After a difficult year, things finally seemed to be looking up for Turkey’s beleaguered economy in early 2023. Just six months earlier, in June 2022, the economy was on the brink: Turkey was facing a potential balance of payments crisis, meaning it would be unable to redeem foreign currency debts and pay the bills for imported goods. The credit default swap premium, paid annually to guarantee redemption of five-year dollar-denominated eurobonds, was hovering over 9% — the highest level since the 2001 banking crisis — and sovereign credit ratings for external loans were the lowest they had been in 20 years. In the months that followed, things slowly began to improve as Turkey benefited from stronger global economic conditions coupled with new domestic corporate capital restrictions, informal cash inflows from abroad, and better-than-expected winter weather, all of which provided a temporary reprieve from the country’s long-standing economic woes.
But then on Feb. 6 the worst happened: Turkey and neighboring Syria were hit by a pair of massive earthquakes, registering magnitudes of 7.8 and 7.5, just hours apart. As of Feb. 13, the total death toll in Turkey was over 30,000; tens of thousands more have been injured, thousands of buildings have been destroyed, and the total physical damage and loss of future growth is estimated in the tens of billions of dollars.
How did the Turkish economy get here, what do we know about the economic impact of the earthquakes so far, and where might things be headed going forward?
Capital controls, informal FX flows, and better weather
Three factors were key to the stabilization of Turkey’s economy in second-half 2022. The first, corporate capital restrictions, follows a decision taken in late June 2022 by the Banking Regulation and Supervision Agency (BRSA), under which companies with an obligation to conduct an external audit can borrow Turkish lira loans if their foreign exchange (FX) financial assets do not exceed 10% of their net sales or total assets. This was the strictest capital restriction since 2001 and forces companies to sell their FX cash holdings and deposits or convert them into FX-protected deposit accounts. Loans with interest rates around 10-15% from the state banks are quite attractive as inflation expectations exceed 30%. Many companies have not hesitated to transfer their FX deposits to FX-protected deposit accounts as both maintain value in hard currency terms. The introduction of FX-protected deposit accounts in late 2021 had already halted dollarization. This new regulation began a process of de-dollarization and the Central Bank of the Republic of Turkey (CBRT) pulled most of the FX deposits to support its weak FX reserves. The cost of this tool is high, however: The Treasury has made 92.5 billion liras ($4.92 billion) in payments to deposit holders so far. The CBRT has also made similar payments, but the total amount has not been disclosed.
The second important factor, informal cash inflows from abroad, is outside of the government’s regulatory power and monetary policy tools. The Turkish government has received funds from overseas by leveraging its bilateral relations, particularly with Russia. External cash inflows not recorded as part of any financial or commercial transactions have long been a means of offsetting foreign deficits; since the war in Ukraine began, these inflows of unknown origin have become a major funding source. During a period of high energy prices that have pushed the current account deficit to $48.8 billion, Turkey received $24.2 billion in informal funds, making it the second-largest source of FX after the tourism industry.
The third important factor, better weather, also benefited the economy. Due to weather conditions that have been much better than seasonal averages, expectations for the global economy have changed drastically in the last six months. European economies, Turkey’s main foreign trade partners, have so far been able to avoid a deep recession triggered by energy rationing. Warm winter weather has not only lowered gas prices on the continent, but it has also reduced demand, resulting in a dramatic decline in Turkey’s energy bill. Lower gas payments to importers and stronger-than-expected export volumes to Europe have contributed a total of more than $10 billion to the economy.
The government managed to escape a looming currency crisis through these policies and changes in the international environment. The underlying problems facing the Turkish economy have not been addressed or even definitely delayed though. The economy remains highly vulnerable to external financial shocks or worsening domestic expectations. The recent earthquakes are only likely to exacerbate these issues. It is unclear if the presidential and parliamentary elections will still take place in mid-May as scheduled, but the Treasury and the CBRT are likely to do whatever they can to create suitable conditions for a victory by President Recep Tayyip Erdoğan and his Justice and Development Party (AKP), including boosting economic activity, supporting household purchasing power, and maintaining financial stability.
Higher public expenditure and credit growth
The tools the government has used to temporarily stabilize the economy have significant drawbacks or limitations. The main side effect of the BRSA’s capital restrictions, for example, is a low credit growth rate and slower economic activity as businesses are heavily in need of liquidity to operate. The government’s use of informal cashflows to fund national deficits is widely known, and business owners and other economy watchers are skeptical of its sustainability. A new currency crisis is broadly expected sometime in the near future. The lira is no longer a cheap currency owing to the low rate of return for deposits and the difficulty of gaining a competitive advantage in trade at its current level. It is difficult to motivate companies to make new investments when they cannot foresee what will happen in the coming months, even in spite of the generous bank loans on offer. The government will likely rely heavily on mega-projects guaranteed by the state to boost demand and push economic dynamism. To make up for weak private sector demand, these projects are being accelerated and new ones introduced.
To strengthen household purchasing power, the government announced significant hikes in civil servant and pensioner salaries that exceed its year-end inflation target. The minimum wage was also increased significantly. In lira terms, it has doubled in one year and tripled in two. It declined to $150 monthly during the peak of the currency crisis in December 2021 and subsequently rose to nearly $450 in January 2023 — well ahead of levels in cities like Shanghai ($380), Sao Paulo ($250), Delhi ($210), Tehran ($180), and Cairo ($90). In addition, the government recently eliminated the age requirement for early retirement, making 2 million more workers immediately eligible. Tax liabilities and social security premiums will be restructured by eliminating interest on late payments, while similar promises were made for student and agricultural loans. Turkey also launched its largest social housing project to date and made middle-income earners eligible to purchases homes.
