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Why is Turkey falling into an economic abyss?

16.07.2018 14:06|Marcin Lipka

"The record weak currency and rampant inflation illustrate the disastrous state of the Turkish economy. This is also confirmed today by the fact that the rating has been downgraded deeper to a junk level. What is worse, the available data indicate that the economic situation by the Bosphorus will deteriorate even further," writes Marcin Lipka, Conotoxia Senior Analyst.

On Friday, Fitch Ratings reduced Turkey's creditworthiness from BB+ to BB with a negative outlook. Since the beginning of the year, all three leading rating agencies have reduced Turkey's rating and Moody's has also placed the country on the watch list for another downgrade. What is the greatest threat to the Turkish economy and why is its credibility at a junk level?

Inflation and external imbalances

In the first quarter of 2018, the Turkish economy grew by as much as 7.4% y/y. However, this growth was strongly stimulated by fiscal policy. The April IMF report drew attention to, among others, temporary tax cuts, subsidies for enterprises employing workers for the minimum wage or an increase in loan guarantees for the private sector.

These initiatives themselves are not bad in principle, but they were applied at the wrong time. The economy is still growing almost twice as fast as its capability, yet it is still being stimulated. This led to an increase in inflation above 15% (the highest level in less than 15 years), although prices in most countries of the world are rising at a rate of about 2%.

The lack of moderation in stimulating the economy has also made the country uncompetitive. The Fitch ratings from Friday estimated that the current account deficit would reach 6.1% of GDP this year, which means that significant capital will have to be raised from abroad (over 50 billion USD). In addition to the current account, Turkish companies are also heavily indebted in foreign currencies, which increases the risks to the stability of the banking system and the cost of funding for companies, especially with a weakening lira.

The collapse in the Turkish lira rate

High inflation and external imbalances put serious pressure on the local currency. Only since the beginning of the year, the dollar expressed in lira increased by 27%. The euro and zloty gained on a similar scale - 24% and 20% respectively.

The strong fall in the Turkish currency does not mean that it is particularly underestimated at present. Depending on the models analysed by the IMF, either the lira is properly priced or it is undervalued from 2% to 9%, so currency drops reflect the low competitiveness of the Turkish economy and are not a result of a short-term exchange rate perturbation.

Structural weaknesses - politics, labour market, education

The economic collapse of Turkey is also influenced by the political situation. After the June elections and early constitutional changes, President Recep Erdogan gained dominant influence over the country's power.

In monetary policy, Erdogan, an economist by education, advocates interest rate cuts. He also argues that the tightening of monetary policy (rate increases) is causing inflation to rise, which is not in line with most economic theories. An unconventional approach to the economy is worrying investors who, for example, invest in the Turkish bond market. However, it is difficult to expect a return in line with investors' expectations. President Erdogan's son-in-law has recently been appointed to the new post of merged treasury and finance ministries.

Last but not least, there are other structural problems in Turkey. According to the latest report on Turkey's competitiveness by the World Economic Forum (WEF) The Turkish labour market is ranked 127th out of 137 classified countries. This is due to very poor cooperation between employee and employer, the inability to attract valuable employees and the fatal economic activity of women. According to the World Bank, only 32% of women over the age of 15 have a job or are looking for one. This is similar to Bangladesh (33%) and Mauritania (31%). In developed countries, this value varies between 50-65%.

Education is also a serious problem in Turkey. According to the WEF, both in terms of the quality of primary and higher education, Turkey ranks outside the top 100 countries in the world (137 countries surveyed).

No positive signs on the horizon

Rising inflation, strong external imbalances and the country's structural weaknesses suggest that the economic situation is set to deteriorate in the coming quarters. It is possible that we will see further rating cuts, and this will mean further downward pressure on currency valuation and a reduction in the purchasing power of Turkish wages.


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