TÜRKİYE ECONOMIC M O N I TO R March 2024 ON THE RIGHT TACK > Contents Executive Summary 10 I. Taking Stock 11 Türkiye’s economic policies built on low cost of borrowing, high investment, exports and employment delivered strong growth performance initially, but had started losing steam and resulted in a widening 11 current account deficit and very high inflation. The economy registered strong growth performance in 2022 but the growth rate slowed down in the 11 second half of 2022 and in 2023. The current account deficit increased rapidly in 2022 and remained large in 2023 13 Monetary policy remained loose in 2022 and in the first half of 2023, despite high inflation and continuing 14 lira depreciation, only to be tightened starting from June 2023. Base effects and policy measures helped inflation ease from its peak in October 2022 until June 2023, but 15 inflation has recently rebounded Corporates faced rising production costs and working capital needs while enjoying lower cost of borrowing 18 in 2022 and in the first half of 2023 The financial sector, supported by the gradual simplification of macroprudential policies, remained 18 resilient amid challenges The rising expenditures and earthquake related investment needs have implications on overall fiscal 20 balances Robust employment and wage growth continue in 2023 with unemployment declining 21 II. Looking Ahead 24 A. A period of the normalization of macroeconomic policies 24 The recent steps taken towards normalization of macroeconomic policies are expected to boost 24 confidence, mitigate macrofinancial risks, and support the vulnerable The policy normalization will likely initially result in a period of depreciated lira and slower economic 25 growth, as the economy corrects the imbalances of the recent past Commitment to tight monetary policy until inflation expectations are anchored will support confidence, 27 but the disinflation will be challenging. The gradual adjustment of financial sector policies to reconverge to international standards will 28 strengthen financial stability Elevated investment needs and high inflation warrant a cautious and well targeted fiscal policy 29 A new window of opportunity to consider structural reforms 29 4 < TÜRKİYE ECONOMIC MONITOR B. Several risks can affect the path of economic growth and poverty reduction 30 Fiscal risks accumulate on earthquake related expenditures, contingent liabilities, wages 30 External imbalances continue despite a recovery in reserves 31 Global economy is on a low-growth trajectory with amplified geopolitical tensions. 33 Slowing economic growth poses risks to poverty reduction in the medium term. 34 III. Special Topic 35 Corporate vulnerability in Türkiye and linkages to financial sector 35 References: 40 Annex 1: Medium-Term Outlook, Nominal 41 Annex 2: Medium-Term Outlook, Percent of GDP 42 > Boxes Box 1: Pass through of shocks to inflation 17 Box 2: Measuring the international reserve position of the CBRT 32 TÜRKİYE ECONOMIC MONITOR < 5 > Figures Figure 1: Economic activity remained robust in 2022H1, but slowed down since 2022H2 12 Figure 2: The momentum of growth is volatile 12 Figure 3: Services sector is the main driver of growth 13 Figure 4: Economic activity has slowed in 2023H2 13 Figure 5: The current account deficit widened 14 Figure 6: …on the back of higher gold imports and contracting merchandise exports 14 Figure 7: The Central Bank started increasing the policy rate in 2023 June after a long-lasted easing cycle 15 causing a rapid increase in inflation and a significant decline in real rates Figure 8: CPI inflation peaked in October 2022, eased until June 2023, but started to increase again 16 Figure 9: The food and services inflation are particularly high 16 Figure 10: Exchange rate pass-through to CPI inflation 17 Figure 11: Pass-through of shock to CPI subcomponents 17 Figure 12: Corporates faced higher cost of production… 18 Figure 13: …while enjoying negative real cost of borrowing 18 Figure 14: CARs have improved recently 20 Figure 15: Sector level NPL ratio is low 20 Figure 16: Strong fiscal balance has been deteriorating… 20 Figure 17: …and primary surplus turned into deficit 20 Figure 18: Total employment is at record levels, while unemployment rates fell to lowest levels since mid-2013 21 Figure 19: Gross wages have increased more than CPI in yoy terms 21 Figure 20: Poverty continued to decline in 2021, income inequality has increased 22 Figure 21: The income growth of top 10 decile was relatively higher in 2021 22 6 < TÜRKİYE ECONOMIC MONITOR Figure 22: Datt-Ravallion decomposition of poverty reduction (2020-2021) 23 Figure 23: The share of casual employment is declining 23 Figure 24: Domestic demand has been the main driver of growth, and to a lesser extent in upcoming years 25 Figure 25: Persistency of inflation has increased 27 Figure 26: Even 5-year ahead inflation expectations are not in single digits 27 Figure 27: Currency composition of government debt poses risks 31 Figure 28: The share of rigid expenditures in the budget is high 31 Figure 29: Swaps and FX required reserves make up a significant portion of foreign currency reserves 32 Figure 30: External financing needs are increasing in the coming months 32 Figure 31: Global IP slightly decreased in Q3 33 Figure 32: Euro area activity is still weak 33 Figure 33: Policy rates are rising in advanced economies 34 Figure 34: Oil price remain high 34 Figure 35: Interest coverage and profitability of corporate sector increased 35 Figure 36: Corporate sector has lowered its open position 35 Figure 37: Corporate vulnerability has declined… 36 Figure 38: …but to a different extent by size 36 Figure 39: The evolution of vulnerability differs by firm size 37 Figure 40: Exchange rate and loan rate shocks and corporate vulnerability 38 Figure 41: Cumulative response of corporate vulnerability to exchange rate and loan rate shocks by firm size 38 Figure 42: Cumulative response of the share of bad loans in total loans to corporate vulnerability shock by firm 39 size in manufacturing industry TÜRKİYE ECONOMIC MONITOR < 7 The Türkiye Economic Monitor (TEM) periodically analyzes economic developments, policies, and prospects in Türkiye. The TEM was prepared under the guidance of Humberto Lopez, Asad Alam, and Antonio Nucifora, by a core team led by Mustafa Utku Özmen, and including Hans Anand Beck, Claire Honore Hollweg, Etkin Ozen, Gunhild Berg, Elizaveta Perova, and Marie Sabine Lydie Albert. The team is very grateful to the following colleagues for advice and technical input: Umut Kilinc, Efsan Nas Ozen, Ibrahim Unalmis. The team is also grateful for the financial support from the Umbrella Facility for Trade Trust Fund. The team is very grateful to Bakhrom Ziyaev and Enrique Aldaz-Carroll for peer review comments and advice. The team is very grateful to colleagues from the Ministry of Treasury and Finance, the Central Bank of the Republic of Türkiye, the Presidency of Strategy and Budget, the Banking Regulation and Supervisory Agency for very helpful discussions on economic developments and policy priorities. The team greatly appreciates insights provided by business associations and the private sector during the preparation of the TEM. The TEM is a product of the staff of the World Bank Group. The findings, interpretations, and conclusions expressed in this report do not necessarily reflect the views of the Executive Directors of the World Bank (or the governments they represent), or the Government of the Republic of Türkiye. > Executive Summary Türkiye’s economic policies played a crucial role in reserves, the improvements in the assessment of credit rating facilitating a rapid recovery from the COVID pandemic. agencies, and a significant decline in the current account deficit. However, the policy framework that ensured a strong Yet, in the short-term economic growth is expected to slow economic performance during and in the aftermath of on the back of policy tightening, slow global growth, current the pandemic also heightened macroeconomic risks and account and budget deficits, and the transition period required created vulnerabilities. The policy framework introduced for stabilization, while the Medium-Term Program (MTP) also during the pandemic was built on loose monetary policy, prudent outlines a shift in growth composition from private consumption fiscal policy, and boosting exports and employment. As a result, to investments and exports. Therefore, maintaining this policy the Turkish economy grew by 11.4 percent in 2021, and 5.5 stance will provide the foundations for sustainable strong percent in 2022. Employment growth remained robust, and the economic growth in the medium to long term. This strategy calls unemployment rate declined steadily. However, these policies -in for a careful tailoring of economic policies towards maintaining