There was a time when the Turkish economy was the envy of the world. Its geographical proximity to the EU markets was an objective factor that hugely contributed to the economy, which had become synonymous with success, as it capitalised on the accession talks with the EU, investors poured in with cash and the Anatolian Tigers witnessed high annual growth to double digits. The economy grew at an annual rate of 7.2 percent between 2002 and 2007—and an interesting fact of the matter is that it performed relatively well during the 2008 financial crisis.
The lira remained stable and the purchasing power of citizens rose on the back of the income per capita crossing the $10,000 per annum threshold. But then something happened. In 2012, the then-central bank governor Erdem Basci used a different method known as ‘interest rate corridor’ for the ‘creation of multiple interest rates’, in response to opposition to interest rate hikes and to satiate the market conditions.
Long story short, a lot of push and pull on the matter took place—and yet the currency remained relatively stable to the point that $1 was still equivalent to two liras. However, concerns for the market began in 2016 when the central bank came under the leadership of its new governor who was no longer able to make independent monetary decisions. After that, things went south: For the first time, credit risk known as CDS, was passed over 300 points, and in the following months the dollar-lira exchange rate had passed 3.8. Two years later, investor sentiment shook again with the announcement that a new presidential system would be introduced and extraordinary powers will be granted to the head of state. The dollar value fell equivalent to over four liras.
Already, the Turkish economy is burdened with a huge current account deficit accumulated over the years. Its annual deficit in 2018 was expected to be more than $55 billion, which was supposed to be financed by an inflow of investors cash. The value of lira nosedived in August of that year and more than 34 percent of its value was lost against the dollar—resulting in a currency crisis.
Volatility and vulnerability of the lira
The lira is considered to be one of the most volatile and vulnerable currencies in the world. The pandemic has pushed its value to a record low over the past few months. By numbers, its value has been down by 20 percent to 25 percent against the dollar since the start of last year. Tatiana Lysenko, a global emerging markets economist at S&P Global, told International Finance, “In our view, it is not the low value but currency volatility—and more broadly, the lack of policy transparency and predictability that has a negative impact on investment and investors’ interest.”
To begin with, investors are concerned whether companies that borrowed to profit from a construction boom will be able to repay loans in dollars and euros, because the weak lira means that there is an increase in the pay back amounts. Tomasz Noetzel, a banking analyst who covers Eastern Europe at Bloomberg Intelligence, told International Finance, “Sentiment towards the country and currency largely depends on the central bank’s credibility to deliver on the inflation target. Recent Turkish central bank actions are the first steps to restore that credibility.”
The boom and bust cycle
Following the serious cracks, the coronavirus pandemic has only upset the Turkish economy even more. The economy contracted by 9 percent in the second quarter of 2020 which points to its worst year-on-year performance in a decade. According to the Turkish Statistical Institute, the fall in GDP is considered historic compared to the first quarter at a seasonal and calendar adjusted 11 percent, even though it was less steep than expected. A degree of optimism was floating around despite the contraction, as “the drastic contraction in activity in the second quarter was followed by a sharp recovery in the third quarter. This was driven by vigorous quasi-fiscal and monetary stimulus and strong export demand that was supported by exchange rate depreciation, as mentioned above,” Rauf Gonenc, a senior economist in the Economics Department of OECD told International Finance.
In Gonenc’s view, the rebound in industrial production was particularly strong. “Business investment remained weak, but job retention programmes in the formal sector reduced employment losses. Still the unemployment rate for new entrants to the labour market and in particular young workers soared to 25 percent in August (the latest month for which data is available),” Gonenc said. “Weakness in tourism activity which accounts for 4 percent of GDP and 7 percent of total employment had adverse spin-offs in tourist regions, despite a partial turnaround in the second half of the summer, thanks to an upturn in domestic tourism demand and visitor inflows from certain countries such as Russia. In the third quarter Turkey experienced one of the strongest quarter-on-quarter recoveries among OECD countries.”
However, Lysenko said that the near-term outlook looks much weaker as far as growth is concerned. “This reflects the worsening pandemic situation, lower demand from the eurozone, as well as the adjustment after an exceptionally strong recovery in the third quarter, as interest rates have risen and the credit stimulus is being withdrawn,” she said. “Exports should drive growth next year . The recovery in tourism will come with a lag, although there is an upside from a faster deployment of a vaccine that would reactivate travel globally. We expect GDP growth to average 3.6 percent next year  and 3.3 percent in the medium term.”
The Turksih economy grew nearly 7 percent in the third quarter—outperforming G20 and China. “That was driven by massive credit expansion which in turn resulted in heightened inflation and lira weakness,” Noetzel said. The exceptionally rapid economic recovery of the Turkish economy and pressures on the lira are “two sides of the same coin” Lysenko explained. The reason for widening of the current account deficit is prompted by two combined factors: The massive credit stimulus that propelled a recovery in domestic demand and imports coupled with a slump in revenues from exports and tourism. That said, “a fast recovery came at the expense of a return of macroeconomic imbalances, balance of payments vulnerabilities and currency volatility,” she added. This could be a sound reason for the recovery to slow again in the last quarter of 2020. OECD had foreseen it to be a weak quarter.
Low investments, lost revenues and risk perceptions
Gonenc explained that policy support was scaled down to contain the excessive current account deficit, inflation and exchange rate depreciation in summer months. “The central bank has raised its effective funding rate and credit interest rates increased substantially; public banks have reduced their credit expansion; and external demand has also weakened,” he said.