All of these policies are triggering demand for hard currencies because of the foreign trade deficit and the low yield but high return on lira-denominated assets. FX-protected deposits are attractive for companies; however, they do not appeal to individual investors given concerns over the high rate of inflation and the depressed value of the currency.
The CBRT’s limited FX reserves
To offset this additional demand for foreign exchange, the CBRT will use its $30 billion in sellable FX reserves. Whenever this amount declines to around the $10 billion threshold, expectations of a new currency crisis soar. The current reserve level is sufficient to maintain financial stability if no populist policies are implemented, but these policies are the essence of the government’s election strategy. Additional sources of funding, particularly from Saudi Arabia and Qatar, have been rumored, but no money has yet arrived. Informal flows from Russia are unsustainable and the pressure from the U.S. Department of the Treasury’s Office of Foreign Assets Control (OFAC), which is responsible for administering and enforcing sanctions, is increasing. No Turkish bank has dared to use the Russian credit card payment system, Mir, since OFAC issued a warning about it last fall. The Turkish Treasury’s access to the international bond markets has eased of late and successive eurobonds worth $8.75 billion have been issued in the last three months.
It is still too early to say how the earthquakes will affect economic activity and the stability of financial markets in the longer term and thus the prospects for an election victory by President Erdoğan and the AKP. It is not clear how much more loan growth and public expenditure there will be in the coming months, as well as how households and businesses will react to the situation and the government’s economic policies. Global financial conditions have improved, but the world economy is treading on thin ice due to recessionary expectations. Some developing countries, such as Sri Lanka, have already defaulted, while others, like Egypt and Pakistan, are getting steadily weaker. Turkey has a far larger economy and is more politically strategic than these countries, however.
A new economic shock is very likely, but its timing is uncertain. If anything, the recent earthquakes are only likely to hasten it. The next government, whether under Erdoğan and the AKP or the opposition, will have to deal with it, one way or another. Their different approaches will determine if the coming crash will be controlled and soft or accelerated and hard. Regardless of how things play out, the economy will likely remain in the headlines for the foreseeable future, at least until after the local elections in March 2024.
Economic consequences of the earthquakes
The total cost of the destruction caused by earthquakes is still unclear, but it will not be less than $10 billion and it could be much more — as much as $84 billion, according to one estimate from Turkish business group Turkonfed, or around 10% of GDP. More than 8,000 residential and commercial buildings collapsed. These will need to be rebuilt and many others will have to be repaired or replaced if construction standards are tightened. Public buildings such as schools, hospitals, and government offices have been heavily damaged. Intercity gas, oil, and electricity lines need to be repaired as well. Some strategic infrastructure, like the Tarsus-Gaziantep Highway, İskenderun Port, and Hatay Airport, was moderately damaged, although the Kirkuk-Ceyhan and Baku-Tbilisi-Ceyhan oil pipelines were reportedly not. No information has been released yet about the Iskenderun steel factory and the Dörtyol gas terminal. There are critical energy production facilities in the region as well, such as the Akkuyu nuclear power plant; Afşin-Elbistan thermal power plant; and Berke, Aslantaş, Atatürk, Keban, and Karakaya dams. So far no significant damage to these has been reported either.
In addition to reconstruction, there are other costs as well, like living expenses for the thousands of people affected by the earthquakes. The total population of the region is 13.4 million. Most of them are safe; however, their work conditions will change. At least half a million of them will need state support to meet their basic needs — food, accommodation, and heating. Medical and educational expenses must be taken into account as well, and the earthquakes will also affect their ability to work and consume. So far, the Turkish government has allocated an initial $5.3 billion in disaster relief.
Outlook
Turkey’s economy was expected to grow by about 3-3.5% in 2023, in line with its natural growth rate. The affected region is one of the most economically important parts of the country after the areas around Istanbul. Recovery will be gradual and will not happen before 2024. Furthermore, Turkey’s different regions are highly integrated, meaning economic activity on the national level will also slow. Therefore, a loss of 2.0-2.5% of growth is possible, meaning that Turkey’s GDP will only grow at a rate of 0.0-1.0% in 2023. This is below the average population growth rate, which is 1.5%, excluding immigrants and refugees, thus the earthquake will lead to a slight decline in national income per capita.
The upcoming elections remain a major source of uncertainty. Social protests are possible and political polarization may trigger dangerous conflicts. Up until now, there has been no change in the economic model implemented, but without a policy shift, FX liquidity will remain a weak point for Turkey.
Despite the uncertainty and different factors at play, such as global economic conditions and internal political expectations, the Turkish economy is likely to stagnate or grow below its natural rate. Inflation will exceed expectations. Although energy prices are still falling, the external deficit will remain high as production capacity and export levels decline. A significant drop in employment is possible. It seems that the government will have to change or at least revise its economic model. More financial support from Qatar, Saudi Arabia, and Russia remains a possibility. A new IMF loan is not expected and any international relief will only cover the basic needs of people in the region affected by the quakes. Financial assistance from international development banks is necessary; however, their contribution will be limited due to the government’s poor relations with the West and will be gradual and allocated in tranches. The challenges facing Turkey’s economy are myriad and regardless of how the upcoming elections turn out, the road ahead seems likely to be rocky.
M. Murat Kubilay is an independent financial advisor on the Turkish economy and a non-resident scholar with MEI’s Turkey Program.
Photo by Ozkan Bilgin/Anadolu Agency via Getty Images
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