addition to the rise in energy prices amid geopolitical tensions stability and confidence and protecting the vulnerable and and the global monetary tightening cycle- also resulted in a very underscores the importance of tackling structural issues to rapid increase in inflation, a widening of the current account strengthen economic performance. deficit, and a decline in FX reserves, which in turn contributed to a worsening of the risk perception and macrofinancial outlook in Several risks can affect the path towards faster economic the run up to the May 2023 elections. With increased internal and growth and poverty reduction. The government’s fiscal external imbalances, the growth momentum also slowed down position while strong, is vulnerable to rising borrowing costs, starting from the second half of 2022. increasing rigidity of public expenditures, and pressing needs to support vulnerable groups during the disinflation phase. Following the May 2023 elections, the new government External risks were particularly elevated in the first half of 2023 started a process of normalization in macroeconomic with declining reserves and a rising current account deficit and policies which can restore sustainable strong economic high external financing requirements. While there has been a growth and price stability in the medium to long term. The substantial increase in FX reserves along with early signs of an new macroeconomic policy framework is centered on tightening improvement in the current account deficit in the second half of monetary policy to achieve disinflation, while maintaining 2023, external risks remain given the relatively low level of net FX fiscal discipline, and a flexible exchange rate, and pursuing reserves and the high external financing requirements. Further, structural reforms to support economic growth. This transition the global economy is recovering to a low growth path on the to macroeconomic stability, however, involves a complex back of tight monetary policy stance, the stagnation in global adjustment process, which needs to be gradually implemented. trade, and increased uncertainty due to geopolitical tensions. So far, the strong monetary policy rate hikes, ongoing Also, the monetary tightening and slowing growth prospects simplification in the macroprudential policy framework, and the may trigger vulnerabilities in the corporate sector which may correction in the exchange rate since May 2023 have helped to have repercussions on the financial sector, as discussed in the gradually rebuild confidence in the economy, while targeted tax special topic section of the report. Going forward there are also increases have helped reduce the fiscal deficit. The impact of the opportunities that can support faster economic growth induced new policy framework has started to be reflected in the reduction by higher productivity, such as the greening of the economy. in risk premia, realignment of interest rates, strengthening in FX 10 < TÜRKİYE ECONOMIC MONITOR > I. Taking Stock Türkiye’s economic policies helped quickly recover from the COVID pandemic. The policies being implemented since late 2021 were built on loose monetary policy, prudent fiscal policy, boosting exports and employment, and managed to deliver strong GDP growth in 2022. These policies, -in addition to the rise in energy prices amid geopolitical tensions and the global monetary tightening cycle-, however also led to a very rapid increase in inflation, a widening of the current account deficit and the decline in the reserves which in turn affected investors’ risk perception adversely and increased macrofinancial pressures in the run up to the May 2023 elections. As a consequence, the growth momentum also slowed down starting from the second half of 2022. Following the elections, the new government started a process of normalization in macroeconomic policies in 2023H2 with an emphasis on tightening monetary policy to achieve disinflation. The monetary policy rate hikes, ongoing simplification in the macroprudential policy framework, and the correction in the exchange rate since May 2023 have helped to gradually rebuild confidence in the economy, and the tax hikes have helped reduce the fiscal deficit. The impact of the new policy framework has started to be reflected in the reduction in risk premia, realignment of interest rates, strengthening in foreign exchange reserves, and the improvements in the assessment of credit rating agencies. Türkiye’s economic policies built on low cost of borrowing, high investment, exports and employment delivered strong growth performance initially, but had started losing steam and resulted in a widening current account deficit and very high inflation. The economy registered strong growth performance in 2022 but the growth rate slowed down in the second half of 2022 and in 2023. The Turkish economy grew at 5.5 percent in 2022 thanks the erosion of price competitiveness gains, which was built up to strong economic activity in 2022H1 (fueled by resilient due to depreciated Turkish lira, through high inflation. The robust exports and private consumption); yet it started to moderate economic activity and private consumption also pushed the since 2022H2, and the economy grew by 4.5 percent in import demand and imports grew by 11.7 percent yoy in 2023, 2023. The strong and robust contribution of private consumption despite a decline from 19.7 percent in 2023Q2. The momentum continued to be the main driver of growth (Figure 1). Sizeable of growth in Türkiye is volatile. The seasonally and calendar wage increases, the availability of low-cost credit and the front- adjusted qoq growth rate in the quarters of 2023 were -0.2, 3.6, loading of spending (to hedge against high inflation) led private 0.3 and 1.0 percent respectively (Figure 2). In Q2, both private consumption to grow by 18.9 percent in 2022, which moderated consumption and imports grew strongly by 4.6 and 4.3 percent, to 12.8 percent in 2023. Meanwhile, exports have significantly respectively, while exports continued to contract. However, in slowed down since 2022H2, as export growth came down from Q3, private consumption of resident households contracted for 18.8 percent in 2022Q2 to -9.4 percent by 2023Q2, only to recover the first time since 2020Q4, and exports have picked up by 5.2 to 1.2 percent in Q3. The loss of momentum in exports was mainly percent, following the monetary policy tightening started in June. led by the slowdown in the growth of major export markets and However, in Q4, private consumption increased by 3.6 percent. TÜRKİYE ECONOMIC MONITOR < 11 On the production side, the services sector was the main Purchasing Managers’ Index (PMI), which remained below 50 driver of economic growth in 2022 and in 2023, while for the majority of 2022, was in positive territory in 2023H1, but manufacturing slowed down. The services value added fell below 50 in July 2023, only to recover to 50.2 in February increased by 9.6 percent in 2022. The momentum of both 2024, and remain at the threshold level in March 2024 (Figure services and industry further slowed down in 2023Q2 (Figure 4). The negative real interest rates and strong domestic demand 3). The loss of pace in the manufacturing value added growth kept the business sentiment strong in the 2023H1, but the start was linked with the weakening external demand and rising cost of the tightening cycle of monetary policy pointed to a slowdown pressures. The manufacturing, however, recovered in second in the economy. half of 2023, while services continued to lose momentum The > > > > > > Figure 1: Economic activity remained robust in 2022H1, but Figure 2: The momentum of growth is volatile slowed down since 2022H2 GDP (growth and contribution, yoy, NSA) GDP (growth and contribution, qoq, SA) 10% 25% 8% 20% 6% 15% 4% 10% 2% 0% 5% -2% 0% -4% -5% -6% -10% -8% 2021Q1 2021Q2 2021Q3 2021Q4 2022Q1 2022Q2 2022Q3 2022Q4 2023Q1 2023Q2 2023Q3 2023Q4 2021Q1 2021Q2 2021Q3 2021Q4 2022Q1 2022Q2 2022Q3 2022Q4 2023Q1 2023Q2 2023Q3 2023Q4 Priv. Consumption Gov. Consumption Priv. Consumption Gov. Consumption Investment Exports Investment Exports Imports Stocks Imports Stocks GDP GDP Sources: Haver Analytics, TURKSTAT, WB Staff estimates. Sources: Haver Analytics, TURKSTAT, WB Staff estimates. In parallel, consumer confidence followed an upward trend of the lira put a drag on consumer confidence which fell to 68.0 in from the second half of 2022, peaking at 91.1 in May 2023, August with an improvement to 79.4 in March 2024. The decline on the back of wage increases and the availability of cheap in consumer confidence from peak values also support the credit boosting private consumption. However, in the second slowdown in economic activity in 2023H2 compared to first half. half of 2023, the policy rate hikes, and the sizeable depreciation 12 < TÜRKİYE ECONOMIC MONITOR > > > > > > Figure 3: Services sector is the main driver of growth Figure 4: Economic activity has slowed in 2023H2 Gross Value Added (growth and contribution, PMI and Consumer Confidence 25% yoy, NSA) 20% 56 100 54 90 15% 52 80 10% 50 70 5% 48 60 0% 46 50 -5% 44 40 2021Q1 2021Q2 2021Q3 2021Q4 2022Q1 2022Q2 2022Q3 2022Q4 2023Q1 2023Q2 2023Q3 2023Q4 Ap r-21 Ap r-22 Jul-21 Ap r-23 Jul-22 Jul-23 Jan-21 Oct-21 Jan-22 Oct-22 Jan-23 Oct-23 Jan-24 Agriculture Industry Construction Services PMI Consumer Confidence, rhs Residual Gross Value Added Sources: Haver Analytics, TURKSTAT, WB Staff estimates. Sources: Istanbul Chamber of Industry Türkiye PMI, TURKSTAT The current account deficit increased rapidly in 2022 and remained large in 2023 After reaching US$49.1 billion in 2022 (from US$7.4 billion deficit has changed. An improving energy trade balance helped in 2021), the current account deficit has remained large in offset rising gold imports and a deteriorating non-gold-or-energy the first five months of 2023 on the back of increasing gold goods trade balance (Figure 6). Services balance also improved imports and a worsening merchandise trade balance but in 2023, on the back of very strong tourism revenues which narrowed in the remainder of the year due to policy shift in the increased by 12.1 percent and reached US$55.9 billion. The economy and measures restricting gold imports to US$45.5 12-month cumulative current account deficit further narrowed to billion in 2023. The current account deficit narrowed by around US$31.8 billion in February 2024. US$4 billion in 2023 (Figure 5). However, the composition of the TÜRKİYE ECONOMIC MONITOR < 13 > > > > > > Figure 5: The current account deficit widened Figure 6: …on the back of higher gold imports and contracting merchandise exports Cumulative current account balance Trade balance 60 (billion USD, nsa) (billion USD, nsa) 0 30 0 -20 -30 -40 -60 -90 -60 Gold balan ce Energy balance Non-gold or Service balan ce Jan Feb Mar Ap r May Jun Jul Aug Sep Oct Nov Dec energy goods balance 2021 2022 2023 2022 2023 Source: Authors’ calculations using data from CBRT. Source: Authors’ calculations using data from CBRT. Monetary policy remained loose in 2022 and in the first half of 2023, despite high inflation and continuing lira depreciation, only to be tightened starting from June 2023. The CBRT started a long easing cycle of monetary policy The macroeconomic policy mix shifted after the May 2023 in late 2021. The CBRT initially cut the policy rate from 19 elections, as the CBRT started an aggressive tightening of percent to 14 percent from September 2021 to December monetary policy. The CBRT has increased the policy rate in nine 2021, and from 14 percent to 8.5 percent from August 2022 meetings from 8.5 percent in May to 50 percent in March 2024 to February 2023. The rate cuts, which started when inflation (Figure 7). Moreover, in the July and November 2023 Inflation was already high (19.25 in August 2021), had a significant Reports, the CBRT has increased the 2023 year-end inflation impact on exchange rate, inflation, and inflation expectations. forecast to 58 and 65 percent, respectively, from 22 percent in its They were accompanied by measures under the ‘Liraization April Report. The end-2024 inflation forecast is kept at 36 percent Strategy’, including the introduction of the ‘FX protected in November 2023 and February 2024 reports. The MPC has put deposit scheme’ to reduce the demand for FX and stabilize forward a clear message indicating that the level of the policy the currency. However, a widening current account deficit and 1 tightness will be maintained until there is a significant decline global monetary tightening continued to put pressure on the in the underlying trend of monthly inflation and until inflation lira. In the first months of 2023 the pressure on the lira reached expectations converge to the projected forecast range. CBRT very high levels, and the central bank’s net reserves fell to US$- also initiated a process to gradually remove the restrictions that 5.7billion in the first week of June. have been in place either to lower the cost of borrowing or to curb the demand for FX (including the FX protected scheme). 1. For additional information on liraization strategy: https://tcmbblog.org/wps/wcm/connect/blog/en/main+menu/analyses/liraization+strategy; on macroprudential measures: https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Announcements/Press+Releases/2022/ANO2022-36 ; on FX-protected scheme: https://tcmbblog.org/wps/wcm/connect/blog/en/main+menu/analyses/a+glance+at+fx-protected+and+standard+deposits+from+an+investor+perspective 14 < TÜRKİYE ECONOMIC MONITOR > > > Figure 7: The Central Bank started increasing the policy rate in 2023 June after a long-lasted easing cycle causing a rapid increase in inflation and a significant decline in real rates Inflation, Policy rate and Exchange rate 100 50 CPI 80 Inf. Exp. (12 m. ahead) 40 60 CBRT Policy Rate, rhs 30 USD/TL, rhs 40 20 20 10 0 0 Jan 20 20 May 20 July 20 Sep 20 Nov 20 Jan 21 21 May 21 July 21 Sep 21 Nov 21 Jan 22 22 May 22 July 22 Sep 22 Nov 22 Jan 23 23 May 23 July 23 Sep 23 Nov 23 Jan 24 24 Eyl-21 Eyl-22 Eyl-23 Kas-23 Eyl-20 Kas-20 Kas-21 Kas-22 Tem-22 Tem-23 Tem-20 Tem-21 Mar-24 Mar-21 May-21 Mar-22 May-22 Mar-23 May-23 Mar-20 May-20 Oca-23 Oca-24 Oca-20 Oca-21 Oca-22 March March March March March Sources: CBRT, TURKSTAT, Haver Analytics. Base effects and policy measures helped inflation ease from its peak in October 2022 until June 2023, but inflation has recently rebounded Inflation rose to very high levels in 2022, peaking at 85.5 inflation came down to 38.2 in June 2023. However, the new percent in October 2022, on the back of loose monetary round of depreciation of the lira post-elections, the significant policy, depreciation of the lira, rising international tax hikes as part of the efforts to finance reconstruction of the commodity prices, and strong domestic demand. Consumer earthquake-affected areas, minimum wage adjustments, and price index (CPI) inflation exceeded 80 percent, reaching 85.5 the surge of international oil prices, all put extra pressure on percent in October 2022, and domestic producer price inflation inflation, putting headline inflation to 64.8 percent in December hit 158 percent (Figure 8). Following that, with the help of the 2023, and 67.1 in February 2024.2 base effects and relative stability in the exchange rate consumer 2. The increase in Value Added Tax rates (by 2 percentage points for most goods and services), coupled with a significant increase the Special Consumption Tax on fuel, also had direct and indirect effects on inflation., which together with the depreciation of the lira explain about half of the surge in inflation since June 2023. The central bank’s Inflation Report 2023-III provides a detailed analysis of the impact of tax and administered prices on inflation. TÜRKİYE ECONOMIC MONITOR < 15 > > > > > > Figure 8: CPI inflation peaked in October 2022, eased until Figure 9: The food and services inflation are particularly high June 2023, but started to increase again Inflation (yoy, % change) Inflation (yoy, % change) 160 160 140 120 120 100 80 80 60 40 40 20 0 0 -20 Jul-21 Jul-22 Jul-23 Apr-21 Apr-22 Apr-23 Oct-21 Oct-22 Oct-23 Jan-21 Jan-22 Jan-23 Jan-24 Apr-21 Apr-22 Apr-23 Jul-21 Jul-22 Jul-23 Oct-21 Oct-22 Oct-23 Jan-21 Jan-22 Jan-23 Jan-24 CPI Core Inf. - C Food Energy PPI Inf. Exp. (12 m. ahead) Core Goods Services Sources: TURKSTAT, CBRT. Sources: TURKSTAT. Despite recent monetary tightening inflationary pressures inflation stuck around 60 percent and further increased to 94.4 are still alive, driven by the persistence of services inflation, percent, currently being the main subgroup with the highest level the existing level of domestic demand and geopolitical of inflation as of February 2024 (Figure 9). Services prices are risks; and medium-term inflation expectations remain sensitive to wage developments, food and energy inputs, and above the CBRT forecasts. As of March 2024, the 12-month- exchange rate shocks, and constitute the stickiest portion of ahead inflation expectation is at 36.7 percent, while the year- the CPI where shocks to prices occur slowly but persist longer end inflation expectation is 44.2 percent, above the CBRT’s compared to other components. Therefore, services inflation forecast for end-2024 of 36 percent. Similarly, 24-month ahead presents an important challenge for disinflation. Furthermore, inflation expectation came down from 25.8 percent in October the rapid increase in inflation also distorts the pricing behavior of 2023 to 22.7 percent in March 2024, being higher than CBRT’s economic agents as increased backward looking pricing further end-2025 forecast of 14 percent. Moreover, the slowdown in strengthens the persistence of inflation, and as high inflation inflation observed from October 2022 to June 2023 has been and inflation uncertainty boosts the pass-through of shocks to limited to goods inflation, while over the same period services inflation (Box 1). 