Turkey Economic Monitor: Minding the External Gap

Taking Stock

A strong policy response – on the back of fiscal buffers, a strong financial system, and favorable external conditions – enabled Turkey to recover from its shock of 2016, with growth accelerating to 7.4 percent in 2017.

Countercyclical fiscal policy and private sector credit boosted demand, and helped overcome labor market and financial sector rigidities to accelerate production. Short-term fiscal and credit measures helped avert a bigger collapse in demand and production after the economy contracted in Q3 2016. They also contributed to progress on poverty reduction.

The balance of risks in the Turkish economy since Q3-Q4 2017 has shifted from growth to stability. Demand has overshot supply capacity and macroeconomic imbalances have widened. The outcome of supply constraints and demand impulse are reflected in high inflation; a large current account deficit; and currency volatility.

Turkey has been prone to large economic swings in the past. The greater the volatility in growth, the more pronounced is the negative impact on productive investment and efficiency of resource allocation. This hurts long term productivity and potential output, both of which have stagnated in Turkey.

Looking Ahead

Growth in Turkey is projected to moderate to 4.7 percent in 2018, although with heightened downside risks. There is high probability of continued expansionary policies driven by the desire to maintain strong growth in the run up to elections in 2018 and 2019. Inflation is projected at over 10 percent and will remain an important policy challenge in the coming year.

Whilst export growth is expected to remain strong, the contribution of net exports to growth is projected to be offset by a large import bill linked to rising commodity prices. Tighter global liquidity conditions in 2018 will affect two soft spots for the Turkish economy: access to and cost of external finance, an important lever of growth for the country.

The government is in a good position to finance its long-term commitments and the composition of public debt does not unduly expose the authorities to a sudden change in financial market conditions. On the other hand, tightening global financial conditions together with elevated levels of external and private sector debt have the potential to rapidly erode fiscal space if the latter become contingent liabilities. The possibility for monetary policy to respond to adverse external developments is more challenging.

A combination of high inflation, on the one hand, and rising (and positive) policy rates on the other, creates challenges for a monetary stimulus in the event of an external shock. This challenge is exacerbated by the need to cool credit expansion, which has been above its long-term trend.

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