summer.

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Conclusion

Economic Environment: Growth is largely dependent on domestic demand fueled by externally financed credit growth, which will add to the country’s need to borrow from abroad to finance its growth and will increase current account deficit. Gradually climbing unemployment will put pressure on the Central Bank to maintain an accommodating policy stance (ie, tolerate FX weakness and look-through inflation) as risks to domestic growth increase (internal and external) with lower domestic savings.

Trade: Over the medium term, import growth is expected to outpace export growth, as a result of stronger domestic demand (stimulated by looser fiscal and monetary policies) and rising commodity prices, while exports will likely remain dampened by security concerns, shrinking tourism sector and slower retail trade growth. Main influencing factor here was significant deterioration in political environment and stability.

BOP: For Turkey Capital and Financial Account Inflows were always a balancing factor against Current Account deficit. However, inflows in 2015 and 2016 were lower than the outflows from Trade Balance causing external reserves to deplete to some extent. It is reasonable now to expect Turkey’s ability to finance its CA deficit to come under increasing medium term pressure as the Fund Flows reverse.

Banking sector: Exposure to foreign currency denominated debt is a key risk. Tier 1 ratio expected to fall due to loan growth, weak internal capital generation and lira depreciation. Short-term borrowing makes up a huge portion of wholesale funding which increases refinancing risks. Turkish banking sector has significant FX reserves held at the central bank, but liquid assets and loan quality is likely to decline and profitability is expected to deteriorate due to rising funding costs and higher cost of external borrowing.

Political Uncertainty: With an attempted coup and rising political uncertainties, investors already cautious due to past crises will be even more skeptical about Turkey’s business environment and the government’s ability to maintain macroeconomic stability. If political noise translates into a visible deterioration of sentiment and capital flows, thereby exposing Turkey’s long-term vulnerabilities and threatening Turkey’s fundamental credit metrics, risks around the sovereign outlook would inevitably increase in the medium term (Barclays Research).  One should also bear in mind, though, that foreign investors’ involvement in Turkish assets is rather limited due to the political risks that have been apparent for a few years. A large-scale sell-off is therefore not on the cards.

Government: The government trying to cope with its deficiencies has adopted number of strategy changes. It has adopted Energy efficiency strategy to reduce the energy intensiveness of the economy. New reforms – mostly legislative – have also taken place to improve the labor flexibility by liberalization of the working agencies which is expected to boost domestic saving rate by 3-4%. It will help to steady raising total External Debt to GDP ratio which has accelerated from around 40% in 2012 to 55.5% in 2016. General Government Debt has also been declining while the share of foreign currency indexed debt has increased.

However, with the latest internal and external political developments government is expected to focus on boosting economy and decreasing unemployment paying little attention to declining TRY.

Currency: In an Inflationary environment loosening monetary and fiscal policy, increased political uncertainty and inability of CBT to respond independently will result in further depreciation in TRY, a steep rates curve and wider credit spreads as the risk-premia of Turkish assets is likely to re-price higher. Perceptions of rising political/geopolitical risks could also increase dollarization.

Despite unlimited liquidity promise by CBT and recent reforms to boost economy by providing state guarantee of up to US$72 billion to corporate loans, banking sector remains vulnerable in the long run due to the weakening profitability, rising foreign currency denominated debt and decreasing quality of assets. We expect further TRY weakening which will weigh on the banking sector.

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