As announced last week, the growth rate of Turkey was 11 percent in 2021. It is too high. So, is it sustainable? At which level could 2022 growth be? What are the risks that can create headwinds?
It is critical to pay attention to two different concepts related to growth. The first is the current growth rate, and the second is the potential growth rate.
The labor force and skill level, physical capital stock, and existing technology determine the potential growth rate. It is impossible to change this rate overnight. We can accept the average of previous growth rates experienced over many years as the potential growth rate. In this case, the potential growth rate of Turkey is around 4.7 percent unless declined due to the significant deterioration in the institutional structure in recent years.
Problems posed by growing above the potential growth rate
It is crystal clear that it would be undesirable for the growth rate to remain below the potential growth rate as it would cause significant problems, such as unemployment.
Conversely, a growth rate that significantly exceeds its potential is also an issue since it would cause higher inflation and widen the current account deficit due to increased imports of capital and intermediate goods, resulting in higher foreign debt.
In addition, an economic policy that tries to boost the growth rate is doomed to create considerable problems. For instance, a sustained period of high credit growth coupled with low-interest rates could easily undermine financial stability.
No economy can grow above its potential for a considerable period of time. When the growth rate drops sharply, investments made with the delusion that growth would stay remarkably higher than its potential become a real burden.
How to increase the potential growth rate?
Take the skill level of the labor force into account, for example. How to step up this level? It is not just high school and college education; on-the-job training, master-apprentice training, the qualifications of teachers, and alike are such deep issues to cover here.
Alternatively else, consider capital stock and its quality. It is directly related to investments, and no one rushes to invest just because the policy rate is low. First of all, there needs to be an investment-friendly environment such as a properly functioning legal system, a foreseeable economic environment –not changing the rules while the game is on-and fewer uncertainties.
A growth of 11 percent is well above our potential. It is equally observable that we have not done anything to increase our potential in recent years; on the contrary, we have worsened the investment environment. Consequently, the answer to the first question in the introduction is quite reasonable: No, this growth rate is unsustainable.
The Russo-Ukrainian war will create substantial risks for our economy. However, even without this war, we would have foremost issues in 2022.
The risk premium (CDS) is at 710 basis points (the pre-war level was 510). The Treasury recently borrowed in dollars in international markets with a five-year maturity at a 7 percent interest rate, and the US bond yield for the same maturity is 1.9 percent -a far cry. The latest inflation figure is 54 percent; it will rise even higher. On the other hand, the CBRT policy rate is 14 percent, and the deposit rate is around 17 percent. The authorities have tried to keep the exchange rate in a narrow corridor despite these inconsistencies, creating another inconsistency.
What if the exchange rate jumps?
The inconsistency of these figures alone confirms that there is quite a dilemma. Unsustainability is a significant setback also in terms of growth. Will the rate of depreciation converge to inflation or vice versa? A substantial cause of uncertainty is a hindrance in making long-term plans.
Moreover, consider the purchasing power of the regular salary earner. The high inflation we experienced in the first two months has taken away a significant part of the minimum wage and civil servant salary increase. The convergence of the depreciation rate to the inflation rate means that the inflation will boost after a while, further shrinking the purchasing power of the regular salary earner. Add the recent increases in energy prices due to the war. These unfavorable developments will harm domestic demand and growth despite interest rates below inflation.
Regarding the possibility of a spike in the exchange rate, put it in the perspective of companies that borrowed heavily in foreign currency. Their balance sheets will deteriorate, and this disruption will limit their activities, which means a decline in production and employment.
We do not desire a sharp depreciation
Thus, a jump in the exchange rate will adversely affect the 2022 growth.
So, what are the underlying conditions for a jump in the exchange rate? Of course, potential developments in foreign exchange supply and demand.
Three main factors to consider: Firstly, very few foreign financial investors are left to convert their lira-denominated financial assets into foreign currency and take it to their countries in an environment of increased stress. Let us assume that there would be no negative shock to increase foreign investors’ demand for foreign currency. Secondly, we have a foreign debt repayment of 172 billion dollars in one year. If debtors cannot roll over 100 percent of this amount, the demand for foreign currency would increase. Third, the more current account deficit is, the more increase will be in foreign currency demand.
The war comes into play: Initially, less tourism income and higher energy import prices. To some extent, less export to those two countries. If the war becomes prolonged, it is likely that exports to other countries to be adversely affected. All of them will elevate the current account deficit and thus the demand for foreign exchange. An accompanying rise in the risk premium will certainly impediment foreign borrowing and increase its cost. Consequently, foreign currency supply can decline when its demand rises.
There is also an upcoming process of interest rate hikes from central banks of developed countries -especially the Fed, meaning the risk for less foreign exchange supply. If the war does not delay this process or reduce the severity of interest rate hikes, countries like ours will be dealt a blow here.
The 2022 growth rate
To sum it up:
1. After 11 percent growth, it is already expected that the growth will decrease towards its potential.
2. Interest rate-risk premium-exchange rate-inflation: not consistent with each other.
3. High inflation drags down purchasing power negatively for growth.
4. If the exchange rate jumps, it will drastically lower our growth rate by boosting inflation and distorting the balance sheets.
5. There are already some steps that may upsurge the exchange rate.
The war will evolve, and the FED’s interest policy is beyond our control. We must avoid policies that will spike exchange rates. The authorities should abstain from boosting the growth rate since such a policy would increase the current account deficit via a rise in imports on the one hand and increase our risk on the other. The first means higher demand for foreign currency, and the second is less foreign currency supply.
In addition, we must keep our fingers cross that a supply shock does not occur. Even if we suppose that the costs of such supply shocks are bearable, possible energy supply shortages will limit our production capacity.
In this context, it is challenging to forecast 2022 growth. Nevertheless, a growth rate below our potential (around 3 percent maybe) seems reasonable under today’s conditions. Note the emphasis on “today’s conditions.” If conditions change, for example, adverse supply shocks materialize, this estimate will certainly change on the downside.