Turkey’s Currency Crash Worsens Outlook for the Economy, But Risks are Limited

Turkey’s economy has deteriorated dramatically during the summer. The Turkish lira crashed by 33% in August, bringing the total depreciation for 2018 to around 70%. Inflation in August reached 17.9% year-on-year, and the central bank raised its key interest rate from 8% to 17.75% during the summer. Both consumer and business confidence has dropped sharply.

Persistent current account deficits (exceeding 5% of GDP in 2017-2018), growing investor concerns about the impact on emerging markets of rising US interest rates, a general distrust of President Erdogan’s expansionary fiscal policy, together with the growing tensions between the US and Turkey, have all contributed to the recent currency collapse and rising interest rates.

The central bank is likely to respond with further interest rate increases bringing its key interest rate close to 20% by the end of 2018. In combination with the lira’s depreciation and significant corporate foreign currency debt, this is likely to contribute to a large increase in business defaults and the proportion of non-performing bank loans, endangering Turkey’s banking sector.

Turkey Real GDP Growth under Alternative Scenarios: 2017-2020

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Source: Euromonitor International Macro Model

Tighter credit conditions and falling private sector confidence are likely to push Turkey’s economy into a contraction at the end of 2018. We have reduced our baseline forecast for Turkey’s GDP growth to 2.5-3.5 in 2018, followed by 1.3-2.7% GDP growth in 2019. We assign this baseline forecast a 20-30% probability over a 1-year horizon.

This baseline forecast is surrounded by major uncertainty. A worsening of the recent sell-off in Turkish financial markets and stronger declines in private sector sentiment would lead to a sharper growth slowdown, with GDP growth of -0.6% to 0.8% in 2019 (15-25% estimated probability over a 1-year horizon), or a more severe downturn with GDP contracting by 1.2-2.6% in 2019 (10-20% estimated probability over a 1-year horizon).

On the upside, a diffusion of the current tensions with the US, and a positive investor response to the government’s medium-term fiscal programme to be presented in September could boost confidence and reduce interest rates. Under this growth acceleration scenario, GDP growth could rise to 3.3-4.7% in 2019 (15-25% estimated probability over a 1-year horizon).

Spill-over risks from Turkey’s current currency crisis are modest. Most of Turkey’s government debt is domestically held, as is 80% of Turkey’s stock market, which only accounts for 0.5% of the MSCI Emerging Markets Index’ value. The exposure of Eurozone banks’ to Turkish assets represents less than 1% of GDP, with the exception of Spain where they represent 5-6% of GDP. There were some signs of Emerging Markets contagion in August, with a significant depreciation in the South African Rand and a worsening of the Argentine Peso’s depreciation.

However, these countries already had significant previous vulnerabilities, with Argentina already in trouble before the recent Turkish lira crash. Outside of these isolated cases there are no strong signs of contagion. Nevertheless an Emerging Markets slowdown remains one of the main risks for the global economy for 2018-2019, potentially reducing annual GDP growth in Emerging Markets by 1-3% over a 3-year horizon. We currently assign this scenario an 8-13% probability over a 1-year horizon.

Emerging Markets Slowdown: 3-Year Average Annual GDP Impact

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Source: Euromonitor International Macro-Model

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