Turkey Outlook: Slowing, But Not Falling Off A Cliff

GLOBAL ECONOMIC OUTLOOK
March 14, 2012
Turkey Outlook: Slowing, but Not Falling Off a Cliff

By Maya Senussi We revise our growth forecast for Turkey upward, as it is benefiting from the improved outlook for the eurozone (EZ) through the confidence, finance and trade channels. Although the chance of a sudden stop in financing has receded, Turkey will still slow sharply and grow below trend. Tightening domestic credit conditions will continue to weaken consumption and investment, implying an adjustment of the external balance, but high oil prices will offset some of the gains. The recent recovery of the lira, helped by a global liquidity surge, should enable the Central Bank of Turkey (CBT) to stick to its flexible regime, but high inflation will prevent further easing.
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Figure 1: RGE Forecasts

2011 GDP (%, y/y) CPI (%, y/y, avg) Policy Rate (%) 8.1 6.5 5.75 2012 2.6 9.4 5.75 2013 3.2 6.8 7
Note: Policy rate forecasts refer to the end of the given period. Macroeconomic Dynamics: More Signs of a Slowdown Recent data paint a mixed picture of Turkish economic activity. As anticipated, manufacturing is facing weakness in external demand: The PMI dipped below 50 (signifying contraction) in February, for the first time since August 2011. The contribution of consumption is also declining: Household consumption has eased and this trend will likely continue in the months ahead as tighter credit reinforces a slowdown in growth. On the other hand, the real sector confidence index has bounced back from its December low and should continue to hold up (Figure 3). Although Q4 2011 GDP data are not yet available, the momentum of last year, particularly the above-potential growth in H1, implies the sequential pace of growth will likely stall in Q1 2012. Nevertheless, given RGEs stronger EZ Outlook and the improvement in global risk appetite, which should support capital inflows, we now expect the Turkish economy to grow by 2.6% in 2012 and 3.2% in 2013, which, although considerably slower than the overheating growth of 2011 and still below potential, represents an upgrade from our previous Outlook. As anticipated, the impact of the tighter monetary policy stance since late October began showing in hard data from Q4. Industrial production, which grew by only 1.5% y/y in January as export demand from the EZ declined, and a drop in the manufacturing capacity utilization rate (to 72.9% in February, from 74.9% in January) clearly point to Turkeys growth returning to a more sustainable level (Figure 4). The easing of global and local conditions suggests it will be a soft landing, delaying an adjustment until 2013 or beyond. Decelerating loan growth (25% y/y in February, down from 40% in mid-2011; Figure 5) will exert downward pressure on domestic demand (private consumption and investment spending) and imports, in turn starting to narrow Turkeys unsustainable current account gap. The improvement will be gradual and modest (the 12-month
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rolling current account deficit remained unchanged at US$77.1 billion in January), particularly if higher oil prices add to the energy import bill, but the non-energy deficit should continue narrow. Large external financing needs, Page | 2 the poor quality of inflows (FDI remains low) and the maturity structure of Turkeys debt (short-term debt outstrips reserves) will mean Turkey continues to be vulnerable to market sentiment swings. Turkeys neighborhood is rather volatile, and the ongoing conflict in Syria and the situation in Iran place it in an awkward policy position, potentially also threatening its domestic stability. Turkeys energy needs (Iran supplies about 30% of Turkeys crude) mean it is unlikely to stop importing Iranian oil despite rising international pressure, and the countries nonoil trade and investment links are also sizeable. Turkey does, however, stand to benefit from the increased wealth of GCC oil exporters, which have been increasing investment. Inflation appears to have stabilized at a high level (Figure 6), easing slightly to 10.4% y/y in February, but we attribute the improvement mainly to seasonal factors and an uplift in market sentiment, which has boosted capital inflows and the lira. We expect inflation to remain above the CBTs comfort zone, hovering around 10% in H1 and falling only gradually thereafter, with most of the decline taking place in Q4, primarily due to base effects. Policy Implications: Keeping it Flexible The CBT acknowledged the reduced pressure for it to support the lira by cutting the corridor ceiling from 12.5% to 11.5% on February 21; however, funding costs had already averaged below 8% between mid-January and midFebruary. Given the slowing domestic demand and external headwinds in 2012, the bank will prefer to keep policy flexible at the cost of higher inflation and refrain from increasing the policy rate for as long as possible. Further decreases in the upper band of the interest rate corridor will depend on capital inflows and the performance of the lira, but we expect the effective funding rate to change only slightly at most, lest it brings a recovery in lending. Slower growth in 2012 will complicate further fiscal adjustment and, as economic activity moderates, so will tax revenues, which are likely to undershoot the official targets, weakening Turkeys fiscal position. Arguably, the government has more space to act than its emerging Europe peers and should have no trouble rolling over the US$50 billion of debt due in 2012. It has already tapped foreign markets for US$3.2 billion, including US$1 billion of 30-year paper at 6.25%, the lowest-ever yield for the maturity, defying fears that it might face higher funding costs. Turkey is, however, likely to proceed cautiously on fiscal policy to achieve the budget deficit target of 1.5% in 2012, thus avoiding the belt-tightening required to address the structural components of the current account deficit. Figure 2: Risks to RGE Forecasts
Risk Middle Eastern countries (particularly GCC members) step up trade and investment, offseting weak demand from Europe. The CBT eases its monetary stance, spurring credit growth and suporting Upside domestic demand. Foreign currency debt rating upgrade boosts and improves quality of inflows. A sharp and protracted oil price spike (caused by conflict with Iran) adds to the inflationary burden and raises the risk of stagnation/recession. Downside Further deterioration in neighboring Syria and Iraq undermines trade and destabilizes Turkey's predominantly Kurdish southeast. A disorderly default in the EZ leads to a credit freeze. Probability High Low Low Medium Medium Low Impact Medium High High High Low High

Figure 3: Real Sector Confidence Points to Better Times Ahead (over 100 denotes optimistic expectations regarding economic activity)
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160 140 120 100 80 60 40 Jan-2008 RSCI RSCI: Export Orders over Next 3 Mos Sep-2008 May-2009 Jan-2010 Sep-2010 May-2011 Jan-2012
RSCI: Vol of Output over Next 3 Months RSCI: Fixed Investment Expenditure
Source: Haver Figure 4: but Manufacturing Paints a Bleaker Picture

30 20 10 70 0 65 -10 -20 -30 Jan-2009 Jul-2009 Jan-2010 Jul-2010 Jan-2011 Jul-2011 Jan-2012 60 80
75
55
Industrial Production (NSA, y/y, % change)
Manufacturing Capacity Utilization (NSA, %)
Source: Haver

Figure 5: Credit Growth No Longer Overheating (%, y/y)
60 50 40 30 20 10 0 -10 -20 -30 Jan-2010 May-2010 Sep-2010 Jan-2011 Housing May-2011 Auto Sep-2011 Other Jan-2012
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Consumer Loans
Source: Haver Figure 6: Inflation Stabilizing at a High LevelMonetary Easing Unlikely (%, y/y)
14 12 10 8 6 4 2 Jan-2007 Oct-2007 Jun-2008 Feb-2009 CPI Oct-2009 Core H Jun-2010 Core I Feb-2011 Oct-2011
Source: CBT
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GLOBAL ECONOMIC OUTLOOK

March 14, 2012