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Pillars of Turkey’s economic success to be tested in next nine months

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Turkish asset prices may face headwinds as the three pillars of Turkey’s economic success story – prudent fiscal management, central bank credibility and political stability – are tested over the next nine months, according to Alexander Perjessy, senior economist, global economic research at Alliance Bernstein.

Turkey embarked on a strong path of economic and structural reforms after its banking and exchange-rate crisis in 2001.

It had a rocky start, despite the International Monetary Fund’s financial backing, due to disagreements among the governing coalition parties. But reform took solid hold after the 2002 elections that gave a majority to the now-ruling Justice and Development Party (AKP).

By the end of 2008, Turkey had cut its public-sector debt almost in half—to 39.5 per cent of gross domestic product from over 75 per cent in 2001. The country also reduced its inflation rate to single digits from an average of more than 50 per cent during the previous three decades.

Along with a freshly restructured and recapitalised banking sector, these economic reforms put Turkey in a relatively strong position to weather the 2008 credit crisis, despite the country’s heavy reliance on external financing.

But now, Turkey faces several challenges that will test the strength of the three pillars on which this economic success story has been built: prudent fiscal management, central bank credibility and political stability.

Perjessy says we may see a relaxation of the fiscal policy stance in the run-up to next year’s general elections, as happened ahead of the local elections last year. Some recent opinion polls show an uncomfortable narrowing in AKP’s lead over the opposition Republican People’s Party (CHP). This has delayed the implementation of a budget-tightening fiscal rule designed in consultation with the IMF. The cabinet has decided to postpone submitting the rule to Parliament, presumably to afford itself some flexibility ahead of the elections, says Perjessy.

Temptation to boost fiscal spending ahead of the elections may increase if the government fails to secure several important constitutional amendments in the upcoming 12 September referendum. Most observers had seen this vote as a foregone conclusion until fairly recently. But it is now becoming too close to call, and the re-energised opposition is framing the referendum as a vote of confidence in the AKP government.

To date, the central bank has been vindicated in its “lower for longer” policy stance by benign inflation developments. But domestic demand is set to pick up—fuelled by the revival of a credit extension at very low domestic real rates—so the central bank will need to begin policy-rate normalization before too long to keep inflation inside the target band, says Perjessy. And that challenge becomes even more daunting next year, when the target band is set to be lowered by a full percentage point to a range of 3.5 per cent–7.5 per cent.

To preserve its credibility, Perjessy believes the central bank should stay ahead of the curve, especially with the uncertainty surrounding next year’s election and the risk of any unexpected pre-election fiscal stimulus.

Another complication that will add to the central bank’s woes is that the current bank governor’s term expires early next spring. The transition in this post did not go smoothly four years ago, which in turn undermined the bank’s credibility and thrust Turkey into the eye of the storm during the mid-2006 emerging-market sell-off.

“The Turkish economy is in dramatically better shape now than it was before the crisis of  2001–2002, and it would be difficult for any new government to alter the general direction now—a courtesy of far-reaching reforms,” says Perjessy. “But history—and a still very politically charged and polarized society—would caution against ignoring the prospect of a coalition government in Turkey.”

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