Understanding Turkey: A Maturing Economy, Despite Declining Growth

Key takeaway – Over the next five years, Turkey’s growth is expected to decline from 5.1 (10-year average) to 3.9 percent, still a solid performance when compared to most peers. Inflation and policy rates are expected to remain elevated, at around 6 and 8 percent, respectively. The USDTRY is likely to depreciate, from 2.1 to 2.4. Declining global liquidity, a complex and non-fully-independent monetary policy, low growth in the EU and the middle-income trap are major economic risks.

A. Economics: lower but less-volatile growth, higher inflation and interest rates, depreciating TRY.

During the past 10 years, GDP grew by 5.1 percent on average, driven by consumption and investments. Over the past decade, the key driver of economic performance was ‘household consumption’ – which accounted for about 70 percent of GDP and on average contributed 3.1 percent to growth. ‘Investment’ accounted for 23 percent of GDP and added an additional 1.7 percent. While ‘exports’ accounted for 25 and ‘imports’ for 28 percent of GDP, ‘net exports’ was a drag to growth, contributing -0.2 percent. Similarly, ‘government’ spending accounted for 10 percent of GDP but its contribution was negligible, at 0.5 percent on average (Figure 1).

Figure 1 – Consumption drives growth, followed by investments

Turkey – Contribution to GDP by expenditure (%)

Source: Turkstat, 2014.

In 2013, the economy grew by 4 percent, up from 2.2 in 2012. In 2014, hampered by political tensions, growth will decline slightly to 2.4 percent (current market consensus forecasts 2.2).  With the USD/TRY exchange-rate leveling at about 2.1, ‘domestic consumption’ is likely to be hampered by increased import prices and a negative ‘consumer confidence’. ‘Investment’ will also suffer higher import costs for energy and a negative ‘investor sentiment’. ‘Exports’ could benefit from the weaker TRY, but the rising cost of imported intermediate goods will contain the upside.

During the past 10 years, average inflation was 8.3 percent. In the inflation basket[1] used to track the Consumer Price Index (CPI), food (24 percent), utilities (17 percent) and transport (18 percent) have the highest weights, followed by household items (7.3 percent), clothing (6.8 percent) and restaurants and hotels (6.3 percent). Due to the large import-content of the CPI, TRY fluctuations impact inflation directly. Over the past five years, however, this pass-through has declined.  According to CBY research[2], between 2002 and 2008 a USD/TRY depreciation of 10 percent added roughly 2.3 percent to headline inflation within one year; between 2008 and 20011 the same depreciation added roughly 1 percent to headline inflation (Figure 2).

Figure 2 – The exchange-rate’s diminishing influence on headline and core inflation

Turkey – Headline and core inflation vs USDTRY

Source: Turkstat, CBT, 2014.

In 2013, headline inflation was 7.4 percent, up from 6.2 in 2012. Since June 2013, the USD/TRY depreciated by about 15 percent. The resulting pass-through to prices lifted inflation in the first half of 2014, up to 9.7 percent in May (Figure 2). Inflation is expected to peak in June and start declining in the second half of 2014, ending the year at around 7.2 percent.

Over the past 10 years, interest rates were cut from 29 percent (2004) to 9.5 (May 2014). Due to a high and structural inflation, interest rates remained elevated until the Global Financial Crisis (GFC). In July 2008, policy interest rates were in upper-double digits: the overnight (o/n) borrowing rate was at 16.75 percent and the o/n lending at 20.25. During the GFC, the Central Bank of Turkey (CBT) gradually cut them, to reach in October 2009 6.5 and 9.0 percent, respectively (Figure 3). Since then, under the newly appointed governor Erdem Başçı, borrowing and lending rates lost their relevance as instrument of monetary policy and the “one week repo rate” rose to prominence.

Figure 3 – In the past years, interest rates declined significantly

Turkey – Policy rates (%)

Source: CBT, 2014.

At the end of 2013, the policy rate was 4.5 percent, down from 5.5 in 2012; yet, in 2014 it jumped to 10 percent. In January 2014, the CBT hiked interest rates by 450 basis points (bps) to 10 percent in an effort to contain “excessive” TRY depreciation. The ensuing carry trade – due to cheap financing in Developed Markets (DM) and double-digit rates in Turkey – brought about declining bond yields[3]. In May and June 2014, the CBT cut rates by 50 and 75bps, respectively – due to foreign investors’ steady interest in the ‘long-end’ of the curve and rising political pressure. On July 1, 2014 the 10-year bond yield stood at 8.62 percent. Demand for the ‘shorter-end’ is more limited: the 1-year bond – mostly owned by local investor and banks – yields 8.35 percent. As a result, the yield curve is virtually flat (Figure 4). Currently, the CBT is under severe political pressure to further cut rates; it is soon likely to give in, and reduce interest rates to 7 percent by yearend, despite a relatively high inflation.

