Hina Mahmood
Last updated: 29 July, 2012

Turkey’s economy: thriving yet vulnerable

One of the most expansive economies in the world, Turkey has so far been able to weather the global crisis. Although there is still a lot of potential for continued growth, the country is facing some risks in the event of another economic downturn.

Turkey, a country with impressive architecture, a deep-rooted culture, where east and west blend seamlessly, is also one of the fastest growing and most dynamic economies in the world. After the global crisis when many countries, licking their wounds, slowly hobbled towards stability, Turkey rebounded energetically witnessing growth of 9% in 2010 and 8.5% in 2011, making it the fastest expanding economy after China.

Due to contagion from the ever deepening Euro crisis, Turkey’s economic growth is projected to slow down this year to 2.3%, but first quarter growth of 3.2% for 2012 is solid enough to allay fears that Turkey will experience a hard landing – a halt in economic growth coupled with high inflation – and is reassuring at a time where EU countries are experiencing slow growth, if any.

There are many reasons to be optimistic about the Turkish economy. Public debt has fallen from 74% of GDP in 2002 to 40% last year, banks are well capitalized after a surge in credit growth, and inflation, though high, is much lower than its 70% rate earlier this decade. Productivity has improved in the past decade, GDP and industrial output per worker have also risen and income per head has tripled in the same period. Domestic demand and growth will continue as the population, much of it young, continues to grow expecting to reach over 90 million by 2050. It also has a coveted location with close trading ties with Germany, Iran, Egypt and Saudi Arabia among others.

“Turkey is one of the world’s largest agricultural producers, and given that the global food industry is the sector that is growing most rapidly in price and speculation, this should be to the country’s advantage,” says Dr. Roland Benedikter, visiting scholar at the European Center at Stanford University, who is optimistic about Turkey’s future success.

“The natural resources and tourism industries will also grow in global importance in the coming years. Last but not least, with relatively low taxes, a VAT still at 18% and thus below most Eurozone-countries, and a GDP growth of more than 8% in 2011, Turkey will remain comparatively attractive to foreign investors particularly as an alternative to the Eurozone,” he said.

Just below the surface of the recently volcanic growth, however, gurgle some unpleasant realities – dependence on external financing, a large current account deficit, and high inflation – that Turkey will need to address if it wants to achieve sustainable growth in the future.

Turkey’s strong dependence on the Eurozone and external financing leaves it extremely vulnerable to conditions in other countries, to boom bust cycles, and to volatile investors. When investor confidence is high, money flows into Turkey in hopes of making high returns but leaves just as quickly when nerves set in and the outlook doesn’t seem as promising. To compound this problem, low interest rates in developed countries in Europe and elsewhere have increased the volatility of flows for high interest countries such as Turkey. Dependence on these interest sensitive portfolio flows and short-term borrowing have made funding sources for the economy much less reliable. Before the global crisis, in contrast, there was much higher FDI and medium and long-term debt flows.

Turkey’s large current account deficit has been fuelled by its energy needs – nearly all of its crude oil and natural gas are imported, making the country extremely vulnerable to changes in oil prices. Given events such as the Arab Spring, which created uncertainty leading to higher energy prices, Turkey’s current account deficit deteriorated at an alarming rate despite the strong growth experienced over the past few years. Recent news that Turkey has trimmed its budget by $2 billion from $69 billion in April to $67 billion in May was welcomed but it is evident that it still has a long way to go. Though energy accounts for the largest part of the trade deficit a recent IMF report points out that non-energy balance has contributed to three quarters of the deterioration in recent years.

One of the key reasons behind the large current account deficit is low domestic saving, particularly private sector saving. Turkey’s relative economic stability and prosperity has discouraged people from putting away money for harder times and has given them access to credit.  Economic activity has become skewed towards domestic demand but it is unlikely that policies will be put in place to curb this demand at a time when key export markets are facing challenges.

To try to reign in Turkey’s vulnerability to volatile external flows and manage inflation, the Central Bank of Turkey (CBRT) has instituted a controversial dual policy framework. A report from The Economist explains that when capital inflows are plentiful the CBRT cuts its borrowing rate at the bottom of the corridor to discourage flighty capital and to stabilize the Turkish lira. When there are capital outflows, the central bank stops providing cheap liquidity at its main policy rate and lends at the top of the corridor helping to support the lira.

“The dual policy framework has been effective in weathering the recent financial crisis,” said Dr. Benedikter. “The challenge will be to continue attracting foreign investment also after the cooling down of the EU accession negotiations, to further decrease inflation and to differentiate the financial sector where more than a third of all Turkish assets remains concentrated in just four banks.” 

Though the new framework may have helped in the recent global crisis, it still remains to be seen how effective it will be in the long term in keeping capital flows and inflation in check. Turkey’s bond yields have been stable indicating that investors believe the central bank can address inflation concerns. When the policy was instituted in October of last year, the interest rates jumped but failed to significantly reduce lira liquidity and currency depreciation has continued. The policy so far has not curbed Turkey’s dependence on short term capital flows as by some estimates in May 2012, 78 percent of all financing flows were short term, indicating that the country is still at mercy to the whims of investors.

Turkey was able to weather the last global crisis successfully due to ample capital inflows, strong balance sheets, inflation management under the central bank, and an overhaul of banking system regulation, but it may find itself more vulnerable to another economic downturn. The large current account deficit and continued dependence on financing flows will become far graver problems if they are not managed carefully.

Hina Mahmood is the Business Editor for Your Middle East.