Recovering from the Global Financial Crisis (GFC) of 2008, Turkey, with a population of 80 million and a high middle-income market, witnessed a robust real GDP growth rate averaging 6.9 percent between 2010 and 2017 as compared to the average global rate of 3.8 percent. Core inflation remained high in Turkey, fluctuating between 6 and 12 percent in the period 2012 to 2018. Differing from conventional policy norms, the benchmark repo rate set by the Central Bank of the Republic of Turkey (CBRT) was brought down from 10 percent in 2014 to about 6.25 percent before the 2018 crisis. This was based on President Tayyip Erdoğan’s reluctance to raise interest rates or rather his contrarian stance that high-interest rates would actually fuel inflation while dampening investment spending.
The Turkish currency crisis of 2018 was triggered by the imprisonment of an American pastor, Andrew Brunson, and the consequent US sanctions on its exports that ultimately resulted in a recession. Last year, just when the economy was gradually reverting back to normal, Turkey once again faced a currency crisis. It began with the pandemic but further worsened on account of growing uncertainties over its political tensions with Greece, Libya, France as well as with Armenia over Nagorno-Karabakh. Without delving into the geopolitical reasons for the crisis, it is interesting to study Turkey’s predicament from a purely macroeconomic perspective.
Turkey’s macroeconomic crisis can be analysed using the sectoral financial balances (SFB) equation, which, drawing upon double-entry bookkeeping principles, states that net financial asset accumulation (NFAA) across the three sectors of an economy – the government, the foreign sector, and domestic private sector (DPS) – must sum to zero, where net implies external to that sector. While a fiscal deficit implies that the government is accumulating net financial liabilities, a current account deficit implies a net inflow of capital into the country implying accumulation of net financial assets by foreigners. It is possible that DPS may accumulate net financial liabilities when at least one other sector is accumulating net financial assets. Given that its fiscal deficits and current account deficit (CAD) were on average 1.5 and 5 percent of GDP respectively, Turkey’s private sector net financial accumulation of liabilities was about 3 to 4 percent of GDP between 2010 and 2017, or, in other words, significant external leveraging by its domestic private sector. The accumulation of net liabilities is in addition to what the corporate sector borrows from other entities within the private sector, which obviously net to zero since there must be a corresponding financial asset for every financial liability. Overall, the credit surge which had effectively begun in Turkey in the early 2000s resulted in overall private sector credit rising from just 15 percent of GDP in 2003 to 70 percent of GDP in 2016.
Before the 2018 crisis, Turkey’s gross domestic capital formation (investment) had seen a robust increase from 24.9 percent of GDP in 2010 to 30.1 percent in 2017. Given Turkey’s strong GDP growth during this period, investment spending in absolute terms had indeed grown considerably. While we have pointed out that Turkey’s DPS (in particular, the corporate sector) was leveraging, it is further noteworthy that external funding for investment spending by domestic firms was through borrowing and bond issuances rather than inward foreign direct investment (FDI). To reiterate, the domestic private sector (and government) had been accumulating financial liabilities while the foreign sector was acquiring corresponding financial assets in Turkey as reflected by its CAD.
External Factors Affecting Turkey’s Economy
As part of sanctions on Turkey, the Trump administration doubled tariffs on imports of steel and aluminum, which sent the Turkish lira (official code TRY) into free fall. Between August 3 and August 13, 2018, the lira fell by some 40 percent to an all-time low of 6.9 TRY/$. One of the first policy steps adopted by the CBRT was to raise interest rates sharply in September 2018 by 6.25 percent, from 17.75 to 24 percent, breaking away from President Erdoğan’s low-interest-rate policy. The effect of the currency depreciation and hike in interest rates severely impacted the balance sheets of firms in the corporate sector, which reacted abruptly, reversing the leveraging cycle into deleveraging. In other words, from a position of accumulating net financial liabilities, the desire of the domestic corporate sector turned into a desire to accumulate net financial assets.