Figure 4 – The yield curve is practically flat

Turkey – Yield curve (%, as of July 1, 2014)

Source: CBT, TBA, Reuters, 2014.

Over the past 10 years, the budget balance declined from -4.8 percent of GDP (2004) to -1.5 (2013); public debt also declined from 59 (2004) to 36 percent (2013). Both budget deficit and public debt are at safe and stable levels and no longer pose a risk to macro stability (Figure 5). The budget deficit significantly declined from its 2001 peak of -15 percent of GDP. However, as expenditure-cuts were limited, most of the improvement came from rising revenue. Despite two elections in 2014, a significant deterioration in the budget is unlikely; 2014 year-end deficit is expected at 2.0 and public debt at 35.8 percent of GDP, respectively.

Figure 5 – Low budget deficit and debt, no major fiscal risks in the medium term

Turkey – Budget deficit and public debt (% GDP)

Source: Turkey’s Treasury, 2014.

During the past 10 years, the average current account (c/a) balance was -5.5 percent of GDP.  Due to Turkey’s lack of natural resources and its relatively low competitiveness, the economy runs a chronic, sizeable c/a deficit. About 80 percent of total ‘exports’ are “low-to-medium” value-added products.[4] Energy makes up almost 45 percent of total ‘imports’. ‘Consumption’ and ‘investment goods’ account for the rest. Before 2008, the c/a balance was mostly financed by foreign direct investment (FDI) and loans from abroad. However, since the GFC, the c/a deficit is increasingly being financed by short-term flows, such as portfolio inflows (Figure 6).

Figure 6 – High c/a deficit, increasingly financed by short-term portfolio inflows

Turkey – c/a deficit and financing (% GDP)

Source: CBT, 2014.

In 2013, the c/a deficit was 7.9 percent of GDP, up from 6.1 in 2012. The c/a balance is highly correlated with GDP growth. As growth is expected to decline in 2014, the c/a balance is likely to narrow to 6.5 percent by year-end. Major financing issues are unlikely.

During the past 10 years, the average of the USD/TRY exchange-rate was 1.52. The TRY is a highly volatile, floating currency. Due to the economy’s large external-financing needs, it is structurally prone to long-term depreciation. After the 2001 crisis, Turkey switched to a free-floating exchange-rate regime. From 2003 to 2007, a period of macro stability ensued. In 2008, the GFC brought about a sharp depreciation (Figure 7). Since, the CBT quietly managed the currency through its reserves, and currently intervenes only when market-driven volatility is deemed excessive. As a result, the TRY – despite its status of floating currency – tends to exhibit a step-function pattern (Figure 7): a) stable for a few years at a given level; and then b) a sudden depreciation (which looks – and to citizens and businesses feels – like a devaluation) to a new level, as a result of an exogenous shock. In 2008, after the Lehman crash, the TRY depreciated from levels around 1.2 against the USD to 1.5; in 2011-12, after the US credit-rating downgrade and the European sovereign debt crisis, from 1.5 to 1.8; and in May 2013, after the US Federal Reserve (Fed) tapering announcement and the Gezi Park protests, from 1.8 to 2.1. Almost all depreciations were sudden; in between depreciations, the TRY remained stable (Figure 7).

Figure 7 – TRY: a floating currency with a long-term depreciation trend

USDTRY, level

Source: CBT, 2014.

At the end of 2013, USD/TRY was at 2.138, up from 1.791 at the end of 2012. In May 2013, because of the Fed hinting at tapering and civil unrest in Gezi Park, the TRY depreciated by 15 percent – from 1.8 to 2.1 levels against the USD. In January 2014, the TRY depreciated further to 2.4 levels due to rising political tensions, worries about Turkey’s stability, and jitteriness in emerging markets (EM). In April 2014, AKP’s electoral victory re-assured foreign investors and local corporates; as a result, the TRY appreciated to 2.1 levels. On July 1, the USD/TRY closed the day at 2.12. While the exchange rate will remain volatile before the Presidential elections in August, it is likely to close the year at around 2.12 levels.

Over the next 5 years, economic growth will slow, as global liquidity normalizes and reforms are delayed. Between 2015 and 2019, Turkey is likely to enter a period of lower-than-potential-growth due to a gradual liquidity withdrawal from EMs and delayed micro-economic reforms. GDP is expected to grow at 3.9 percent in average, in line with other EMs and comparable to some BRICS countries[5]. While demographic fundamentals (Turkey has 75 million citizens, 50 percent of which is under-30) and a sizable domestic market (Turkey is the 17th largest economy in the world) will be supportive of growth, given low domestic-savings (at about 13 percent of GDP in 2013) and tighter external financing (Figure 8), growth performance is likely to stay well below its 10-year average of 5.1 percent. Driven by TRY depreciation and public incentives to investment, the economy is expected to rebalance: the contribution of ‘domestic consumption’ to GDP will decline while ‘investment’ and ‘net exports’ will pick up.

