Turkey: depreciation followed by recession

The flight of capital from the Turkish lira, which marked an interim peak in mid-August, has dramatically highlighted the real conditions underlying the Turkish economy. President Erdogan’s „growth model“ of boosting domestic demand by means of an expansive fiscal policy, major public construction projects, interest rate subsidies for the private sector and other measures has put excessive demands on the country’s economy. The high growth rates of the last two years way exceeded the potential rate and were unsustainable. The artificial boom has demonstrated Turkey’s dependence on net foreign capital inflows.

A strategy must now be pursued that will tangibly reduce the current account deficit. To achieve this, Erdogan will be forced to rely on a restrictive fiscal policy and, most importantly, finally allow the central bank to pursue an independent monetary and interest rate policy. Ultimately, it will have to raise interest rates significantly in order to curb inflation and regain the confidence of foreign investors that the country still so urgently requires. This is the only way for the currency storm to subside, not just temporarily but over a sustained period. For the time being, however, the economy needs to absorb the exchange rate-induced surge in inflation resulting from the recent crisis.

Consumers can be expected to show great reluctance in the current situation characterized by double-digit inflation rates and, by extension, significant declines in real income. At the same time, the costs for repaying the high foreign loans in the private sector will rise noticeably in response to the lira’s depreciation, creating problems for many companies and dampening their investments. We therefore see a likelihood of a recessionary economic trend that can be expected to materialise in the second half of the year and continue well into next year. Thanks to the robust growth in the first half of 2018, full-year growth should still amount to around 3 percent this year. For 2019, however, we expect average annual economic growth of only “around the zero mark”.

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