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Turkey’s Economy Faces Uncertain Future Amid Political Turmoil and External Pressures

In the midst of a highly polarized political climate, Turkey’s economy is grappling with significant challenges that are expected to persist in the coming years.

Unorthodox Policy Stance Contributes to Economic Instability

According to a recent report by ATRadius, the central bank’s unorthodox policy stance, which has led to a depreciation of the lira against major currencies, is likely to continue until the elections. However, once the vote is held, a major tightening of the policy rate seems unavoidable to stabilize the lira.

Lira Depreciation and Limited FX Reserves

The lira has been a major casualty of the central bank’s policy stance, depreciating by 34% against the US dollar since the easing cycle began. The bank has attempted to manage pressure on the currency through capital controls and interventions in foreign exchange markets, but its ability to intervene is constrained by limited FX reserves.

Macroeconomic Challenges

To combat lira weakness, the central bank has resorted to using instruments such as:

  • Capital controls
  • Other macroprudential measures, including the exchange-rate protected deposit account (KKM)

These measures have not prevented a further depreciation of the lira since early 2023, with experts expecting it to gradually depreciate further against major currencies in 2023-2024.

Weak External Position and High External Debt

Another significant vulnerability facing Turkey’s economy is its weak external position, characterized by:

  • Structural current account deficits
  • High external debt

The country’s current account deficit widened to 5.7% of GDP in 2022 and is expected to remain wide in 2023 at 4.5%. The main factor driving the wide current account deficit is the rising import bill, particularly energy imports.

Government Finances and Banking Sector Resilience

Government finances remain sound, with government debt estimated at 32% of GDP in 2022. However, public debt is expected to increase to 36% in 2023 due to social spending initiatives and earthquake relief efforts.

The banking sector remains resilient, with a Tier 1 capital ratio of over 16.8% and a capital-adequacy ratio of 19.5%. However, the sector is exposed to Turkey’s heavily indebted private sector, which has already been experiencing difficulties in rolling over its debt.

Expert Insights

“The winners of the upcoming Turkish elections will be inheriting a highly vulnerable economy,” said Theo Smid, Senior Economist at ATRadius. “With global monetary policy tightening and domestic policy space tightening, the urgency to return to more conventional policy is rising.”

The report warns that any pivot to more conventional policies will be a difficult and gradual process, with hiking interest rates being the first step towards preventing capital outflows and rebuilding FX reserves.

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