Turkey Economy: Business Climate Overview

The Justice and Development Party (AKP) government, led by prime minister Recep Tayyip Erdogan, is expected to stay in power up to and beyond the next general election, due in November 2007. EU accession negotiations will be difficult and slow. We expect Turkey to adhere in broad terms to the three-year IMF stand-by agreement signed in May 2005, but delays in meeting IMF targets and conditions will upset the financial markets. Growth is forecast to average 5% in 2006 and 4% in 2007. The softer lira and weaker domestic demand will help to lower the current-account deficit in 2007.

Economic growth

GDP growth has been strong since the 2001 crisis, fuelled by falling nominal and real interest rates, strong consumer credit growth and investor confidence. Improve-ments in productivity and lower unit labour costs have also helped to bolster several export-oriented manufacturing sectors against the impact of the strong real appreciation of the lira between 2002 and mid-May 2006. We expect GDP growth to have been robust in the first two quarters of 2006, continuing the pick-up registered in the second half of 2005. A gradual slowdown is then expected in the second half of this year and in the first half of 2007, as a result of the sharp fall in the value of the lira and higher oil prices.

Economic policy

The economy has become more robust and resilient to shocks, as a result of the IMF-backed reform programmes in place since late 1999. However, the large government debt, the burgeoning current-account deficit, substantial external debt-servicing and heavy reliance on short-term capital inflows, combined with periodic domestic political tensions leave the economy vulnerable to sudden shifts in investor sentiment.

Inflation and the exchange rate

In December 2005 the consumer price inflation rate was 7.7%, just below the IMF-agreed year-end target of 8%. However, since the beginning of 2006 it has edged upwards, driven by strong domestic demand growth spurred by lower interest rates and strong credit growth. Our baseline forecast is that it will stand at about 10.5% at the end of 2006, significantly above the IMF agreed target of 5%. There is a substantial risk of much higher inflation if the lira falls further and the Central Bank fails to tighten monetary policy sufficiently in the coming months.

The real effective lira exchange rate appreciated by almost 40% in 2002-05, which, combined with strong domestic demand, has seen the current-account deficit balloon. Between early May and the beginning of June the lira depreciated steadily, falling by 16% against the US dollar and 18% against the euro. We currently expect the lira to stand at about YTL1.75:US$1 at end-2006, and to stabilise at around this level in 2007.

The external sector

The current-account deficit increased sharply to about 6.5% of GDP, in 2005. The deterioration was driven by strong import demand and high oil prices. Despite the fall in the lira in mid-May, we expect the deficit this year to rise further, to about US$26bn, almost 7% of GDP, driven by still strong domestic demand growth, higher oil prices and a fall in tourism earnings. In 2007 we expect a reduction in the deficit to about 5-5.5% of GDP, as domestic demand growth slows. A softer lira should give a fresh boost to exports.

Political outlook

Since the beginning of 2006 the government has come under greater domestic political pressure because of increased tensions with the secularist establishment, corruption allegations, violence in the Kurdish south-east of the country, mounting problems with the EU, and reported divisions between conservative and liberal members of the cabinet. That said, Mr Erdogan's leadership of the AKP and the government do not appear to be under threat, and so far he has generally proven to be adept at managing divisions and tensions. Between now and the next election, Mr Erdogan's main challenges will be to continue to apply the IMF-backed economic programme, especially in light of the financial market volatility in May-early June, and to meet the EU's demands for more consistent and concerted human-rights reforms.

EU accession negotiations were officially opened in October 2005, but will be difficult, lasting at least until end-2013. The risk of a disruption in the short term has increased recently over the Cyprus issue and a lack of progress on human rights, freedom of speech and protection of minorities. Before the next annual progress report to be published by the European Commission in October the government will need to produce clearer evidence of further progress on human-rights reforms than it has done in recent months.