Turkey Economy: Lira Rides High, Heading For a Fall

Turkey's short-term economic prospects have continued to improve in recent months and the Economist Intelligence Unit is no longer forecasting that GDP will contract in 2004. But we still expect concerns about the burgeoning current account deficit to trigger a sharp adjustment in the value of the lira, albeit later than we were previously forecasting.

Recent indicators show the economy has fared well in 2003. In November consumer price inflation was 19.3%, below the IMF agreed year-end target of 20% for 2003, and GDP growth for the first nine months of the year was 5.4%, meaning the government's projection of 5% growth for the year as a whole will almost certainly be achieved. In addition, it looks likely that the delay in the release of the next IMF credit tranche, worth about US$500m, which was to have been approved in October/November, will be overcome in the coming weeks. Also helping to ease concerns about the government's ability to meet its external financing requirements in 2004-05 has been the IMF's agreement in August to ease Turkey's repayment schedule in 2004 by moving some of the repayments from 2004-05 to 2005-06. In late September Turkey also successfully concluded negotiations with the US regarding loans worth US$8.5bn that the US promised in April in return for partial Turkish support in the war against Iraq. The loans, the government has promised, will be used to pay down more expensive domestic debt and not to finance spending projects.

Our baseline forecast 

Source: Economist Intelligence Unit

But Turkey's burgeoning current-account deficit remains, in our view, a serious threat to economic stability. We continue to believe that a sharp correction of the lira-dollar exchange rate is likely in the next 12-18 months. In the second half of October a fall of about 7% in the value of the lira against the dollar (the depreciation against the euro was only slightly larger in the same period) is not likely to have been sufficient to curtail the rise in the current-account deficit. It has only slightly reduced the lira's overvaluation by historical standards. The Central Bank of Turkey's real effective exchange rate trade weighted CPI-based index declined from a peak of 151.5 in September to 140.3 in November, but was still well up on January, when it stood at 119.2.

We estimate that the current account deficit widened from about 1% of GDP in 2002 to about 3% in 2003, driven by the recovery in domestic demand growth and real appreciation of the lira. Assuming a substantial fall in the international oil price in 2004, no further major real appreciation of the lira, and stronger growth of exports of goods and services than we are forecasting in our baseline scenario, our model shows that without an exchange rate adjustment in 2004/05, the current-account deficit will continue to widen. The deficit would reach levels that could make the external financing requirement unsustainable, especially when principal repayments on Turkey's external debt rise in 2005-06.

Alternative scenario (Assuming a stable exchange rate in real terms) 

Source: Economist Intelligence Unit

The timing and extent of an exchange rate adjustment, and the size of the impact on the real economy, are extremely difficult to predict. If the adjustment occurs gradually, the impact on economic growth and inflation would be more limited than we are forecasting. Given past trends, however, a sharper, more disruptive, adjustment seems more likely on balance.

In the light of the unexpected stability of the lira following the terrorist attacks in Istanbul and the widespread acceptance of official forecasts that there will be a substantial improvement in the current-account balance in 2004 (the IMF projects a reduction of the deficit from an estimated 3.2% in 2003 to 2% in 2004), we now expect the lira to remain stable in real terms during most of 2004. This would push the exchange rate adjustment back to the end of 2004/early 2005, much later than previously predicted.

The eventual correction is likely to be triggered by concerns about the continued deterioration of the current-account balance and the prospect of rising principal repayments on Turkey's medium and long-term external debt in 2005. We also expect that the government will struggle to meet the ambitious fiscal targets agreed with the IMF, since we expect the government and the Turkish tax payer to experience a degree of fatigue after the efforts made in 2003. Substantial spending cuts will be difficult to implement, particularly in the first half of 2004 when local elections are due to be held. Also, despite ongoing reform of direct taxation to improve collection and widen the tax base, there is concern that the tax amnesty introduced in 2003 will encourage non-payment of future tax by creating the impression that penalties will not be enforced.

As a result of the change in timing, the impact on economic growth and inflation is expected to be limited in 2004 (hence the substantial revisions to our forecasts for GDP growth, the current-account balance and inflation in 2004-05). However, the longer the exchange rate remains at its current level the more likely it is that the adjustment will be disruptive. A much weaker lira will also increase the cost of servicing Turkey's government debt given that a large share of it (about 50% in October 2003) is either foreign-currency denominated or linked. We assume that Turkey will obtain sufficient multilateral and/or bilateral aid to avoid a debt crisis during the outlook period. However, the availability of such aid will depend to a large extent on the government being able to convince its creditors that it will continue the reform process.

Source: ViewsWire London