Turkey: Country outlook
(EIU Viewswire Via Thomson Dialog NewsEdge)COUNTRY VIEW
FROM THE ECONOMIST INTELLIGENCE UNIT
OVERVIEW: The Economist Intelligence Unit believes that the Justice and Development Party (AKP) government, led by the prime minister, Recep Tayyip Erdogan, will stay in power until the next election is due in late 2007. EU accession negotiations, which were officially opened on October 3rd, will not be easy. Despite some slippages and delays, we expect that Turkey will adhere in broad terms to the three-year IMF stand-by agreement signed in May 2005, which envisages, among other things, continued tight fiscal policy, state-bank restructuring, and privatisation. In 2006 we expect a fall in the value of the Turkish lira to lead to slightly higher inflation and GDP growth of about 3.5%, down from about 5% in 2005. A pick-up in domestic demand and strong exports should result in higher growth in 2007. The predicted slowdown in 2006 should help to reduce the current-account deficit from about 6.5% of GDP in 2005 to a more sustainable 3-3.5% in 2006-07.
Domestic politics: We expect the AKP government, led by Mr Erdogan, to remain in power up to and beyond the next general election due in November 2007. Despite several defections, mainly in the first half of 2005, the AKP still has a large majority with almost two-thirds of the 550 seats in parliament, and Mr Erdogan retains substantial public support.
International relations: EU membership negotiations were officially opened on October 3rd, but will be long and difficult, lasting at least ten years. In the short term the main source of difficulty is likely to be Cyprus. In July 2005 Turkey signed the protocol extending its customs union agreement to the new EU member states, including Cyprus, but has refused to recognise the (Greek Cypriot) government of Cyprus and has not yet opened Turkey's sea and air ports to Cypriot ships and planes. The 25 EU member states agreed in the negotiating framework document approved at the last hour that they would re-examine the question of recognition and of opening ports and airports in 2006. However, Turkey is likely to stick to its position that it will only recognise the government of the Republic of Cyprus if an intercommunal settlement on the island is achieved. Given the large differences in position between the Greek and Turkish Cypriots on the island, we do not expect a renewed attempt at settlement until 2007, with only a limited chance of success.
Policy trends: The Turkish economy has become more robust and resilient to shocks, as a result of the reforms introduced under IMF-backed stabilisation programmes in place since late 1999. However, much still remains to be done, and external conditions in 2006-07 may not be as supportive as in the last two years, if international liquidity is curtailed. The new three-year IMF stand-by credit facility approved on May 11th 2005 should help to reassure investors of the government's commitment to continued reform. From time to time there have been delays in the fulfilment of conditions and disbursement of credit tranches, but we do not expect such delays to upset the financial markets too much, as long as fiscal performance remains as strong as it has and there is some progress on structural reforms. So far this year measures have been introduced to improve the tax administration and further strengthen the banking system. The government must also reform Turkeys creaking social security system; accelerate state-bank restructuring and privatisation; recover assets related to the state bail-out of about 20 private banks; and increase labour market flexibility. Privatisation resumed in earnest in 2005 and is expected to continue in 2006 and 2007. Nevertheless, Turkey's large government debt, its burgeoning current-account deficit driven by a steady real appreciation of the lira over the last three years, robust domestic demand growth and high international oil prices, leave the economy vulnerable to sudden shifts in investor sentiment.
International assumptions: The world economy has slowed from exceptionally strong growth of 4% in 2004 (in terms of market exchange rates) to an estimated 3.3% in 2005, but is expected to continue to grow fairly robustly at about 3% in 2006 and 2007, with world trade rising by about 7% in each year. We expect that growth in the euro area, Turkeys main export market, will increase from 1.1% in 2005 to 1.6% in 2006 and 2% in 2007. However, this benign central forecast faces a number of risks. The most prominent risk is that posed by the burgeoning US current-account deficit, itself a result of heavy borrowing by consumers, business and government. If one or more of these sectors were to retrench there could be a sharp weakening of US demand, which could be accompanied by a more severe weakening of the dollar than in our central forecast A collapse of the dollar against the euro could also be triggered by a loss of investor confidence. A second risk lies with high oil prices, which have contributed to Turkey's large current-account deficit. Although we have substantially raised our oil price forecasts, we still expect the average price per barrel of Brent to stabilise in 2006 and fall in 2007. There are risks either that oil prices could be higher than forecast or that the current resilience of economies to high prices might fade.