Figure 8 – GDP growth is mostly driven by global liquidity

Turkey’s GDP growth (in USD terms) vs Global liquidity*

Source: Turkstat, PBoC, European Central Bank, Federal Reserve, Bank of Japan, Bank of England, 2014.

* Global liquidity is defined as the monetary assets of major central banks (listed above).

Over 2015-19, average inflation is expected at 7.0 percent … In 2015, as prices adjust to the new TRY-level and GDP growth declines, inflation is expected to decline to an average of 6.0 percent. However, over the next five years, inflation is expected to suffer the volatility of food and energy prices and move between 6 and 10 percent, averaging 7 percent (Figure 9). Inflation is unlikely to decline to the low levels observed in developed nations or in the BRICS economies, leading, as a result, to a loss in competitiveness. Yet, the business community and households are highly leveraged and will “welcome” ‘mid-to-high single-digit’ inflation.

Figure 9 – Lower growth ahead, inflation to remain high and volatile

Turkey – GDP growth and inflation forecasts (%)

Source: Turkstat, authors’ calculations, 2014.

… while interest rates will decline first and then rise. As inflation is expected to be volatile, interest rates are likely to fluctuate as well. In the short term, the CBT is likely to give in to political pressures and cut rates to 7 percent by year-end. However, as global liquidity is withdrawn from EMs, interest rates are due to rise, possibly back to 10 percent levels (Figure 10).

Over 2015-19, budget deficit and public debt will slowly increase to 3 and 40 percent respectively … Over 2015-19, on the revenue side, slowing growth will result in lower tax income. Minimal privatization proceeds, largely due to over-pricing and lack of demand, might also contribute to lower government revenues as a percentage of GDP. On the expenditure side, the recent increase in Treasury-backed private sector debt and increased government hiring will boost commitments and spending, resulting in higher budget deficit and debt – which are however expected to remain manageable and pose no major fiscal risks.

… the c/a balance will decline to 5.5 percent … Over 2015-19, in absence of a major, sudden withdrawal of global liquidity, the c/a deficit will remain manageable at around 5.5 percent. Households, banks and the government sector do not have large open FX positions. Only the corporate sector has a large open FX position (21.2 percent of GDP in 2013); however – as long as global liquidity declines gradually – Turkish corporations are likely to be able to roll over their foreign borrowing. A balance of payment crisis is unlikely.

… and the TRY to depreciate to 2.4 levels. Over the next 5 years, Turkey’s large external financing needs (25.2 percent of GDP in 2013) and a high inflation environment will result in steady TRY depreciation (Figure 10).

Figure 10 – Interest rates to remain high, depreciating TRY

Turkey – USDTRY and policy rate

Source: CBT, authors’ calculations, 2014.

Over 2015-19, the export-oriented sectors will do well, along with the private provision of social services. Over the next 5 years, the rebalancing of the economy – supported by TRY depreciation – and its further development are likely to boost the performance of export-oriented (i.e.:, automobiles, white goods manufacturing, tourism) sectors and foster the private provision of social services (i.e.:, education, healthcare). These sectors have low leverage, little FX exposure and can rely on a young, growing population. Indeed, Turkey’s human-development gap remains high: average education is only 6.5 years; life expectancy, at 74.9 years, is the lowest in the OECD after Hungary.

B. Economic risks: global spillovers, slow reforms, loss of CBT independence.

The major risks for the economy are: a sudden liquidity withdrawal, a complex and non-fully-independent monetary policy, low growth in EU, and the “middle-income trap”.

1. A sudden liquidity-withdrawal would bring about TRY depreciation … As DM central banks will progressively decelerate liquidity supply, global financial conditions will tighten, leading to periphery-to-core flows (i.e. funds repatriation from EMs to DMs). Countries with frail fiscal and current-account positions (i.e. the so-called “fragile 5”: Brazil, India, Indonesia, South Africa and Turkey) may suffer currency depreciation, rising inflation and declining growth. Turkey’s short-term macro-economic fragilities could trigger an acceleration of capital outflows: the chronic current account deficit (7.5 percent of GDP in 1Q14), the large external-financing needs (at 25.2 in 2013) and the open FX position of the Turkish corporate sector (at 21.2 in 2013) would result in TRY depreciation, rising NPLs and low growth.

… yet, Turkey strong long-term fundamentals will support FDI inflows. In presence of liquidity withdrawals, EMs with weak macro frameworks will be most affected, and policy makers will face a tough choice: either to a) raise interest rates and face lower growth (a likely move in current-account deficit countries); or b) keep rates low and face outflows. In Turkey, both choices are likely to lead to slower economic activity over 2014/15. Domestic credit conditions – currently tight to preserve currency stability, reduce inflation, and gradually re-adjust the external balance – are restraining ‘consumption’ and ‘investment’.