16 < TÜRKİYE ECONOMIC MONITOR > > > Box 1: Pass-through of shocks to inflation Inflation in Türkiye has been subject to sizable shocks recently: Inflation has been fueled by the significant depreciation of the Turkish lira, the increase in import prices following the post-COVID global recovery, Russia’s invasion of Ukraine, and the strong domestic demand fueled by loose credit policy and minimum wage increases. In addition, inflation expectations have increased, and pricing behavior has been distorted, adversely affecting the pass-through of shocks to consumer inflation. A VAR analysis conducted with monthly data and including import unit value index in USD, USD/TL exchange rate, minimum wage, industrial production, inflation, policy rate and inflation expectations, has been estimated for January 2005 to June 2023. The results suggest that the pass-through of an exchange rate shock on headline inflation is around 30 percent (Figure 10). One striking observation is the speed of pass-through of an exchange rate shock: About half (two thirds) of the pass-through happens in two (three) months, and the pass-through of the exchange rate shock is completed in around one year. The sensitivity of inflation to shocks and the speed of transmission has considerably increased in recent years making the disinflation foreseen by the authorities even more challenging. Comparing the pass-through estimates (cumulative responses after 24 months) for 2005-2023 with those for 2005-2020 suggests that the exchange rate, import price and minimum wage pass-through has increased in the recent period for almost all subcomponents of the CPI (Figure 11). For instance, the exchange rate pass-through to core goods (services) has increased from 32 percent (6 percent) to 35 percent (20 percent); and the pass-through of minimum wage on food prices has increased from 14 percent to 30 percent in the latest estimation sample. Especially, the notable increase in the sensitivity of services inflation to shocks makes the disinflation period ahead more difficult than previous episodes of disinflation. > > > > > > Figure 10: Exchange rate pass-through to CPI inflation Figure 11: Pass-through of shock to CPI subcomponents Exchange rate pass-through on CPI Pass-through of shocks to CPI subcomponents 40% 60% 50% 30% 40% 30% 20% 20% 10% 0% 10% 2005/20 2005/23 2005/20 2005/23 2005/20 2005/23 Exchange rate Import prices Minimu m wage 0% passthrough passthrough passthrough 1 3 5 7 9 11 13 15 17 19 21 23 Sampl e: 01/2005-06/2023 Energy Core Goods Food Services Sources: TURKSTAT, CBRT, WB staff estimations. In left panel, the horizontal axis represents months following the shock and cumulative responses are reported. In the right panel, cumulative responses at the end of 24 months are used to calculate the pass-through coefficients. TÜRKİYE ECONOMIC MONITOR < 17 Corporates faced rising production costs and working capital needs while enjoying lower cost of borrowing in 2022 and in the first half of 2023 Average cost of production increased significantly through increased working capital needs (Figure 13). Overall, despite 2022 on the back of lira depreciation and high inflation cost increases, corporates enjoyed a significant increase in their but eased in 2023H1 before accelerating again in 2023Q3. sales and profits given the strong domestic demand. The recent The significant depreciation of the lira caused a surge in cost increase in interest rates, however, has pushed the real interest of imported inputs and the wage adjustments increased the rates into positive territory resulting in more stringent financing cost of labor contributing to rising cost of production (Figure conditions for corporates which might increase corporate 12). Meanwhile, corporates enjoyed low cost of borrowing (with vulnerability (as will be discussed in section III).3 negative real interest rates), which helped them finance their > > > > > > Figure 12: Corporates faced higher cost of production… Figure 13: …while enjoying negative real cost of borrowing Business Tendency Survey, Average Unit Cost Weighted Average Interest Rate on (Balance, NSA, %) Commercial Loans (%) 80 60 60 30 40 0 20 Jan 20 20 Sep 20 Jan 21 21 Sep 21 Jan 22 22 Sep 22 Jan 23 23 Sep 23 Jan 24 -30 Eyl-20 Eyl-21 -20 Eyl-22 -21 Eyl-23 -22 -23 Oca-20 Oca-21 Oca-22 Oca-23 Oca-24 May May May May Jan 20 May 20 Sep 20 Jan 21 May 21 Sep 21 Jan 22 22 Sep 22 Jan 23 May 23 Sep 23 Jan 24 May May May May Oca-20 Eyl-20 Oca-21 Eyl-21 Oca-22 Eyl-22 Oca-23 Eyl-23 Oca-24 May-20 May-21 May-22 May-23 May Average Unit Cost-past 3 months Average Unit Cost-next 3 months Nominal Real Sources: Haver Analytics, TURKSTAT, CBRT. Sources: Haver Analytics, CBRT, WB Staff calculations. Notes: Balance: Difference between percentage of “increase” and Notes: For calculating real rates, 12-month ahead inflation expectations “decrease” responses are used. The financial sector, supported by the gradual simplification of macroprudential policies, remained resilient amid challenges The financial landscape in Türkiye has undergone indirectly supported the domestic government bond market. Real significant changes, driven primarily by policy interventions, credit growth declined mainly in private banks, while state banks macroeconomic challenges, and market dynamics. Under continued to push their loan offerings at the expense of straining the ‘Liraization Strategy’, the CBRT introduced measures aimed their capital buffers. As a result of lower credit growth compared to at stabilizing the lira, and guiding selective credit growth, and deposit increase, the loan to deposit ratio decreased significantly reducing FX demand. Notable interventions include the ‘FX- since the high of 121 percent at end-2017 to 88 percent at end- protected TL deposit scheme’ and adjustments to reserve ratios. 2022 (108 percent end-2020). The uncertainties combined with This regulatory approach impaired banks’ lending practices, and tight credit conditions increased corporate funding challenges, 3. The MPC argues that selective credit tightening may also lead to the improvement in the distribution of financing sources, which will have positive effects factor productivity. https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Announcements/Press+Releases/2023/ANO2023-37 18 < TÜRKİYE ECONOMIC MONITOR particularly for SMEs, and depreciation also increased banks State banks’ CAR stood at 15.7 percent in 2022 compared to and corporates’ FX risks. In addition, high inflation eroded the 23.1 percent for domestic private commercial banks, reflecting savings of households, pushing them towards FX, gold, real their stronger lending activity, intensified by sticky inflation and estate, and other assets for genuine returns, which led to a lira depreciation. As of 2023Q3 CARs stood at 15.9 percent, 21.2 significant real increase in asset prices. percent and 19.9 percent for state banks, domestic private banks and foreign banks respectively (Figure 14). Private banks saw The new economic team has started to gradually unwind soaring profits thanks to wide net interest margins and inflation- the complex network of macroprudential regulations of indexed government bond holdings, which allowed them to boost the financial sector in Türkiye. Recently introduced monetary their capital reserves. Returns on Equity increased from 11.4 policy normalization and gradual easing of macroprudential percent to 49.9 percent between 2020 and 2022 for the whole policies to improve the functioning of transmission mechanisms banking system, with private banks enjoying higher returns than will provide buffers for banks’ profitability and capital adequacy. state banks (50.1 percent versus 27 percent in 2022). Additionally, Banks have already started to ease their commercial lending banks are still using regulatory forbearance, allowing them to conditions amid high demand for corporate finance despite use a more favorable exchange rate to calculate risk-weighted rising loan costs. However, higher policy rates and still very high assets, though this relaxation is gradually being phased out. inflation keep the loan growth contained. Despite the very high Removing or quickly tightening forbearance without a consistent nominal rates, the real loan growth (yoy, adjusted by the annual decrease in macroeconomic and financial stability risks, along CPI inflation) as of 2023Q3 for state banks, domestic private with stabilizing FX rate, might cause the capital ratios of some banks and foreign banks was 5.1 percent, -16.8 percent and -9.5 banks to approach the minimum thresholds of 