Worsening inflation outlook amid slower growth in 2022

After growing by a stronger-than-expected 11% in 2021, Turkey’s economy will slow in 2022, mainly due to sharp increases in energy prices and supply disruptions in critical commodities due to the war in Ukraine. Turkey imports nearly 30% of its natural gas from Russia and almost 20% of the metals and chemicals required for domestic production. The imposition of Western sanctions on Russia, the removal of some Russian banks from the SWIFT system, and the closure of some ports in the Black Sea region due to the war have negatively affected trade flows between Russia and Turkey. Uncertainties about payments will deter many companies from trading with Russia. On the other hand, the unfavorable base effect and rising inflationary tensions will hamper growth performance. The drop in household purchasing power will weigh on private consumption (60% of GDP). Due to the heavy sell-off of the Turkish lira in November and December 2021 and globally rising commodity prices, inflation is expected to hit 70% annually in May. Pass-through impacts from producer prices, which skyrocketed in February (+105% YoY), will be a crucial driver of inflationary pressures. The slowdown in domestic demand will restrain companies’ ability to pass rising production costs to their clients, leading to lower profit margins. With the front-loaded central bank rate cuts (500 basis points between September and December 2021), the resulting lira depreciation, and cheaper credit, the authorities will continue to support investment, exports, and employment. The government’s announcement of a new financial mechanism that protects local currency deposits from the lira’s depreciation may shield the lira in the short term. However, as the interest rate is limited to three percentage points in addition to the central bank’s policy rate (currently at 14%), the new tool may not be able to offer adequate remuneration to the lira investors compared with inflation. On the other hand, highly high inflationary pressures may push the central bank to halt the rate-cut cycle in the upcoming period. On the back of three-year high capacity utilization rates (78% as of December 2021), machinery and equipment investments seem to continue after increasing for nine consecutive quarters as of Q4 2021. However, the uncertainty resulting from the geopolitical situation and fragile financial stability will likely weigh on companies’ decisions in 2022. 

Current account deficit to widen again due to the soaring energy bill

Despite benefiting from a weaker lira and diversification of supply chains globally, exports will be affected by the global stagnation resulting from the impacts of the war in Ukraine. Lower demand in EU markets will weigh on Turkish exports to this zone (around 40% of total exports), pushing exporters to diversify their key clients toward other needs. The import bill will continue to increase due to soaring commodity prices and manufacturers’ willingness to build inventories to counter supply issues. In January-February 2022, Turkey’s energy imports in 2021 – which represent 93% and 99% of oil and gas consumption, respectively - jumped to USD 16.8 billion, from USD 5.4 billion a year earlier, according to the International Energy Agency (IEA). The sharp increase in oil prices will halt the narrowing of the current account deficit. Another critical challenge for Turkey’s economy would be the crucial tourism revenues (3% of GDP in 2021). Last year, Turkey attracted nearly 30 million tourists, of which 4.7 million were from Russia, and 2 million were from Ukraine (in 2019, 45 million tourists came to Turkey, of which 7 million were from Russia and 1.5 million from Ukraine). Given the current situation, it may be difficult for Turkey to reach the end-2022 tourism revenue forecast of USD 35 billion. This will also contribute to the widening of the current account deficit. Turkey’s need to attract foreign investments will remain high due to the high short-term external debt level (as of Q2 2021, gross international reserves covered 77% of short-term external liabilities), which leaves the economy vulnerable to the volatility in international investors’ sentiment.

The public accounts should remain solid, although the government is likely to increase current spending from the second half of 2022, ahead of the presidential election (June 2023), after reducing VAT (from 18% to 8%) on electricity, hygiene products, and medical equipment in March 2022 to counter inflation. The state-proposed protection of savings against lira depreciation may burden the budget. Nevertheless, the public debt outlook should not represent a critical risk for Turkey, as it remains low as a share of GDP. However, it is essential to note that rising stocks of FX debt (60% of the total as of early 2022, compared with 45% in 2018) may represent a source of volatility.

Domestic political tensions may increase ahead of the elections. 

As elections get closer (June 2023), society’s polarization risk may increase. However, this should be fine with the political stability of the country. Recently, moving beyond regional issues of contention, Turkey has restored its relations with the United Arab Emirates (UAE). In November 2021, both countries signed bilateral trade, energy, and environment cooperation agreements. According to some media reports, Saudi Arabia, Egypt, and Israel have also taken action to create a new level of relations with Turkey. These improvements are expected to have reciprocal positive economic contributions.