Summary

For several years, the Turkish economy has managed to keep its balance despite teetering on the brink of major problems. In 2013, the notorious "taper tantrum" exposed Turkey as one of the Fragile Five countries that would be most affected by an expected tightening in U.S. monetary policy, and the outlook for the country appeared bleak. But Turkey has broadly defied its naysayers. In the years since, its gross domestic product has grown steadily, inflation has been manageable and it has had no major debt defaults, all despite the fear that U.S. interest rate increases would actually come to fruition. Favorable circumstances have helped the Turkish economy defy the gloomy expectations — particularly the 2014-15 drop in global oil prices. But as oil prices stabilize and other positive factors fade away, Turkey looks likely to suffer greater economic hardship over the coming months.

A ferry steams past the Hagia Sofia, a major tourist attraction in Istanbul. Tourism, a prime source of foreign currency in Turkey, has suffered as the result of terrorist attacks this year. (CHRIS MCGRATH/Getty Images)

Analysis

The origins of Turkey's economic fragility stem from a period of rapid growth in the 2000s. Unlike other high-growth countries in the period such as China, which focused its economy on manufacturing and exporting products to the global market, or Russia, which grew off the back of global demand for its commodities, Turkey's boom was largely based on domestic consumption and investment. While Turkey's export capabilities did grow, notably in the white goods sector (washing machines and other electrical appliances), its growth rested overwhelmingly on consumption and on a thriving construction sector. As a result, Turkish growth came with a current account deficit; this meant that speculative foreign capital coming into the country made it possible for Turkey to bring in more products from abroad than it was exporting. That type of growth is sustainable as long as foreign investors believe they can achieve a better return for their money in Turkey than somewhere else; when they lose faith, the ensuing loss of liquidity can cause sizable problems.

In Turkey's case, the repayment of foreign currency debt could emerge as a particular problem. It is an issue that has recurred around the world many times: During good times, residents and companies in a high-growth country take out loans in a foreign currency (usually in dollars), lured by low interest rates offered by investors looking to share in the growth. Then when a downturn arrives, the national currency weakens, making it much harder for debtors receiving earnings and wages in the local currency to repay the dollar-denominated debt. These effects can be tempered if foreign investors are willing to roll over loans or make new ones. But this is reliant on continuous, external goodwill.

The moment when the market lost faith in Turkey appeared to have arrived in May 2013, when former U.S. Federal Reserve Chairman Ben Bernanke announced the tapering of U.S. government bond purchases. This signaled the end of quantitative easing, the loose monetary policy that had flooded the world with dollars, many of which flowed into the Turkish economy. The announcement caused Turkey (along with India, Indonesia, South Africa and Brazil, the other members of the Fragile Five) to experience a sharp economic shock as money flowed toward the United States in anticipation of an interest rate hike. At the end of 2013, Turkish companies held $38.8 billion worth of dollar-denominated corporate bonds, and with the lira depreciating, foreign investors looked at risk of default. The cost of insuring against a Turkish default through an instrument called a credit default swap soared, and the lira began to weaken, as the market foresaw a crunch arriving. This wider episode came to be known as the taper tantrum.

Turkey's Situation Deteriorates

But the envisioned disaster never truly arrived, or at least not in Turkey, an apparent anomaly, because in many ways the case for investment in Turkey was deteriorating. In 2014, Recep Tayyip Erdogan left the prime minister's office, which he had held for 11 years, to become president and set in motion the process of shifting power to the presidency. These changes were accompanied by increased incarcerations of journalists and temporary suspension of media outlets such as Twitter. For an overseas investor who values a rule of law guaranteed by democratic institutions, a move away from democracy can be a worrying trend.

At the same time, the Turkish security situation was also worsening. The battlefields in Iraq and Syria on Turkey's southern border were becoming more chaotic, and Turkey began to receive more refugees fleeing the fighting. The conflicts also re-energized Kurdish separatists, who saw an opportunity to unite with their Iraqi and Syrian kinsmen to fight toward their goal of an independent state; this in turn created more friction with the Turkish government. The result has been a steadily increasing campaign of terrorist attacks targeting Turkish military targets and population centers.

Meanwhile, Turkish government policy has also been undermining the country's economic position. As 2014 dawned, interest rates in Turkey more than doubled overnight to 10 percent. That move buoyed the value of the lira. Those rates, now 8.25 percent, have steadily dropped in a move popular with Turks as Erdogan has looked to sustain political support by keeping growth steady. Another populist measure, the introduction of a higher minimum wage in early 2016, undermines the economy's manufacturing base by decreasing Turkish competitiveness internationally. That move not only weakened the lira but also could hurt employment, as small and medium-sized companies, facing increased wage costs, trim staff. The government committed to help companies pay for some of the wage burden, but only during 2016.