12% target ratio percent, respectively. set by BRSA for Turkish banks. The net FX position of the banking sector has improved Gradual monetary policy normalization will limit the potential significantly following the monetary policy normalization. risks to asset quality. Nominal loan growth, largely driven by Despite the slowdown in FX loan growth, the FX protected inflation, improved the NPL ratio (1.5 percent as of 2023Q3 deposit scheme and TL supportive required reserve policies compared to 4.1 percent in end-2020). Besides the credit growth, supported the net FX positions of banks with the FX net position/ slow-down in new NPL inflows and increase in NPL collections regulatory capital increasing from -1.1 percent in February 2023 also helped the decrease in NPL ratio. There remain concerns to 4 percent in February 2024. Despite episodes of increased related to the high credit growth during the pandemic, the effect uncertainty and volatility in the past years, banks were able to roll of depreciation on FX-exposed firms, the high but declining stock over their external debt at above 100 percent during postelection of Stage 2 loans (8.0 percent, as of September 2023), and the period, albeit at higher costs. Turkish banks’ short-term external rise of loan restructurings since 2018 (Figure 15). Corporate debt stood at US$69.9 billion as of January 2024. Banks continue vulnerability has decreased, mainly driven by lower cost of to show maturity mismatches along their historical averages with borrowing and strong domestic demand. However, the recent a maturity mismatch of 9.3 months for TL assets and liabilities, tightening in the policy rate is translating into higher borrowing and a mismatch for foreign currency assets and liabilities of 5.8 costs amid a slowing economy, which could negatively affect months as of 2023Q3.4 FX liquid assets over FX short-term debt corporates financial soundness and lead to asset quality risks ratio stood at 259% as of February 2024. for banks (see Section III). Since 2018 banks have restructured their distressed assets5 (as 55% of Stage 2 loans) and have built Banks’ reported capitalization is supported by solid free significant low NPL and free provisions to cover potential risks provisions for reserve coverage of distressed loans. which can be further limited by the balanced and gradual policy The capital adequacy ratio (CAR) across the banking sector normalization. increased from 18.7 percent in 2020 to 19.5 percent in 2022. 4. Financial Stability Report, November 2023, https://www.tcmb.gov.tr/wps/wcm/connect/EN/TCMB+EN/Main+Menu/Publications/Reports/Financial+Stability+Report/2023/Volume+37 5. Banks Association of Türkiye (https://www.tbb.org.tr/en/Content/Upload/Dokuman/1222/Classification_Of_Loans_September_2023.pdf) TÜRKİYE ECONOMIC MONITOR < 19 > > > > > > Figure 14: CARs have improved recently Figure 15: Sector level NPL ratio is low Capital Adequacy Ratios 80,000 7 24 NPL Stock (TRY Mil) and NPL Ratio (%) (%) 6 22 60,000 5 20 4 40,000 18 3 20,000 2 16 1 14 Sector Domestic Private 0 0 State Foreign Jan 14 July 14 Jan 15 July 15 Jan 16 July16 Jan 17 July 17 18 July 18 Jan 19 July 19 Jan 20 July 20 Jan 21 July 21 Jan 22 July 22 Jan 23 July 23 Tem-14 Tem-15 Tem-16 Tem-17 Tem-18 Tem-19 Tem-20 Tem-21 Tem-22 Tem-23 Oca-14 Oca-15 Oca-16 Oca-17 Oca-18 Oca-19 Oca-20 Oca-21 Oca-22 Oca-23 12 Jan Mar-23 May-23 Jul-23 Mar-20 May-20 Jul-20 Mar-21 May-21 Jul-21 Mar-22 May-22 Jul-22 Nov-22 Jan-23 Jan-20 Nov-20 Jan-21 Nov-21 Jan-22 Sep-22 Sep-23 Sep-20 Sep-21 State Domestic Private Foreign Sector NPL Ratio, rhs Sources: Haver Analytics, BRSA Sources: Haver Analytics, BRSA. The rising expenditures and earthquake related investment needs have implications on overall fiscal balances The budget deficit remained manageable in 2022 with a positive issued, around one fourth of the size of the 2023 budget. In this primary balance over the year. However, in 2023 the budget framework, significant tax increases were introduced, including a deficit significantly widened with a primary deficit (Figure 16). 2-percentage point increase in VAT and a significant hike in fuel The significant increase in expenditures stemmed from significant Special Consumption Tax (SCT). In spite of these tax increases, increases in personnel expenditures, current transfers primarily to however the 12-month cumulative primary balance as of December compensate for high inflation and current and capital transfers to remains in deficit, around 2.7 percent of GDP (Figure 17). The support earthquake recovery. In July, a supplementary budget was budget deficit was largely financed with domestic borrowing in 2023. > > > > > > Figure 16: Strong fiscal balance has been deteriorating Figure 17: …and primary surplus turned into deficit CG fiscal balance and primary balance (share Central Government Budget and Primary 500 of GDP) Balances (12-m rolling. billion TL) 2% 0 0% -500 -2% -1,000 -4% -6% -1,500 Nov-22 Nov-23 Nov-20 Nov-21 Jul-22 Sep-22 Jul-23 Sep-23 Jul-20 Sep-20 Jul-21 Sep-21 Jan-23 Jan-24 Jan-21 Jan-22 Mar-21 May-21 Mar-22 May-22 Mar-23 May-23 Jan-20 Mar-20 May-20 De -2 0 De -2 1 De -2 2 De -2 3 Sep 20 Sep 21 Sep 22 Sep 23 M a 20 M a 21 M a 22 3 Jun 20 Jun 1 Jun 2 Jun 3 c-2 r-2 r-2 r-2 - - - - c- c- r- c- Ma Budget Balance Primary Balance Budget Balance Primary Balance Sources: MOTF. Notes: 2023Q4 value is WB staff estimate. Sources: MOTF 20 < TÜRKİYE ECONOMIC MONITOR Robust employment and wage growth continue in 2023 with unemployment declining The number of people employed reached an all-time high in mid-2013, before edging to 9.1 percent in January 2024. The 2022 and continued to increase in 2023 along with buoyant reduction in unemployment was more pronounced for men and economic activity. As of January 2024, the seasonally adjusted for the youth. Yet, the youth unemployment remains high at 16.6 number of employed people reached 32.2 million (Figure 18). percent as of January 2024. Wages also continued to grow, with Meanwhile, the strong employment growth also led to a decline gross wages and salaries index surpassing annual CPI inflation in unemployment rates, as the total unemployment rate came in 2023Q3 (Figure 19). down to 8.6 percent in October 2023, the lowest reading since > > > > > > Figure 18: Total employment is at record levels, while Figure 19: Gross wages have increased more than CPI in yoy unemployment rates fell to lowest levels since mid-2013 terms Employment (SA, Million) and Average gross wages and CPI 30 Unemployment rate (SA, %) 32 150 (yoy percent change) 25 31 30 120 20 29 15 28 90 10 27 26 60 5 25 30 0 24 0 Tem-20 Tem-21 Tem-22 Tem-23 Oca-20 Nis-20 Eki-20 Oca-21 Nis-21 Eki-21 Oca-22 Nis-22 Eki-22 Oca-23 Nis-23 Eki-23 Oca-24 Jan 20 20 July 20 20 21 21 21 21 Jan 22 22 July 22 22 Jan 23 23 July 23 23 Jan 24 Jan Apr July Oct Apr Oct Apr Oct Apr Oct -30 Emp loyment, rhs Unemp. rate 2018Q3 2019Q3 2020Q3 2021Q3 2022Q3 2023Q3 Unemp. rate (Male) Unemp. rate (Female) Industry Construction Trade an d Services CPI Unemp. rate (Youth) Sources: TURKSTAT. Sources: TURKSTAT. Note: Quarter averages are used. Despite robust labor market performance and wage the wealthier segments of the population. First, with higher increases, the poorest appear to have been hurt the most credit scores, they might have disproportionately benefited from by inflation in a similar pattern observed across many effectively negative interest rates on consumer loans. Second, countries. Inflation weighs more on the consumption of poorer imported goods might constitute a higher share of consumption households because most of their income is spent on necessities. of the wealthier households, thus they may have also benefitted For instance, the share of food and non-alcoholic beverages in more from the relatively stable lira (resulting from interventions consumption basket went up to 35.8 percent in 2022, from 30.7 to limit pace of depreciation) until the May 2023 elections, which percent in 2019 for the bottom quintile, while it only increased effectively subsidized prices of imports. by 1.3 percentage points to 16.6 percent for the top quintile. Coupled with the rapid increase in food prices (food inflation The poverty rate continued to decline while inequality has being higher than headline inflation), it forced poorer households increased in 2021 in Türkiye. The latest available micro data to spend a much higher proportion of their income on food items, reveals that the poverty rate declined from 9.8 percent in 2020 to cutting back spending on other goods and services. The prior 7.6 percent in 2021, mainly driven by changes in labor earnings loose monetary policy stance may also have been benefitting affected by the minimum wage hike in 2021 (Figure 20).6 At the 6. In 2021, 55% of observed decline in poverty is due to labor earnings. The second largest contributor