The earthquake damaged the economy and inflicted a heavy death toll. Reconstruction and additional tax options are on the agenda, but the important thing is to return to reasonableness in the post-election economy. President Erdoğan is seen leading the cabinet meeting at AFAD Headquarters on February 14.
The earthquake caused great suffering. Massive loss of life, numerous injuries, destroyed homes, broken families… It is hard to comprehend that pain unless you have experienced.
There was also significant economic destruction due to the earthquake. Many homes and businesses collapsed, and many more became unusable. Schools, hospitals, and other public buildings should be added to them. The infrastructure was severely damaged, and there was a loss of machinery and equipment in workplaces and a considerable loss of workforce.
The cost of removing the devastation
Here, I will elaborate on the effects of possible actions to secure the economy after this destruction. Two fundamental questions need to be answered. First, can Turkey manage to mend this significant damage and overcome the extra burden on the budget without causing major economic problems? Second, how will our growth rate be affected by these events?
There is too much uncertainty. It is too early to state the approximate cost of repairing these damages; expertise is needed to make such an estimate.
An official statement was made on February 18 regarding the number of to-be-demolished buildings. Friends close to the subject reported that some big construction companies, considering this number, calculated the cost of constructing social housing with earthquake-resistant 105 square meters of apartments in that region could reach 35 billion dollars. Add to that the cost of rebuilding infrastructure, including hospitals, schools, roads, etc. Take into account earthquake aid and unemployment payments. There will be a much higher cost.
Calculation in line with the estimates
Instead of calculating this cost under such uncertainty, let me take a value considered a “ceiling.” Turkey’s 2022 GDP is around 850 billion dollars. Let the total cost be 10 percent of this, that is, 85 billion dollars. Suppose these expenditures are spread over two years and will be financed entirely from the budget.
Namely, an expenditure of 5 percent of GDP every year: Pretty high. Let us assume that a tax increase will finance 0.5 percentage points each year. Since the remaining expenditure will be funded exclusively through debt, the debt ratio will increase by 4.5 percentage points in the first year and 4.5 points in the second year.
Room to maneuver
To answer both questions rationally, I will first focus on policy responses to reverse this trend when economies are drastically contracting and experiencing sharp job losses during crises or in the Covid pandemic. What is meant by the policy response is that: government increases public spending and lowers tax rates, and monetary policy is also loosened.
There is a burden on the budget, especially by fiscal policy maneuvers. Soaring budget deficits are financed by borrowing. The lower the public debt is before the economy falls into this situation, the more it is possible to loosen the fiscal policy. For every economy, there is an upper limit that the public can borrow, which is called the “debt limit.” The closer to the debt limit, the higher the borrowing cost and the shorter the debt maturity. The increase in cost is not linear either; it increases incrementally near the limit. Therefore, the farther the current public debt-to-GDP ratio (debt ratio) is from the debt limit, the easier increasing public spending and lowering taxes. In short, the extent of the maneuvering area is crucial.
New tax option
The earthquake was significantly different: the disaster did not affect every part of the country. Tax revenues can remain constant even when the government makes tax abatements and amnesties in affected regions and sectors: new tax can be introduced on the unaffected.
Therefore, the government can spend more with the same debt increase compared to a situation where they do not have this chance, for example, a general economic contraction and a hike in unemployment due to the pandemic. The first thing that comes to mind is the introduction of a wealth tax.
Reaction to the global crisis
As soon as the devastating effect of the global financial crisis on the economies emerged, most countries announced that they would loosen their fiscal policy. Let us look at the ratio of the sum of the rises in public expenditures and decreases in tax revenues to GDP, which the G20 countries, including us, announced they would make in the first months of 2009. The average ratio of the measures announced by the developed countries of the G20 to their GDP for 2009 and 2010 is 3.5 percent, while that of emerging market economies is 3.8 percent.
Nevertheless, some responded even more. For example, Korea is 8.3 percent, Russia is 5.4 percent, and South Africa is 5.1 percent. Also, public expenditures come into play automatically when economies contract without the need for any decision, such as unemployment payments.
The average value is 8.5 percent of the total GDP for developed countries and 5.6 percent for emerging market economies. For details, see Table 2 in the IMF report appendices.
