A more orthodox monetary policy
Following his re-election in May 2023, Erdogan appointed a new, more orthodox economic team led by Finance Minister Mehmet Simsek and Central Bank Governor Hafiz Gayye Ercan.
Since taking office, Erkan has implemented more orthodox monetary policies, including gradually raising the base interest rate to 40% (8.5% in early June 2023), allowing the Turkish lira to depreciate, and phasing out some unorthodox financial instruments (such as the Exchange Protected Deposit Scheme). The return to more orthodox monetary policies has put significant pressure on the Turkish lira, which has fallen sharply. As a result, inflation (see graph below) is rising again.
The 2023 budget deficit is expected to be larger than in 2021-2022
Since taking office, Simsek has tightened fiscal policy by increasing the VAT rate, raising fuel taxes and introducing public sector cost-cutting measures. Despite these measures, the total budget deficit (Turkish lira) is expected to be larger in 2023 than in previous years (see graph showing total budget balance for the year). This is mainly explained by higher fiscal expenditures before the parliamentary and presidential elections (May 2023) and the reconstruction costs after the devastating earthquake in February 2023. Despite the widening deficit, public debt is expected to remain moderate, at 35% of GDP at the end of 2023. Going forward, the overall public deficit (% of GDP) is expected to decrease, despite an expected increase in the interest payment-to-revenue ratio.
Real GDP growth is expected to slow
In the past few years, real GDP growth has been very strong and resistant to external shocks (COVID-19 and the war in Ukraine). This was fueled by a very expansionary monetary policy that boosted credit growth and created large macroeconomic imbalances, such as rising corporate debt, pressure on foreign exchange reserves, and continued pressure on the Turkish lira. In this context, the implementation of less expansionary fiscal and monetary policies since President Erdogan’s reelection would inevitably lead to a slowdown in economic growth and a welcome rebalancing of the macroeconomic situation. However, it remains to be seen to what extent the authorities will accept a slowdown ahead of the municipal elections scheduled for March 2024. In a broader sense, it remains to be seen whether President Erdogan, who opposes high interest rates, will ultimately agree to a more orthodox monetary policy being implemented for a longer period. Indeed, in recent years, President Erdogan has appointed, but later dismissed, more orthodox central bank governors.
Reducing imbalances will require the implementation of legitimate policies over the long term.
With the long-term implementation of orthodox policies, domestic and external imbalances will continue to gradually decrease. The current account imbalance has already decreased, and there was even a temporary current account surplus in June and September, as import growth was slower than export growth. The total foreign exchange reserves are on the rise again (as shown in the liquidity position graph), but the central bank’s short-term external liabilities have stopped increasing. In fact, the central bank has stopped borrowing from outside (and from the domestic banking sector) in the short term in order to increase foreign exchange reserves. This should gradually improve the liquidity position and increase domestic and international confidence (which should reduce gold imports, which residents use as a safety net against lira depreciation). If such improvements continue, the Credendo will raise the short-term political risk, which represents the country’s liquidity.
Strong payment capacity
Turkey’s solvency is good. In fact, total external debt and debt service ratios are moderate. Public finances are sound despite recent deterioration. Moreover, the economy is well diversified, even though tourism accounts for about 12% of current account income. The biggest weakness is the high reliance on short-term external borrowing and capital inflows. Other weaknesses stem from high corporate debt, which has however declined significantly recently and is mainly held by the banking sector. Even if the banking sector’s net external asset position has improved relative to GDP, the latter is mainly financed by external loans. In this context, any improvement in medium- to long-term political risks depends heavily on the continued implementation of more orthodox policies. With real GDP growth slowing and inflation rising, the upcoming municipal elections will be a major test. Indeed, given the high need for external financing and the high reliance on short-term external financing, a return to unorthodox monetary policies would lead to new capital outflows and new pressure on foreign exchange reserves. If this were to happen, the country risk classification could be downgraded.
Analyst: Pascaline della Faille – P.dellaFaille@credendo.com