is pensions (19%), followed by business income (14%) – as per decompositions using Shapley value. TÜRKİYE ECONOMIC MONITOR < 21 same time, income inequality widened. The Gini coefficient such as housing, and rents, and from the transfers of the FX- increased from 43.2 to 46.0 (Figure 20). This dynamic of protected deposit scheme. Overall, income growth -rather simultaneous reduction in poverty and increase in inequality is than redistribution- continued to be the main source of poverty explained by two facts: first, the high growth rate in 2021 (11.4 reduction between 2020 and 2021 (Figure 22). While the bottom percent) which more than offset the increase in inequality; and decile experienced the highest increase in labor income (26 second, the fact that the bottom and, particularly, the top deciles percent), the top decile benefitted the most from increase in were the ones that benefitted the most from growth between business income. Some of the increase in labor income among 2020 and 2021 (Figure 21). Growth in incomes among the top the bottom decile may be attributed to improvements in the decile significantly exceeded growth in all other income deciles, quality of jobs, potentially associated with the rebounding from -a deviation from recent historical trends- further strengthening the COVID-19 pandemic in 2021 as the share of those working in the income inequality. The macroeconomic indicators suggest casual employment declined and the share of full-time employees that the income of the top deciles may have been growing at increased the most among the bottom decile (Figure 23). disproportionally high rates due to the surge in asset prices > > > > > > Figure 20: Poverty continued to decline in 2021, income Figure 21: The income growth of top 10 decile was relatively inequality has increased higher in 2021 25 Poverty and Income Inequality 47 Income growth incidence curves for 50% different periods 46 2009-2016 20 45 40% 2016-2020 Total Growth in Income (%) 2020-2021 15 44 30% 43 10 20% 42 5 41 10% 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 0% 1 2 3 4 5 6 7 8 9 10 Headcount Poverty Rate (%) -10% Gini Coefficient, rhs Income Deciles Source: WB staff calculations using SILC 2008-SILC 2022 data from the Sources: TURKSTAT SILC Data, WB staff calculations TURKSTAT. Notes: Income reference periods are the previous calendar Notes: Using per capita income in PPP terms as welfare aggregate year. Per capita income is used as welfare aggregate. Absolute poverty line of US$6.85/day at 2017 PPP. 22 < TÜRKİYE ECONOMIC MONITOR > > > > > > Figure 22: Datt-Ravallion decomposition of poverty reduction Figure 23: The share of casual employment is declining (2020-2021) 2009-2016 2016-2020 2020-2021 Share of Full-time and Casual Employment 100% 50% 1.04 0.34 -1.09 40% -2.61 80% Change in poverty 30% -8.21 rate (in pp); -0.05 Change in poverty 20% 60% rate (in pp); -2.26 10% 40% 0% -2.00 Income growth 1 2 3 4 5 6 7 8 9 10 Change in poverty Redistribution Full-time Em p. 2020 Full-time Em p. 2021 rate (in pp); -10.22 Causal Emp. 2020. rhs Causal Emp. 2021, rhs Source: WB staff calculations using SILC data from the TURKSTAT. Sources: TURKSTAT SILC 2021-2022 Data, WB staff calculations. Notes: Full time employment: worked in a full-time job at least 9 months. Notes: Decomposition based on Ravallion et al. (1991). Taking a long term perspective, the reduction in poverty rate 2010s should have contributed to lower inequality. Yet, inequality is remarkable. The headcount poverty rate declined from 20 increased over this period. One potential explanation for the percent in 2007 to 7.6 percent in 2021. Moreover, the downward rebound of income inequality might be linked with sectoral shifts trend, which stagnated over 2016-2020, remerged with the latest in the economy and demand for different skills.7 The declining available data. However, income inequality -measured by the Gini share of employment in agriculture (from around 20 percent in coefficient- has followed a U shape over the last two decades, the mid-2010s to around 15 percent now), and in construction declining until 2013, before picking up afterwards. Significant (from around 7 percent in the mid-2010s to around 6 percent decrease in informality, increased participation of women in now) could signal a lower demand for low skilled workers, which the labor force, and declining spatial inequalities since the mid- could then have implications on income inequality. 7. Other factors such as wealth concentration, tax policies, wage gaps, automatization, shrinking income share of the middle class and the disproportionate income increase of the top decile could also play a role. Regarding the sectoral shifts, the move from labor-intensive sectors towards more technology- driven industries might leave low-skilled workers behind, leading to stagnant wages and widening income gaps. TÜRKİYE ECONOMIC MONITOR < 23 > II. Looking Ahead Türkiye’s normalization of macroeconomic policies after the elections introduces both opportunities and challenges. The reorientation of monetary policy to restore price stability, the adoption of disinflation as a main policy target by the entire administration, and the strong support for the Medium-Term Program, all contribute to stabilize the markets and build confidence in the economy. Yet, in the near-term economic growth is expected to slow on the back of policy tightening and slow global growth, while domestic (budget) and external (current account) imbalances persist with high inflation. The current outlook therefore calls for a careful calibration of policies aimed at maintaining stability and confidence and protecting the vulnerable and underscores the importance of tackling structural issues to strengthen the economic performance. A. A period of the normalization of macroeconomic policies The recent steps taken towards normalization of macroeconomic policies are expected to boost confidence, mitigate macrofinancial risks, and support the vulnerable After the May elections, the government started implementing the macroprudential measures require a cautious and calibrated a new policy mix centered on reducing inflation while approach. For instance, a rapid exchange rate depreciation would maintaining financial stability and keeping the economy feed into inflation; very strong rate hikes might hit corporates growing. The policy mix includes tight monetary policy and and the financial sector; or a fast unwinding the complex web selective fiscal tightening accompanied with income policies and of macroprudential measures might threaten financial stability. a reform agenda. Given multiple challenges built up over the past few years, a gradual process of policy normalization that New settings for monetary, fiscal, and income policies allows for corrections appears appropriate, though this means have introduced a relative stability in the markets, boosted that it will take time for the results to be evident. The strategy confidence and reduced uncertainties. The current tightening of the government, which was outlined in the Medium-Term of the monetary policy and measures taken to improve fiscal Program announced in September 2023, prioritizes (i) anchoring outlook helped improve the risk perceptions in the economy. inflation expectations relying on a credible (and tight) monetary Reflecting greater investor confidence, CDS spreads have come policy and on forward policy guidance, (ii) building back external down from 679 in mid-May, to under 300 in December, their reserves to comfortably withstand external volatility, and (iii) lowest level in two years; and three major rating agencies have keeping fiscal policy prudent and well targeted to protect the upgraded the outlook for the Turkish economy recently, with one poor. The task is not easy given the complexity of the adjustment of them increasing the rating as well, raising the prospects for needed to achieve macroeconomic stability. Adjusting the policy further upgrades in Türkiye’s sovereign ratings. rate, assuring the flexibility of the exchange rate, and simplifying 24 < TÜRKİYE ECONOMIC MONITOR The policy normalization will likely initially result in a period of depreciated lira and slower economic growth, as the economy corrects the imbalances of the recent past The current policy framework aims at correcting domestic lead to a moderate growth path over the coming years in the and external imbalances to secure macroeconomic baseline scenario. stability. Such a correction is expected to be gradual and to Key Macroeconomic Indicators 2022 2023 2024 2025 2026 Real GDP Growth 5.5 4.5 3.0 3.6 4.3 Inflation (%, year average) 72.3 53.9 57.8 28.9 16.4 Inflation (%, end of period) 64.3 64.8 43.1 23.1 12.2 Current account balance (% of GDP) -5.4 -4.1 -2.8 -2.4 -2.5 General government balance (% of GDP) -1.0 -5.4 -5.4 -3.7 -2.4 Notes: 2023 general government balance and all 2024-2026 values are WB staff estimations. > > > Figure 24: Domestic demand has been the main driver of growth, and to a lesser extent in upcoming years 20 Growth (%), Contributions (percentage point) 10 0 -10 -20 2020 2021 2022 2023 2024 2025 2026 Private Consumption Government Spending Investment Exports Imports Stocks Source: TURKSTAT and WB staff calculations. TÜRKİYE ECONOMIC MONITOR < 25 Economic growth is expected to moderate in 2024 and pick Monetary policy is expected to remain tight, and inflation up in 2025 and 2026. After expanding 11.4 percent in 2021, 5.5 is expected to gradually decline after May 2024. The central percent in 2022, and 4.5 percent in 2023, the economy is expected bank projects inflation to fall to 36 percent by the end of 2024 to grow at 3.0 percent in 2024 according to our estimates (Figure and to continue its downward trend, receding to 14 percent by 24). Economic activity has started to weaken in the second half the end of 2025. The monetary policy is expected to remain of 2023, as inflation eroded the purchasing power of households, tight for a long period to achieve a sustained disinflation path. slower consumer credit growth hampered the frontloading of In this perspective, inflation is expected to peak in May 2024, consumption by households, and external demand weakened. followed by a sizable decline in 2024H2 on the basis of policy Private consumption, which grew strongly in 2023H1 with the impact and the base effects. Inflation will however remain high, help of sizeable wage increases and availability of cheap credit, with end-2024 inflation of slightly above 40 percent and with was the main driver of growth in 2023. Nonetheless, the pace annual average inflation staying above 50 percent in 2024. In our of private consumption appears to have moderated starting in baseline scenario of a period of moderate growth, the disinflation the second half of 2023 due to the monetary policy tightening is expected to be gradual with average inflation staying in double and the slowdown in credit growth, and it is projected to further digits in 2026 as well, while getting closer to single digit levels. slowdown in 2024, and to recover moderately in later years. The increased welfare effect felt by those who have benefitted The current account balance is expected to further improve from the recent rapid increase in asset prices (i.e., house prices, starting from 2024, on the back of the change in growth rents, stock market, FX-protected deposit scheme) may contain composition, relying less on domestic demand with a higher the expected slowdown in private consumption. Government contribution of net exports. In this perspective, the current consumption also had a significant contribution to growth in 2023 account deficit, which remained relatively high in 2023 (4.1 due to the stimulus measures and earthquake reconstruction percent of GDP), is expected to further narrow down in 2024 (2.8 related expenditures. However, going ahead the growth of percent) and onwards. Moreover, the exchange rate is expected government consumption is expected to be much lower in line to continue its gradual depreciation pattern over the medium with the expected fiscal consolidation. Meanwhile, investment term; increased net financial inflows are expected starting from growth was strong in 2023 primarily due to negative real interest 2024H2 with increased confidence in the normalization policies rates on credits which was observed in the first half of the year. and central bank reserves increasing accordingly. However, with the impact of monetary tightening, investment growth is expected to slowdown in 2024 before gradually The general government deficit is expected to be 5.4 percent improving in 2025 and beyond. The contribution of net exports of GDP in 2024, as the earthquake reconstruction adds to has been negative in 2023. The loss of competitiveness from pressures from a rising public wage bill and pensions, before the appreciation of the lira and the slowdown in the major trade a stronger fiscal consolidation is observed in 2025 and 2026. partners have put a strain on exports in the first half of 2023, and Given the expected slowdown in the economy, the revenue despite the recent depreciation of the lira since May. Meanwhile, generation will be more constrained, and the tax revenues to with a strong domestic demand, imports grew rapidly in 2023 as GDP ratio is expected to remain modest, despite an uptick due well. In 2024 and onwards, however, the composition of growth is to tax rate hikes in 2023. Accordingly, the deficit is expected to expected to be more balanced with lower contribution of private be covered by additional borrowing and the debt to GDP ratio is consumption, and a positive contribution of net exports. expected to gradually increase in our baseline scenario. 26 < TÜRKİYE ECONOMIC MONITOR Commitment to tight monetary policy until inflation expectations are anchored will support confidence, but the disinflation will be challenging. Disinflation has been set as the main target of the macro digits (Figure 26). Third, the pass-through of shocks to inflation policy mix by the new economic team in the government has strengthened (Box 1). Therefore, the commitment to tight and the CBRT. The MPC of the central bank have started a monetary policy until expectations are anchored to the inflation cycle of aggressive increases in the policy rate, unquestionably path forecasted by the authorities is needed for disinflation to reversing the earlier policy approach. The firm commitment of be successful, as also highlighted by the CBRT. The CBRT also the government to disinflation has also been declared in the conducts liquidity measures to complement policy rate hikes. MTP. Nonetheless, the disinflation process will be challenging. While these measures may help lower inflation in the short First, the persistency of inflation, measured as the dependence term, continuation of a tight monetary stance with clear forward of current inflation to lagged inflation, has increased considerably guidance will be essential to help avoid excessive volatility in the recently (Figure 25). Second, despite a decline in medium term capital markets, address dollarization, ease pressure on the lira, inflation expectations -primarily for 12 and 24-months ahead-, anchor inflation expectations, and reduce inflation. even the 5-year ahead inflation expectations are not yet in single > > > > > > Figure 25: Persistency of inflation has increased Figure 26: Even 5-year ahead inflation expectations are not in single digits Rolling Coefficients of Lagged Inflation Inflation Expectations (%) 50 12-month ahead 0.8 0.6 40 24-month ahead 5-year ahead 0.4 30 0.2 20 0 10 -0.2 0 Oca… JulyTe… Oca… Te… Oca… Te… Oca… Tem-13 Eki-15 Tem-16 Eki-18 Tem-19 Eki-21 Tem-22 Eki-09 Tem-10 Eki-12 Oca-18 Nis-20 Oca-21 Nis-23 Oca-09 Nis-11 Oca-12 Nis-14 Oca-15 Nis-17 Jan 09 09 July 10 11 Jan 12 12 July 13 14 Jan 15 15 July 16 17 Jan 18 18 July 19 20 Jan 21 21 July 22 23 21 Apr 21 21 Oct 21 22 Apr 22 July 22 Oct 22 Jan 23 Apr 23 July 23 Oct 23 Jan 24 Nis-21 Eki-21 Nis-22 Eki-22 Nis-23 Eki-23 Apr Oct Oct Oct Apr Apr Apr Oct Apr Oct Jan Jan Sources: TURKSTAT, WB staff estimates. Sources: CBRT. Notes: The coefficient of past inflation in a regression where seasonally adjusted CPI inflation is regressed on its own lag, controlling for exchange rate, oil price, industrial production, and minimum wage changes, is reported for rolling samples of 48 months. Last sample ends in July 2023. TÜRKİYE ECONOMIC MONITOR < 27 The growth-inflation tradeoff will likely kick-off starting in faster disinflation. Moreover, a frontloaded tightening also helps the last quarter of 2024. After peaking in 2024Q2, inflation is prevent inflation from becoming stickier and costly to reduce to expected to start falling in the second half of the year with the targeted levels in terms of forgone growth. On the other hand, a impact of monetary policy tightening and with the help of base strong frontloaded tightening has initial contractionary impacts effects. However, reducing inflation over the medium term (along on the economy and may raise financial stability concerns as path outlined by the authorities) will entail a period of slower it may increase risks on corporate vulnerability, specifically for economic activity (reflecting the tradeoff between growth and small businesses, (see section III). The central bank’s latest inflation). The gradual approach considered in our baseline Inflation Report alludes to another intermediate scenario where scenario outlined above, contains a moderate growth scenario in inflation reaches single digits in 2026, which comes at the cost the medium term and therefore a gradual disinflation path. This of a sizeable output gap over the disinflation process pointing approach of very gradual disinflation runs the risk of not effectively to a slower growth (but not a contraction) than in the baseline controlling the inflation expectations, which could further extend scenario discussed above. Overall, all alternative policy choices the duration of the disinflation process. An alternative scenario have pros and cons, and therefore a clear communication would be a frontloaded monetary tightening, which is more strategy is needed to bring the support of all the economic effective in anchoring inflation expectations and securing a agents to achieve a sustained disinflation.8 The gradual adjustment of financial sector policies to reconverge to international standards will strengthen financial stability The government and the central bank have already taken borrowing costs amid a slowing economy, which could negatively steps to improve the macro financial regulatory environment affect corporates financial soundness and lead to asset quality and continue converging with international norms. Policy risks for banks. Removing or quickly tightening forbearance efforts have been aligned with the FSAP recommendations. 