Economic vulnerabilities
It is customary for developed countries to give such a fiscal policy response (fiscal stimulus) when their economies contract. However, this phenomenon is only sometimes observed in some G20 emerging market economies such as Argentina, Brazil, Indonesia, Mexico, and Turkey. The main reason behind this asymmetry is the vulnerabilities of the countries I have mentioned—for example, high debt ratios and therefore being close to the debt limit. However, as of 2009, such a situation did not exist in these countries. Those who want more details can refer to my article in the eighth part of this resource.
The ratio of fiscal policy measures to GDP announced during the pandemic is much higher. The relevant IMF report shows that the sum of the increase in public expenditures and the forgone public revenues to GDP ratio in most developed countries is more than 10 percent. The average of the measures announced for 2020, 2021, and beyond is 16 percent of GDP. The average value for emerging market economies is around 5 percent. These ratios do not include loan guarantees and the like.
Any problems?
Considering this framework, Turkey’s fiscal policy response of 9 percent of its GDP in two years is not insignificant; however, it is not an ‘extreme’ size either. Moreover, we have a considerable advantage: Our debt ratio is relatively low. The ratio of public debt to GDP is 30 percent in 2022, well below our debt limit. The limit is also about how much debt is in foreign currency, and the high share of foreign currency debt reduces the room for maneuvering in fiscal policy. Nevertheless, as demonstrated in a TEPAV study, the 30 percent debt ratio implies that there is considerable room to maneuver.
Consequently, a rise in public debt from 30 percent to 39 percent in two years will not pose a significant problem under normal conditions.
This is where the main problem arises. As I repeatedly stated in YetkinReport before, Turkey has a fragile economy, and this fragility stems from an unsustainable economic policy. This policy has to change. There is no need to go into details about how it can be done; however, I wrote about what kind of change is needed in two articles; one is about the possible economic developments in 2023, and the other is about the economic and financial policies of the opposition. If Turkey reverts to “reasonability” in its economic policy after the election, it can make the necessary budgetary expenditures to remove the earthquake’s devastation without increasing its risk.
The effect on growth
How will this expense affect growth? This question is about how close the debt limit is and the state of the economy.
In terms of proximity to the debt limit, the situation is as follows: If the current public debt-to-GDP ratio is close to the debt limit, a policy risk that will increase the public debt can negatively affect growth as it will spike interest rates and the exchange rate since the two effects work in opposite directions. The increase in public expenditures will increase domestic demand, thus increasing growth. However, high-interest rates and high risk negatively affect the remaining components of domestic demand and reduce growth. The net effect is likely to be a downward pull on growth. The TEPAV study I mentioned above mainly examines this problem. However, the fact that our public debt is as low as 30 percent of GDP shows no such danger.
There should be a “return to reasonability” after the election
In terms of the state of our economy, it is as follows: Although it is not an issue in terms of public debt, if the policy already implemented is not sustainable, such a rise in public expenditures will bring forward the date when this unsustainable situation will end, which is impossible to predict. Our risk premium and inflation are very high, whereas the domestic interest rate is low. The exchange rate trend is upward. This trend is tried to be broken with interventions and resources provided by friendly/new friendly countries. A significant election expenditure had begun to be made. Major central banks are in the process of raising interest rates. In this environment, loosening fiscal policy to contribute positively to growth is challenging.
Hence, back to square one: If Turkey returns to “reasonability” in its economic policy after the election, it can make the necessary budgetary expenditures to remove the devastation brought by the earthquake without increasing its risk.
Central Bank: what kind of donation is this?
Lastly, I cannot end without adding this; there cannot be anything more bizarre than stating “we are donating” to a source that will already be transferred to the public budget as revenue and used for public expenditures when the institution is responsible for transferring that income, due to the earthquake. For example, the Central Bank of Turkey’s donation comes from its profits and was already going to be transferred to the Treasury. What kind of donation is this?
The same question applies to public banks and public institutions wholly owned by the Treasury (or Turkish Wealth Fund) or institutions where the Treasury or the TWF is a significant stakeholder. At most, they would transfer their profits early, when they already will transfer to the Treasury (if there is a legal basis.) Then again, that does not necessarily mean donation.
