A crisis with the U.S. puts the brakes on the economy once again

The economic crisis triggered in August 2018 is pushing the embattled domestic political scene in Ankara more and more every day. It is very clear that the timing of Turkey's northern Syria operation was arranged with the goal of taking off some of this pressure. 

But things didn't turn out as expected. When U.S. President Trump wrote “I will destroy your economy” in a letter, although it may seem like a “light sanction,” the fact that this is now on the table meant a red light for potential international capital flow into Turkey. 

While capital flows and domestic loan growth, both fuel for high economic growth in the past, were already inclined to slow down, everything reversed after the Brunson crisis with the U.S. in August 2018. Although the government let state banks give out all the credit they could in the period before the March 31 local elections, it did not help economic growth get back on its old track.

Instead of creating a solution for this negative situation, a series of efforts were made to polish up indicators, postpone the publication of data, and even replace the head of the statistical institute. These efforts raised eyebrows.

After losing the two largest metropolises for the first time in a quarter of a century (Ankara on March 31 and İstanbul on June 23 after the repeated election), the government immediately turned to Central Bank resources to try to improve the economy.

The governor of the Central Bank was dismissed from his post on June 6 in a manner that violated Central Bank law. Then, interest rates were swiftly pulled down by order of President Erdoğan.

Even though interest rates were lowered 7.5 points by the Central Bank in the period between July 19-October 11, there was no significant increase in the credit stock in Turkish lira.

During that period between the end of July and mid-October when Central Bank lowered rates by 7.5 points, Turkish Lira loans increased by 54.4 billion lira, with state banks providing 51.9 billion of that total. No increase was seen in foreign banks, while local banks only saw an increase of 4.2 billion lira.

The growth of state banks' loan volume is related to them recently starting to grant real estate loans with interest rates below the deposit rate. A quarter of the said increase in state bank loans comes from real estate loans.

It seems that while the interest rate cuts by the Central Bank have not stimulated loans other than from state-owned banks, the lira deposits used for granting loans are quickly being converted to foreign currency. The 31 billion dollar worth of increase seen in foreign currency accounts still continues alongside interest rate cuts. In the period of 2.5 months between July 24, when Central Bank began lowering rates, and October 11, individuals and institutions bought almost 6.5 billion dollars worth of foreign currency. It is also known that most of this amount was sold by state banks drawing from Central Bank reserves through "back door" methods.

Sanctions, the Sword of Democles

The dangerous side is this: Turkey's operation in northern Syria entered this picture very suddenly. And this time, the crisis has gone so far as to involve a showdown with the U.S. During the similar Pastor Brunson crisis in August 2018, sanctions caused a swift exit of capital. 

According to balance of payments data, during the week of Brunson crisis, not only non-residents, but also resident citizens of Turkey either withdrew or transferred abroad 7.5 billion dollars of foreign currency deposits from the banking system.

From the perspective of foreign creditors, this was the first time Turkey entered into such a crisis with a NATO ally and economic partner.

Although Pastor Brunson was released on October 12, 2018, the situation regarding capital movement never returned to its old “normal.”

This time, regarding the second sanction decision by the U.S. due to the northern Syria operation, President Erdoğan's "less loses less, more loses more" statement, makes one think that Turkey's potential reaction to a deeper crisis could be even more harsh. That’s because, according to BIS data, residents of Turkey owe 13.8 billion dollars to banks, government and companies in the US.

Although Turkey's northern Syria operation, which began on October 9, the following showdown with the U.S., and the sanctions decision were all followed by a 120-hour ceasefire agreement, the crisis has not been normalized.

U.S. President Trump’s display of “making a deal with Turkey”—which is understood as a domestic political maneuver—does not make the heavy sanctions bill, which is still waiting in Congress with the backing of Republicans, go away. 

This kind of situation has been in the "risk calculations" of institutions that define foreign currency credit limits for Turkey for a long time; now it’s even more strengthened their analysis. 

The three-way wheel of the Turkish economy, which depended on the flow of foreign capital, domestic credit growth, and household consumption, has stopped. The effort to grow using domestic resources is not working at the moment. A good example of this is that even though interest rates for mortgage loans and credit growth were quite low, it was only second-hand housing sales that increased, not first-hand housing. If there’s a wheel that’s spinning in the economy right now, it belongs to exporters who produce goods for foreign markets, and partially to the tourism sector.

The "printing press" effect on the budget

The state budget, which is considered to be a domestic resource, has hit the highest deficit of the last ten years. 

In 2018, the Central Bank transferred 12 billion lira in profit to the budget; this year, the budget received 37 billion. In addition to that, a change was made to the law, the item called "contingency reserves” which equivalent of 41 billion lira at the Central Bank's balance sheet was transferred to Treasury accounts.” In 2019, the amount that was transferred from Central Bank profit and contingency reserves was 66 billion lira more than 2018. 

According to the 2020-2022 New Economic Program announced by Treasury and Finance Minister Berat Albayrak, the budget deficit, which was 72.8 billion lira in 2018, is forecasted to be 125 billion lira in 2019. Within this budget, although the "one-time" additional 66 billion lira from the Central Bank had a "remedial" effect, it should be noted that the real deficit is almost 200 billion lira. With this calculation, it is very clear that the ratio of budget deficit to GDP is not 2.9 percent as assumed, but actually more than 4.5 percent.

The fact that the budget deficit is being dealt with this way instead of through domestic borrowing makes one think that interest rate hikes and the crowding out effect that comes with borrowing are “paper over the cracks” for now. 

The economic program forecasts the 2020 budget deficit as 138.9 billion—which means an increase of almost 11 percent compared to 2019. With a budget calculation that applies a "carbon copy" 10 percent increase to budget income and expenditures, this kind of deficit does not seem at all possible. 

This framework is also a sign of how far from reality budget preparations actually are—like the dream of 5 percent growth with a 1.2 percent current deficit.

It seems like the politicians running the country in Ankara couldn't find the answer to "What awaits the Turkish economy in 2020?"—since they undertook a military operation in Syria to get back the votes they lost due to the economic crisis.

The answer to the question is this: Unless Turkey turns to democratization in politics and rule of law, normalizes and takes the necessary steps to solve the economic crisis, it will be on a course of ever-shrinking capital inflows. This will mean that an "anemic" economic activity will continue with volatile financial parameters. And that will mean that companies that reached the highest level of debt in the last quarter century will be significantly suffering this slowdown and their balance sheet will also be damaged.