A Stay of Execution

With all of the headwinds blowing Turkey's way, it could be considered surprising that it has not suffered significant economic problems in the past three years. The reason it has not is that the global environment changed between then and now. The expected interest rate boost by the U.S. Federal Reserve did not occur until December 2015. And by that point, other circumstances had shifted. Between July and December 2014, the price of oil halved from $100 per barrel to $50. Oil-exporting countries, including many of Turkey's peers in the developing world, saw a sizable drop in revenue that left large holes in their budgets. But for oil importers such as Turkey, the decline reduced the cost of energy and automatically improved the country's current account balance by reducing its import burden.

Though Turkey received direct benefits from the lower commodity prices, the most important gains it experienced were probably the indirect ones. Recessions in Russia and Brazil made Turkey, which was still growing, a relatively more attractive investment prospect. In addition, as a result of patchy growth that held inflation in the United States in check, the U.S. monetary tightening cycle was much less rapid than anticipated. The result of all of these circumstances is that Turkey has continued to attract capital from global investors, postponing the day when it is deserted by international capital.

Storm Clouds Forming

Turkey's relative outperformance of its peers and the ongoing postponement of U.S. tightening that made Turkey attractive to flows of capital from abroad both look under threat. The oil price, which had dropped to $35 a barrel at the start of the year, appears to be stabilizing at around $50, and commodity-exporting countries have begun to recover. The economies of Russia and Brazil, for example, are both forecast to emerge from harsh recessions in 2017. Economists, meanwhile, expect the United States to boost interest rates in December — its first such decisive move in a year.

Meanwhile, within Turkey, the case for investment has continued to deteriorate. Tourism, a historical source of foreign capital, has suffered after recent high-profile terrorist attacks within the country. Tourism receipts were down 36 percent year-on-year in the second quarter of 2016. Internal instability was also thrown into sharp relief by the attempted coup in July, which saw Standard and Poor's immediately downgrade Turkey's credit rating to junk status, an action that was then echoed by Moody's in September. The Turkish administration's response to the coup attempt, which has involved increased authoritarianism, more imprisonments and a likely change to its constitution, has contributed further to investor misgivings.

The Horns of a Dilemma

The result of these factors has been a tightening of Turkey's economic position. The administration now finds itself on the horns of a classic dilemma: With capital fleeing, it faces a choice between increased inflation or more unemployment. Tighter monetary policy would stave off capital outflows by increasing investors' returns from holding lira, but it would also slow economic growth (which is already expected to miss its targets for the next three years, according to a recent Reuters poll of economists) and drive up unemployment. For its part, the unemployment rate, now at 10.7 percent, is already nearing five-year highs, and the possibility of it rising much further is politically unpalatable.

The administration's other option, moving interest rates down to try to sustain growth, is equally problematic. The lira is already at record lows, and even though this has not yet fed through to create high inflation, it is hard to imagine that state of affairs prevailing for long, especially considering that the Turkish central bank has cut rates in seven of its last eight monthly meetings. In addition, signs are beginning to emerge that a reckoning may be in store for companies that owe payments on dollar-denominated corporate bonds (investors in Turkish firms hold $68.4 billion in such bonds). In September, for instance, Turkey's largest telecom company failed to make a debt repayment for the first time, a possible harbinger of things to come.

Thus, Turkey's economy appears to be entering a difficult period. At this point, the only way for it to regain its balance would be either through an influx of foreign investment capital, which would probably require an improvement in Turkey's unstable relative geopolitical position, or an increase in exports relative to imports (in 2015, exports constituted 28 percent of gross domestic product; imports stood at 31 percent), which would start generating natural inflows of capital. Neither of these eventualities appear likely to occur anytime soon: If anything, Turkey is getting pulled more deeply into the conflicts across its southern border, and a rapid economic rebalancing could be achieved only by a sharp drop in imports, which would itself result in hardship within the country.

There are, however, reasons for positivity about Turkey's longer-term outlook. In 2014, Turkey was home to 42 of the world's top 250 construction companies (second only to China), so it is well positioned to take advantage of the rebuilding project when the conflicts in Iraq and Syria finally end. But before reaching those good times, Turkey looks like it is about to experience some hard economic times of its own.

"Rough Seas Ahead for the Turkish Economy is republished with permission of Stratfor."