Is the Turkish economy on the eve of a recession?

Global and local shockwaves are continuing to shake the Turkish economy. A second wave hurt the Bourse İstanbul, taking it down sharply while market interest rates continued their climb. Within the past month, the Turkish lira has lost more than 8 percent of its value against the foreign exchange basket despite many interventions by the Central Bank of Turkey through the selling of hard currency. The two-year benchmark bond yield rose over 8 percent on Friday; it was around 5 percent only a few weeks ago.
Dangerous tension for Turkey Admittedly, the shock is not peculiar to Turkey. As assessed by Bloomberg, “the game seems to be over” for the emerging markets amid the changing stance of the Fed regarding its future monetary policy. This changing stance was part of the game. If the US economy stays on the path to recovery, the Fed will be stopping its cheap, rampant liquidity policy. These expectations cause, quite naturally, capital outflows from emerging economies, particularly from those considered most fragile. There is no surprise in this new state of affairs. However, the Turkish economy has felt the effects more than others. Why? I think there are two main reasons: The first is the pre-existing weaknesses of the Turkish economy. Readers are certainly aware of these weaknesses, but let's recall them briefly. The current account deficit (CAD) to gross domestic product (GDP) rate is 6 percent, which is still high and, moreover, is increasing because of a recent revival in domestic demand along with sluggish exports and increasing imports. Inflation, at roughly 6.5 percent, is over its target of 5 percent and the GDP growth rate is below 4 percent. This state in which we find macroeconomics is already alarming and necessitates a different policy response than the current one. In this setting, the Justice and Development Party (AK Party) government very poorly managed the Gezi Park crisis. Prime Minister Recep Tayyip Erdoğan preferred to accuse the “interest rate lobby” as well as his Western allies of being responsible for the Gezi Park protests. As I have already put forth in previous articles, this irrational attitude causes worry among investors regarding the ability of AK Party to properly manage an open market economy in troubled times. This is, I believe, is the second reason why the Turkish economy has been affected more than others. When the first shockwave due to domestic tension struck a week ago, Central Bank of Turkey Governor Erdem Başçı stated his belief that the Gezi Park events are responsible for one-third of the market-related problems. Given fact that the AK Party responded harshly to European criticism over Gezi, thereby provoking a crisis in the harmonization process, the second shock certainly amplified the drift in the main macroeconomic indicators. This is not the first time that the Turkish economy has faced a sudden stop concerning capital flows. In these circumstances, the central bank would react by increasing interest rates to stop the bleeding and regain control over the rapid depreciation of the Turkish lira. This policy would bring about a new equilibrium of relatively lower but balanced growth and a competitive exchange rate. This time is different, for two reasons at least. The rebalancing operation had already failed and in order to increase economic growth, which had dropped to 2 percent, the central bank and the government were trying painfully to revive domestic demand through rather loose monetary policy. Expected real interest rates were falling and this was already a hotly debated issue. The external shock occurred at a time -- and this is the second reason -- when Turkey needed to keep investor confidence strong in terms of political and economic stability. What is happening now? Conspiracy theories and the tension with the EU undermined this confidence and the sword of Damocles is hanging over the central bank, which risks being accused of being part of the interest lobby if it reacts by increasing interest rates. The upper limit of the interest corridor has been lowered to 6.5 percent, the rate at which the central bank provides short-term loans to banks, whereas the bond yields now exceed 8 percent. So, the central bank is trying desperately to stop the devaluation of the Turkish lira by selling dollars. Obviously, the Turkish economy now seriously faces a risk of recession. President Abdullah Gül said recently that “building a reputation can take 10 years, but this reputation can be lost in 10 day.” The Central Bank of Turkey had painstakingly built a solid reputation over the past several years and now risks losing it if it does not quickly tighten its monetary policy. But, above all, the AK Party rulers must find a way to radically change their minds if they do not want to have an economic recession on their hands.