Turkish economy battles high inflationahead of elections
Atradius Economic Research – May 2023
Summary•••

The race between incumbent president, Recep Tayyip Erdogan, and opposition leader, Kemal Kilicdaroglu, is neckand neck just days ahead of Turkey’s upcoming elections. The dire state of the Turkish economy, exacerbated by theFebruary earthquakes and subsequent policy response, is fuelling the uncertainty.
The chances that the outcome will require a run-off vote on May 28 are increasing, as are the risks of politicalinstability. We expect President Erdogan’s AKP to remain the largest single party in parliament but the six-party
opposition bloc, “Nation Alliance”, is likely to take the majority.
Regardless of the vote’s outcome, the next administration is facing an uphill battle to bring stability to an economy
characterised by low interest rates, fiscal stimulus, currency depreciation, soaring inflation, and a complicated webof unorthodox macro-prudential policies. We see both political polarisation and economic turbulence to remain in
the cards this year.

With elections fast approaching, the Turkish economy isstruggling with high inflation, a weak lira and the impactof the earthquakes that took place in February. The
upcoming general elections for the presidency andparliament on May 14 are set to be a particularly close
contest, potentially resulting in divisive court challenges,
which could unleash political instability.
President Erdogan’s Justice and Development Party(AKP) is polling around 34% of the vote, as of May 8
according to PolitPro. The runner-up Republican
People’s party (CHP) is polling just below 30% of the vote.
Polls indicate the opposition bloc (“Nation Alliance”),
consisting of six parties, is close to gaining a majority,
but nothing is certain yet. The presidential election is
likely to be a close race between Erdogan and the main
opposition candidate, Kemal Kilicdaroglu (CHP). While
Kilicdaroglu has a slight edge over Erdogan – 49% vs.
43% respectively – the chances that he will surpass the50% threshold required to declare victory is still tight.
This would require a run-off presidential vote on May 28.

Economy is entering a slower growthtrajectory
The incumbent Justice and Development Party (AKP)
came to power more than two decades ago with thepromise of structural reforms to address a series ofeconomic and financial crises since the late 1990s. Theirstructural reform programme laid the foundation for
more sustainable growth by taming rampant inflation. It
also significantly reduced the public debt ratio andputting the banking sector on much more solid footing.
Turkey enjoyed a period of solid GDP growth between
2009 and 2018, fuelled by cheap foreign borrowing andcharacterised by robust domestic credit growth. The
credit bubble eventually burst as the lira sold off in 2018
and a more modest growth trajectory followed.
Nevertheless, the economy was quite resilient during thecoronapandemic. Turkey was one of the few G20
countries that managed to avoid a recession in 2020 andshowed a solid growth recovery in 2021 (11.4%).

Growth declined to 5.6% in 2022 and we expect it to slow
further to 1.0% in 2023, barring any major changes to thedirection of economic policy. Economic activity isconstrained by high inflation and a weak lira that are
weighing on consumer purchasing power. Furthermore,slowing export growth and the negative impact of theearthquakes (which are assessed by Oxford Economics tobe in the order of 0.3 to 0.4 percentage points) are also
weighing on GDP growth. An expansionary fiscal policy
does provide some counterweight to growth slowdown,
but it is likely that the government will cut down on
spending after the elections are over. We expect period ofslower growth over the next 10 years as less abundant
global liquidity and slower credit growth keep economic
activity on a more modest trajectory. Current
macroeconomic imbalances are likely to remain
prominent in the coming years, potentially leading tovolatile growth.

Unorthodox monetary policy fuels highinflation
One of the key vulnerabilities of Turkey’s economy ishigh inflation, caused by an ultra-loose monetary policy,
credit-driven growth and high global commodity prices.
Since September 2021, the key central bank policy rate
was reduced by 10.5 percentage points to 8.5% in March
this year, despite very high inflation. The inflation raterose to 85% year-on-year in October and November 2022
(figure 1). Despite easing somewhat in recent months due
to favourable base effects, inflation remains very high(in April 2023 it was 44% y-o-y).

protected deposit account (known as KKM) are used.
These offer depositors protection against a depreciationof the lira against major currencies such as the USD andthe EUR. Other measures target banks and businesses
that hold large FX deposits or earn mostly in foreign
currencies. For instance, an export-oriented company
operating in Turkey must convert up to 40% of theirforeign currency export receipts into Turkish lira. Thesemeasures, however, did not prevent a furtherdepreciation of the lira since early 2023. We expect thelira to gradually depreciate further against other major
currencies in 2023-2024, given political uncertainty andexternal imbalances.

