Turkey Economy: Shock Therapy

The 175-basis point (bp) hike in interest rates was a salutary shock for Turkish markets. Yet there is a risk that the respite will be brief, and further policy action will be necessary

The larger than expected interest rate hike was announced by the Central Bank of Turkey on June 7th following an emergency meeting of the monetary policy committee (MPC), and should help to repair some of the recent damage done to the bank's credibility. Questions about the future independence of the central bank from political influence have arisen following a month-long political battle over the appointment of the new governor, which fuelled tensions between the Islamist-leaning government of Recep Tayyip Erdogan, the prime minister, and the staunchly secularist president, Ahmet Necdet Sezer. This was finally resolved on April 18th with the appointment of Durmuz Yilmaz, but the jitters returned at the end of that month after the MPC's premature decision to cut interest rates by 25 bps. This move coincided with higher than expected inflation data and persistent calls from some members of the business community and the ruling party to lower interest rates to end the steady real appreciation of the lira.

Vulnerable

However, while the 175-bp rate rise was dramatic, it may well prove insufficient on its own to restore confidence and stabilise the lira. Turkey's large government debt, the burgeoning current-account deficit, substantial external debt-servicing and heavy reliance on short-term capital inflows all make the currency vulnerable. In addition, the country is experiencing periodic domestic political tensions, and there are clear obstacles to Turkey's EU membership, both of which suggest that the economy will remain highly sensitive to sudden shifts in investor sentiment for some time to come.

The situation is made even more fraught by the sharp increase in risk aversion in the global financial markets in recent weeks. Although we expect the government to adhere in broad terms to the three-year IMF stand-by agreement signed in May 2005, delays in meeting targets and conditions will upset the financial markets more than has been the case in the past. It is possible that the government's commitment to the IMF programme will falter as the next election, due to be held in November 2007 at the latest, draws closer. Although it is unlikely to say so publicly, the government will not be happy with the size of the central bank's rate hike. Higher interest rates are likely to hurt the small businesses that constitute an important part of Mr Erdogan's electoral support.

To prevent the recent turmoil turning into another major crisis, continued fiscal consolidation will be crucial. In this area the government has so far performed well. However, the task of achieving IMF-agreed fiscal targets will be more difficult in 2006-07, when economic growth is likely to be weaker and political pressure on the budget to mount ahead of the next general election (the hike in interest rates will make the situation yet worse). As part of its tax reform, the government has announced larger than expected corporation and personal income tax cuts for 2006. Also, in breach of the agreement with the IMF, the government cut value-added tax (VAT) on textiles, clothing and some leather goods in March to help domestic producers and announced an additional pay rise for public servants at an estimated cost of YTL2bn (US$1.5bn), more than increases already allowed for in the 2006 budget. Keeping fiscal policy tight is also required to help to prevent Turkey's current account deficit from becoming unsustainable. The day of the MPC meeting the central bank released the latest balance of payments data that showed a 60% increase in the current-account deficit in April compared with the same month last year and an annual increase of just over 40% for the first four months of the year. In 2005 it stood at an already worrying 6.4% of GDP, up from 5.1% in 2004.

Political tensions

The government also needs to do much more to reduce domestic political uncertainty, which has weighed heavily on investor sentiment in the last month. Tensions between the country's secularist bloc which includes the president, the judiciary and the military, and the government have worsened. A judge at the Council of State (Turkey's highest administrative court) was murdered on May 18th by an Islamist extremist who objected to the court's stance on banning the wearing of headscarves. The secularists view Mr Erdogan's Justice and Development Party (AKP) with deep suspicion because of its Islamist roots, and praised the anti-government, pro-secularist street protests that followed the assassination. The risk of a disruption to Turkey's EU accession negotiations later this year has also increased recently owing to the hardening of positions on the Cyprus issue and a lack of recent progress on human rights, freedom of speech and protection of minorities.

At best, an abrupt economic slowdown is in prospect. However, if investor confidence is not restored and the lira keeps falling, interest rates may need to rise to a level which does serious, lasting, damage to the economy.