Currently, the world is used to watching a downward economic trend as a result of the pandemic, but Andy Birch, principal economist at IHS Markit puts an interesting spin to the weak lira, in an interview with International Finance, that it is a “reflection of the low investor interest in Turkey more than a cause of the low investor interest.” Heightened lira volatility is not good for the Turkish economy and investment decisions. When Gonenc talked about the weak currency’s impact on investments and investor interest, he said there are two different impacts depending on background conditions. First: When the weakness of the currency and exchange rate volatility are perceived as structural, they can worsen risk perceptions, risk premia and dent investor interest. Capital outflows tend to be stronger and capital inflows weaker than in comparable economies. Second: In contrast, low asset prices and high yields make investments in Turkey more attractive. “Provided that expectations improve and the future is perceived as more stable and predictable than the past, this can stimulate stronger and less volatile capital inflows than in comparable economies,” Gonenc added.
Certainly, the pandemic has brought in its powerful act into the Turkish economy by adding to the “pressures of domestic companies and banks and their ability to repay external obligations,” Birch said. Bankruptcies and lost revenues are playing a big part behind the scenes in pushing companies to approach banks to restructure their loans, in turn causing a need for banks to turnaround and restructure their own repayments.
According to Birch, the weak lira is raising risks that Turkish companies and banks will be unable to meet heavy external repayment obligations in the short-term. “Those Turkish companies that earn large shares of their earnings domestically but borrowed internationally are particularly vulnerable due to the growing mismatch between lira earnings and obligations in dollars. The continued depreciation of the lira also fuels inflationary pressures within Turkey. Annual inflation further accelerated in the final months of 2020, reflecting the impact of the record lows of the lira,” he said.
Investors are worried about the risk of a rising inflation in the country and even a balance-of-payment crisis. In the context of 2020, Douglas Winslow, director of the Sovereign team at Fitch Ratings, told International Finance, “Lira weakness reflects greater pressure on Turkey’s balance of payments and weaker confidence. In the near-term, lira’s weakness contributed to higher inflation, of 14.6 percent in December, and a rise in the share of bank deposits held in foreign currency. It also pushed up holdings of gold which alongside the collapse in tourism and higher imports due to earlier strong policy stimulus has widened the current account deficit to 4.2 percent of projected GDP so far this year . These contribute to falling foreign exchange reserves, and ongoing weak investor sentiment. The lower level of the lira however will also have some positive impact on the competitiveness of Turkish exports which can provide support over time to the balance of payments position.”
It is reported that there are mounting concerns in relation to depleted currency reserves, expensive foreign currency interventions and a trend is observed among Turks purchasing foreign currencies. Noetzel reiterates that the key threat of the weak lira is heightened inflation which in turn leads to higher interest rates. “The central bank has for long done nothing to address and the recent November and December move will likely help to ease inflation expectations,” he said. “Weak lira may also cause some asset quality trouble for the banks.”
A bright side to the Turkish economy
According to Lysenko, Turkey is a catching up economy with a young and growing population. With an adaptable and resilient private sector, the country offers many opportunities for profitable investment. “Recent changes of leadership at the Ministry of Finance and the central bank have improved investor sentiment, but it is too early to say whether these changes are part of a broader strategy to return to more conventional and transparent macroeconomic policies over the medium term,”she added.
Another relief here is that major economies fared worse in the second quarter, while Turkey outpaced some of its peers like Mexico which contracted more than 17 percent on a quarterly basis. For Turkey, “we project the economy to grow by 2.9 percent and 3.2 percent respectively in 2021 and 2022,” Gonenc said. The country’s GDP recovered in the third quarter “buoyed by a government-induced surge of credit that fueled the economy, providing a strong boost to both household consumption and gross fixed capital formation,” Birch said. “However, this strong credit expansion has been a contributing cause for the ongoing lira depreciation. With the replacement of the central bank head and the finance minister President Erdogan seems to have allowed a pivot to more restrictive economic policies which should provide some support for the lira.”
The central bank is in distress
It seems that “subjugation of the central bank to political control has severely undermined both investor confidence in the country and subverted the value of the lira,” Birch said, further explaining that “with the central bank’s institutional integrity undermined, it has pursued growth at the expense of economic stability, keeping its main policy rate below the prevailing rate of inflation for several months.” In the big picture, “these steps have served to lower interest rates and to undermine the value of the lira.”
Will the restrictive policies promise a wholesome benefit to the economy? “Tightening credit conditions combined with an intensification of Covid-19 infection and reintroduction of weekend lockdowns will limit the future economic gains,” Birch said. In light of the current circumstances, early 2021 will be undermined by the double impact of tighter economic policies and the struggle with the pandemic. However, growth should resume in the beginning of the second half of 2021, as vaccines are distributed and economic activity slowly normalises across the globe.
Optimism around the stabilisation of the lira points to the replacement of the governor and finance minister which is “indeed a pivot to more restrictive economic policies aimed at stabilisation of the economy,” Birch said. But given the “nature of the replacement of the positions, it does little to rebuild the institutional integrity of the central bank. However, assuming President Erdogan allows monetary policy to remain more restrictive for at least 4 to 5 months, the lira could avoid the deep lira losses being noted in late October and early November,” he added. Allowing tight monetary policy will exacerbate the economic downturn in early 2021, but it will also provide enough stability so that monetary policy could begin to be relaxed in mid-2021—when perhaps foreign service inflows could return and provide an alternative support for the lira.
That said, lira’s structural weakness might continue into the year given the three complex factors: Rising tensions in the Eastern Mediterranean might hurt the country’s external trade; lira’s rapidly depreciating value coupled with the administration’s policy leading to more weakness could escalate costs for the Turkish economy; and liquidity shortages might strain economic growth—overall forming a loop back to feeding lira’s weakness. However, the year 2021 is hoped to be different following President Recep Tayyip Erdogan’s shift to more conservative policies, as reported.