2. Low growth in the European Union (EU). On the whole, EU growth determines Turkey’s economic performance, via trade and financial links. Exports to the EU – the major trading partner – account for more than 45 percent of total exports. Turkish corporates and financial institutions mostly borrow from EU banks. Thus, external demand weaknesses, driven by EU stagnation, results in suffering exports and tighter credit conditions, which in turn lead to low growth.

3. The absence of microeconomic reforms in the tax code, the labor market and key sectors, such as: i) education; ii) energy; and iii) agriculture, will lower potential growth – currently estimated at 4.5 percent – to around 3.5, and push the economy into the “middle-income trap”. Indeed, over the past five years, Turkey’s per capita income has remained stagnant at around USD 10,000. Without overarching reforms, Turkey will be unable become more competitive and rise to the status of “high income economy”. Also, the ongoing weakening of democratic institutions is likely to hamper – as it often does – the transition to an innovation-driven economy and contribute to the growth-decline. In the medium-term, low growth will inevitably result in higher unemployment[6], increasing the risk of social tensions. In order to boost growth back to potential, micro reforms are needed, such as:

  1. Tax code. A simpler tax code is necessary, with special emphasis on increasing direct (e.g. income tax, today at about 17 percent of total revenues) vs indirect taxes (e.g. value added tax and “special consumption tax”, today at about 30 percent of total revenues). The 18 percent ‘corporate tax rate’ could be reduced. The reduction of green or red tape could also act as a tax cut.
  2. Education levels of the labor force must increase. About 60 percent of citizens have only primary education or less. More investment is needed on vocational training and – in general – to: i) boost the quality of education; and ii) better link educational institutions to the labor market.
  3. Labor market regulations need to become more flexible. Allowing part-time work and easing constraints on hiring and firing would help. Decreasing the labor tax could boost the formal economy (to date, 36 percent of the labor force is still unregistered).
  4. Access to finance.  SME financing needs to increase. Only 20 percent of total loans go to SMEs. As the bulk of job creation comes from the SMEs, more loans to SMEs would bring about more jobs and hence higher growth.

4. A monetary policy byzantine, less effective … Officially, the CBT targets inflation, but unofficially it handles a large set of targets, including – but not limited to – financial stability, economic growth, foreign-exchange rates, current-account balance, and lending growth. According to the CBT, the excessive volatility of international markets often dissociates key economic indicators – such as the exchange rate and the current account – from fundamentals. Such misalignment between investor sentiment and economic reality needs to be handled with easily reversible, short-term, non-conventional policy tools – such as “daily TRY liquidity”, “reserve requirements”, and “foreign-exchange reserves”. The CBT makes use of policy rates only as a “last resort”, when it believes there is a non-cyclical, non-market-driven change in the economy. Most market participants do not fully understand CBT’s policies. As a result, the correlation between “policy rates”, “interbank rates” and “market rates” is gradually declining, along with the effectiveness of the transmission-mechanism of monetary policy.

5. … and not fully-independent. Over the past few months, Erdoğan put explicit pressure on CBT’s Governor to act under the direction of the government and reduce interest rates. In May, the CBT cut rates by 50bps. On June 12, top-level CBT bureaucrats were reshuffled without the Governor’s explicit consent. In June, rates were cut by another 75bps. While independent central banks are more successful in reaching price stability, recent events suggest that the CBT is losing its operational independence. As Turkey’s own history has repeatedly shown, a lack of central bank independence will result in boom–and-bust cycles, as politicians are tempted force rate cuts before elections.

In sum, Turkey’s economy is maturing, despite volatile politics and declining growth. Over the next five years, Erdoğan and AKP are likely to stay in power but face a vocal opposition both from the Parliament and the civil society. Economic growth will decline to a lower, less-volatile level than in the past ten years, but performance will be better-than-peers. The major risks are a liquidity withdrawal from EMs, low growth in the EU and falling into the “middle-income trap” because of a lack of microeconomic reforms.


[1] The “set of consumer products and services” valued on an annual basis by the Turkish Statistical Institute.

[3] On January 24, 2014, the 10-year bond stood at 10.8 percent; on January 29, after CBT’s hike, it declined to 9.8 percent.

[4] While “low-technology goods” (e.g.:, food and textiles) make up 38 percent, “medium-technology goods” (e.g.:, automobiles, white goods, steel) account for 40 percent of total exports.

[5] Over 2015-19, Brazil is expected to grow at 2.8 percent, Russia at 2.2 percent, India at 6.3 percent, China at 6.9 percent, and South Africa at 2.9 percent.

[6] Over the past decade, every year an average of 800,000 new entrants got into the labor force; the trend is supported by demographics and likely to continue over the next five years.