Annual inflation has reached 61%, reflecting the seriousness of the problems in the economy
There is almost an exhaustive list of factors responsible for high inflation: FX pass-through, elevated global commodity prices, poor weather conditions, robust domestic demand, administrative price hikes, easy monetary and incomes policies, unorthodox policy decisions (that create a positive feedback loop through loss of credibility, higher inflation expectations and a weaker currency).
True, some of these factors will lose momentum in the coming months. If the lira maintains its stability, FX pass through could diminish; higher inflation has eaten away the wage increases and this along with weaker sentiment (which at least partly followed the war in Ukraine) should lead to a weakening in demand pressures; and, strong precipitation points to better agricultural output and, hence, weaker prices in the coming months.
However, global commodity prices are likely to remain high and the risk of supply disruptions continues. More importantly, weak policy credibility makes it impossible to anchor inflation expectations. Hence, we expect inflation to stay around 65% until the very end of the year.
It is interesting and unfortunate to see the CBRT showing no reaction to this surge in inflation
Policy makers continue to disregard the need for policy tightening and we see the policy rate unchanged at 14.0% until the end of this year. The CBRT seems to be putting all its emphasis on lira stability that could follow increased demand (local and foreign) for the FX-protected TRY deposit scheme. Setting aside the associated costs (such as increased FX exposure of the public sector), this scheme alone is unlikely to solve such a complex and difficult inflation problem. This suggests that until orthodox policies are introduced, inflation will likely remain much above global standards and the lira will remain vulnerable to shifts in local and global risk appetite.
Turkey has been hit hard by higher energy prices and the recovery in tourism could be hampered by the war in Ukraine
With higher energy and commodity prices, we expect Turkey’s current account deficit to widen to US$30.4 billion (3.8% of GDP) in 2022 from 1.8% of GDP last year. The impact of the war in Ukraine on Turkey’s merchandise exports should be limited given how diversified Turkey’s export markets are and how flexible Turkish exporters have been in shifting their exports during times of crises.
More important will be the impact on tourism as around 1/4 of total tourist arrivals to Turkey was from Ukraine or Russia. We expect the loss from Ukraine/ Russia to be partly offset by more tourists from Europe and GCC countries, but still the war creates risks for a wider deficit. Up until now, the wider deficit has been financed by increased borrowing. Given the sharp deleveraging delivered by the Turkish companies in recent years, we think there is potential for a further increase in external borrowing in the coming months.
The real risk remains the resilience of the local investor confidence
The last two years saw a rapid outflow of international investors. The share of foreign investors in the local government paper market plunged to below 4% from above 20% in this period. Hence, it is the local investor who will likely determine the outlook for the lira and the Turkish markets. The local confidence got dented by unorthodox policies, resulting in heavy currency substitution towards the end of 2021. The government responded by introducing an FX protected TRY based deposit scheme through which the depositor would be compensated for any lira deprecation in excess of the interest income during the term. Although the scheme comes with potential long-term risks on the public sector, it helped to stabilize the local sentiment. However, given the deeply negative real interest rates and political/policy uncertainty, local investor sentiment needs to be followed closely.
Three Scourges of Turkish Economy: Unemployment, Inflation, and External Deficit
We expect GDP growth to slow sharply to 3.2% in 2022 from 11.0% last year. High and volatile inflation makes it very difficult to forecast real growth. Negative real interest rates and the expectations for a further rise in prices support private consumption. However, given the weakening in domestic sentiment, tighter global liquidity, the uncertainties regarding the war in Ukraine and a very strong base, we expect growth to subside to 3.2%. A further weakening in local sentiment could hurt growth momentum while populist policies by the government in the run-up to the election could lead to a temporary recovery in growth pace.
Ukraine Crisis Could Cost Turkey $30 Billion | Real Turkey
Ongoing fiscal discipline eases the pressure on the Treasury. Thanks to the rapid recovery in economic activity and ongoing spending discipline, central government budget deficit declined to 2.7% of GDP in 2021 from 3.5% a year ago. Given that the burden of the new deposit scheme will be shared with the CBRT, we expect the deterioration in the fiscal performance to remain manageable. We see the fiscal deficit expanding to 3.7% of GDP.
From JP Morgan Report “Emerging Markets Outlook and Strategy”
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