NFAA by the DPS, however, implies that there must be a net financial accumulation of liabilities by the government and/or foreign sectors. Even though Turkey pursued austerity policies by curtailing government expenditures, the fiscal deficit increased to almost 3 percent of GDP in 2019. At the same time, the slowdown in GDP growth and depreciated lira, resulted in reduced imports and increased exports so that the current account saw a surplus of 1.2 percent of GDP in 2019 or, in other words, net financial accumulation of liabilities by foreigners. From accumulating net financial liabilities, the domestic private sector had begun accumulating net financial assets to the tune of about 4 percent of GDP, a clear sign that it was deleveraging. This, however, had an unprecedented negative effect on the economy.
Investment spending declined sharply, by almost 22 percent between July 2018 and the end of 2018, forcing the economy into a recession. However, tightening monetary policy in response to the growing pressure of international rating agencies (who President Erdoğan termed as “impostors” and “racketeers”), reined in the sliding lira and accelerated inflation expectations. The growth rate rebounded into positive territory in 2019; in the last quarter, Turkey beat market expectations and saw GDP grow (partly due to the base effect) at 6 percent y-o-y although it began to slacken in the first quarter of 2020 to just about 4.5 percent.
The ‘Lockdown’ Effect
Turkey’s economy tanked by 10 percent and with its exports, investment, and consumer spending too. Inflation soared to more than 12 percent during the time of the pandemic. The expected depreciation of the lira and possible bankruptcies of companies that carried dollar and euro-denominated debt triggered a flight of foreign currency out of Turkey. Pressure on the lira mounted while the CBRT attempted to prop it up by dipping into its reserves. This was, however, unsustainable and had to be given up with dwindling reserves. Between March and the end of October, the lira had fallen from 6 TRY/$ to 8.3 TRY/$. This was in spite of the CBRT raising overnight interest rates by 2 percent to 10.25 percent in September. Qatar too came to the aid of Turkey with massive (dollar) investments that helped ease the currency crisis but the decline in the lira continued into November reaching an all-time low of more than 8.5 TRY/$, which forced another strong intervention by the CBRT. Interest rates were raised by 475 basis points, from 10.25 to 15 percent, which brought the lira down to about 7.55 TRY/$ on November 19, 2019. On December 24, the CBRT further hiked interest rates up to 17 percent bringing the lira down to 7.43 TRY/$ by the year-end.
The political tensions between Turkey and several other countries continue to contribute to uncertainty over trade and capital flows, and consequently over the lira. Meanwhile, the 2018 story played out once again in 2020 with deleveraging by the Turkish corporate sector (as can already be seen in the paring down of debt), an increase in net financial asset accumulation by households (including gold), a slowdown in the economy, larger fiscal deficits and a contraction of the current account deficits (or even a surplus). For the deleveraging cycle to be sustained without larger fiscal deficits, a lot depends on the ability of Turkey to maintain the impressive export growth seen in 2020. However, the depreciated lira has increased the foreign currency-denominated debt burden on the corporate sector (in lira terms) that could result in widespread loan defaults with an adverse impact on banks including foreign banks that have high exposure to Turkish corporate debt.
Turkey provides an interesting case study for the macroeconomic crisis. There are several positive features of the Turkish economy including its low fiscal deficits, moderate debt to GDP ratio combined with robust investment, and real GDP growth. However, Turkey has a serious inflation issue that both, are influenced by and influence the exchange rate. A shock that triggers a currency crisis is immediately transmitted to the relatively highly externally leveraged corporate sector, which induces a deleveraging cycle. At the same, inflation expectations and consequently a possible depreciation of the lira turns into a self-fulling prophecy, necessitating an increase in interest rates to quell the outflow of foreign currency. While Turkey remains a vibrant economy, it is susceptible to external shocks and frequent bouts of instability.
The International Monetary Fund (2019), Country Report No. 19/395, Turkey : 2019 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Turkey (imf.org)
Sivramkrishna, Sashi and Dhruva Nandipati (2019), Turkey’s macroeconomic policy challenges in the aftermath of the 2018 crisis: A sectoral financial balances analysis, Theoretical & Applied Economics, No.4/2019 (621), Winter, pp.111-128, Microsoft Word – 9_733_sivramkrishna-nandipati.docx (ectap.ro)
Heteconomist (2014), Introduction to the Sectoral Financial Balances Model, Introduction to the Sectoral Financial Balances Model | heteconomist