External position is a major weak spot
Another vulnerability of Turkey’s economy is its weakexternal position, characterised by structural current
account deficits and high external debt. The current
account deficit widened to 5.7% of GDP in 2022 (figure),and we forecast that it remains wide in 2023 at 4.5%. Themain factor driving the wide current account deficit isthe rising import bill, specifically of energy imports. As
energy and raw materials are denominated in USD, theweakness of the lira only has a limited positive effect on
the current account. We forecast the current accountdeficit to narrow in 2023-2024 as slowing economic
growth curbs the rise in imports, while lira depreciation
boosts exports.
Figure 2 Current account deficit widens further

Figure 1 Interest rates continue to decrease despite soaring
inflation

We expect the central bank to continue its unorthodox
policy at least until the elections. After the vote, however,a major tightening of the policy rate seems unavoidable
to stabilise the lira. The lira has been a major casualty of
the central bank’s policy stance. Since the easing cycle
started, it has depreciated by 34% against the USD. The
central bank attempts to manage pressure on the lirathrough capital controls and interventions on foreignexchange markets. But the ability of the central bank tointervene in the currency market is constrained by thelimited amount of FX reserves. Therefore, the main
instruments to combat lira weakness are capital controls
and other macroprudential measures. Exchange-rate

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Turkey has large external financing needs, including
short-term external debt repayments and current
account financing. We estimate that the gross externalfinancing need was USD 245 billion in 2022, or about
30% of GDP. We forecast that the external financing
requirement will increase in 2023-2024 to an average ofUSD 267 billion. Foreign-exchange reserves currently
cover less than 30% of the external financing
requirement. To meet its financing requirement, Turkey
relies heavily on short-term borrowing, making it
vulnerable to a balance-of-payments crisis in the comingyears.

Government finances still healthy
Government finances remain sound, despite higher
spending. We expect the government deficit to widen in
the near term, from 0.9% of GDP in 2022 to 4.2% in 2023,
due to social-spending initiatives ahead of the elections,
including high public wages and pension increases, early
retirement (potentially benefitting up to 2.1 millionemployees) and debt forgiveness for certain utilities andstudent loan payments. In addition, the earthquake relief
and reconstruction will also add pressure to fiscalaccounts. The government has already allocated TRY 100
billion (USD 4.8 billion) to relief efforts, and directedtransfers to affected families, unemployment
compensation and announced the postponement of tax
payments in the region. Meanwhile, revenue is likely toslow as the economy weakens. In the medium term, thefiscal deficit is likely to decrease as the government isexpected to rein in spending after the elections.
We estimate the government debt to have been 32% of
GDP in 2022. Public debt is likely to increase to 36% in
2023. A vulnerability of the fiscal position is that anincreasing percentage of public debt is denominated in
FX (more than 70% in 2023, up from around 40% in2017). However, fiscal sustainability risks in Turkey
remain relatively low. The government maintains a
comfortable position with low public debt as a share ofGDP and historically low deficits and thus has somescope for stimulus in another economic downturn.

Banking sector remains resilient
The banking sector as a whole is well capitalised, with a
Tier 1 capital ratio of over 16.8% and a capital-adequacy
ratio of 19.5% in Q4 2022. The non-performing loan (NPL)
ratio stood at 1.9% in February 2023, but this partly
reflects a more lenient classification regime: from early2020 the Turkish authorities classified a loan in theworst NPL category only when it was 180 days overdue,
rather than 90 days previously. High inflation andmonetary easing have sent short-term real interest rates
into negative territory, risking a disruption in credit
intermediation. The banking sector is exposed toTurkey's heavily indebted private sector, which has
already been experiencing difficulties in rolling over its
debt, one-third of which is denominated in foreign
currency. The risks to Turkey’s banking sector are clearly
increasing, vulnerable to the lira’s developments. Given
the sector’s still-healthy metrics and track record of

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resilience through economic and financial crises, ourbaseline view is that this will be maintained this year.

Facing up to the economic challenges
To conclude, the winners of the upcoming Turkish
elections will be inheriting a highly vulnerable economy,
grappling with soaring inflation, a structural accountdeficit and a high dependence on short-term foreign
capital inflows. With global monetary policy tightening
and domestic policy space tightening, the urgency toreturn to more conventional policy to get inflation undercontrol and reduce Turkey’s external imbalances isrising. Some change to policy under the next government
is seemingly inevitable, but election promises do notreflect this.
The incumbent AKP is committed to alleviating thissituation post-elections by maintaining accommodative
monetary and fiscal stances while relying on
unconventional macro-prudential policies to ensureliquidity. In the case that Erdogan would reverse thedirection of his economic policy by shifting to interest
rate hikes, past policy u-turns and uncertainty will keep
investors wary. In case the opposition succeeds,
following through on their promises to return to policy
orthodoxy – including inflation-targeting monetary
policy and improving central bank independence – will
be easier said than done. The cohesiveness of theopposition, comprised of six parties from across thepolitical spectrum, still needs to be tested.
Whether the AKP or opposition wins this May, we can beconfident that the political situation will remain highlypolarised, keeping policy uncertainty elevated andincreasing the risk of instability. The extent of economic
challenges and depth of external vulnerabilities ensurethat any pivot to more conventional policies will be adifficult and gradual process. Hiking interest rates would
be the first step towards preventing capital outflows andrebuilding FX reserves but would also spur the firstannual contraction in economic activity since 2009.
Theo Smid, senior economist
theo.smid@atradius.com+31 20 553 2169
Dana Bodnar, economist
dana.bodnar@atradius.com+31 20 553 3165

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