Economic growth: After the surge in private consumption and fixed investment in the first half of 2004, Turkish GDP growth has slowed sharply. However, it was still quite robust at 4.2% in the second quarter of 2005, supported by historically low nominal and real interest rates, strong consumer credit growth and improvements in productivity, which have helped to increase the competitiveness of Turkey's export-oriented manufacturing sectors. As a result of base effects and a slight pick-up in activity in the third and fourth quarters, we estimate that GDP growth will be 4.9% in 2005, compared with 8.9% in 2004. Based on our forecast that the lira will fall sharply against the US dollar and the euro in the first half of 2006, we forecast a further slowdown in economic growth to about 3.5% next year. A weaker lira is expected to lead to a moderate rise in inflation and interest rates, which will dampen domestic demand growth. This will be partly offset by a sharp deceleration in imports and a rise in export growth, adding 2-2.5 percentage points to growth. That said, the timing and the extent of the currency adjustment are difficult to predict. If the adjustment is delayed or occurs gradually, economic growth in 2006 is likely to be higher than we currently expect. A sharper and deeper devaluation would result in substantially weaker growth. In 2007 we expect the pace of growth to pick up in response to more investment, more stable exchange-rate conditions, a less challenging baseline and an improvement in European economies.
Inflation: The process of disinflation under way in Turkey has been impressive. Driven by the strength of the lira, tight fiscal policy, a major improvement in productivity and falling inflation expectations, consumer price inflation fell to single-digit figures in mid-2004, compared with an annual average inflation rate of just under 80% in the 1990s. After a slight rise to 9% in April-June 2005, consumer price inflation eased again to around 7.5% in October and November, despite special consumption tax increases on alcohol and tobacco and soaring oil prices. We expect the annual rate to be just below the IMF-agreed 8% target in December. In 2006 we forecast that inflation will edge up again, but only slightly, to an annual average rate of about 10%, reflecting the inflationary impact of our forecast of a softer lira and some second-round effects from high oil prices. Assuming the lira and commodity prices stabilise and fiscal policy is not relaxed too much in the run-up to the general election, we expect the rate of inflation to fall again in 2007, to an annual average of about 8%.
Exchange rates: Given the volatility of global currency markets and of the Turkish lira, any exchange-rate forecast must be considered tentative. We continue to believe that there will be a sharp fall in the lira at some time over the next 12-18 months. The real effective lira exchange rate has appreciated by almost 30% in the past three years, which, combined with strong domestic demand, has seen the current-account deficit balloon. During early 2006 we expect concerns about the size of the current-account deficit, large external debt repayments, coupled with slightly tighter international liquidity conditions to exert downward pressure on the lira, which is forecast to depreciate in real terms against both the dollar and the euro. Following this adjustment, the nominal exchange rate will continue to fall against the dollar and euro, but in real terms we expect the lira to stabilise again in 2007.
External sector: The current-account deficit widened sharply in the first nine months of 2005, driven by strong import demand and high oil prices. As a result, we expect the deficit for the year as a whole to be just under US$23bn (6.4% of GDP). In 2006 we forecast that a softer lira and weaker domestic demand growth will result in higher exports, lower imports and a reduction in the current-account deficit to about 3%-3.5% of GDP. In 2007 a similar-sized deficit is expected. Turkey will continue to receive IMF support, helping to reduce its net repayments to the Fund, but will also have to rely on large short-term capital inflows, leaving it vulnerable to changes in investor sentiment.