9 and faster monetary tightening without a consistent decrease in The CBRT’s efforts to increase the Lira’s share in banking macroeconomic and financial stability risks, along with stabilizing system and streamline access to credit and export loans are FX rate, amid high stock of FX deposits and the FX-protected part of a broader strategy to enhance the monetary transmission deposit scheme might cause potential stress for the financial mechanism. Simultaneously, the Banking Regulation and sector. Carefully planned and well-communicated approach to Supervision Agency (BRSA) should enhance its ongoing process normalizing policies will help to reduce overall financial risk. of realigning regulatory standards with international norms to improve banking sector transparency. A significant focus is on Türkiye can benefit from the accelerating global trend managing systemic foreign exchange (FX) risks, exacerbated by of investors seeking green investment opportunities. the close relationship between the CBRT and domestic banks, Türkiye’s vulnerability to climate change necessitates significant with a substantial portion of the CBRT’s FX liabilities tied to these investment in climate mitigation, adaptation, and resilience, banks. This necessitates a more assertive supervisory approach, as highlighted in the World Bank’s Türkiye Country Climate including contingency plans for FX shocks and enhanced liquidity and Development Report (CCDR).10 A projected investment of risk monitoring. Clear policy communication, effective corporate US$165 billion is required from 2022 to 2040, in addition to the insolvency, and debt resolution frameworks, coupled with a US$482 billion baseline in sectors like power, residential, and financial policy framework aligned with international standards, transport. Accessible and affordable long-term finance will be are vital for de-risking the corporate and financial sectors. needed for sustainable economic growth, the green transition, and job creation. This underscores the financial sector’s critical The policies follow a balanced approach to maintain role in mobilizing capital for Türkiye’s green transition, going financial stability while addressing existing challenges. beyond the capacities of the public sector and banks, and The recent tightening in the policy rate is translating into higher necessitating the involvement of private capital. 8. As also alluded by the CBRT, the current policy rate tightening cycle is approaching to its limits. Our estimations based on Taylor rule type of analysis suggests that the current level of the policy rate is close to the levels consistent with reaching the disinflation path envisaged by the CBRT in 2024. Meanwhile, the tightness of the monetary policy should be maintained until the inflation expectations are in line with the targeted disinflation path for later years. 9. The Financial Sector Assessment Program helps countries identify financial system vulnerabilities and appropriate policy responses. The most recent report for Turliye is found here: https://www.imf.org/en/Publications/CR/Issues/2023/08/17/Republic-of-Trkiye-Financial-System-Stability-Assessment-538281 10. https://www.worldbank.org/en/country/turkey/brief/key-highlights-country-climate-and-development-report-for-turkiye 28 < TÜRKİYE ECONOMIC MONITOR The development of a conducive environment for green identification, measurement, monitoring and control of climate- finance is essential, particularly in anticipation of the related risks to which the banking sector may be exposed, and growing financing demands due to the increasing frequency this guideline is planned to be put into practice by the end of 2024. and severity of natural disasters. Regulators are at the forefront In the capital markets, the Capital Markets Board (CMB) issued of greening the financial sector. The BRSA’s Sustainable Banking the “Guidelines on Green Debt Instruments, Sustainable Debt Strategic Plan marked an early step in this direction, followed by Instruments, Green Lease Certificates, and Sustainable Lease the collaborative effort with the Banking Association to develop Certificates” in 2022, promoting green capital market instruments the Green and Sustainable Banking Guideline, aligning with and enhancing their capacity in sustainable and green finance international best practices. Subsequently, the Green Asset Ratio analytics. This comprehensive approach aims to foster a robust, Communique and Climate Risk Management Guidelines were inclusive, diversified, and sustainable financial system in Türkiye, introduced last year. A Draft Guideline on Effective Management aligning with macroeconomic fundamentals and international of Climate-Related Risks by Banks has been prepared for the banking standards, clarifying regulatory roles, and bolstering the central bank and financial regulators’ operational independence. Elevated investment needs and high inflation warrant a cautious and well targeted fiscal policy  Securing the disinflation requires support from fiscal policy Effective use of available fiscal space whilst maintaining as well. The previous loose monetary policy stance had put much fiscal sustainability will be important going forward. In the pressure on fiscal policy measures to compensate for the widening MTP, the government announced projections for the fiscal balance external imbalances and to help ease the pressures on the lira (such with and without expenditures related to earthquake recovery. For as with the introduction of FX-protected deposit scheme). With 2023, the budget deficit was predicted to be 6.4 percent of GDP the normalization of the monetary policy stance, fiscal policy can including earthquake related expenditures (current and capital), and now concentrate on the earthquake recovery related investments a lower 3.4 percent of GDP when earthquake related expenditures needs, and on supporting vulnerable groups against high inflation, are excluded. Meanwhile, the realization was 5.2 percent of GDP while keeping a prudent fiscal stance. To support the disinflation, including earthquake related expenditures, 1.6 percent of GDP changes in administered price and public wage adjustments should when earthquake related expenditures are excluded. This suggests be benchmarked against the predicted inflation path, rather than a deterioration in the fiscal performance compared to previous years. historical inflation, as already been indicated in the MTP. Moreover, according to the MTP, the budget is expected to yield a primary surplus only in 2026. This very gradual return to primary surplus may reduce the effectiveness of the polices for disinflation. A new window of opportunity to consider structural reforms The period ahead also provides opportunities for tackling of the economy and competition, and to boost productivity, which structural issues. In the 2024-2026 MTP, the government has in return will ease the output cost of achieving disinflation. expressed its commitment to advance structural reforms over the next three years on areas including growth and trade, human The greening of the economy stands out as an important capital and employment, price and financial stability, public opportunity that could lead to both higher growth and finance, disaster management, green and digital transformation, increased productivity. For example, the European Union’s business and investment environment. For instance, reforms Carbon Border Adjustment Mechanism (CBAM), which will come addressing structural issues related to price stability (such as into full force in 2026, is an opportunity for the Turkish industry. backward-looking wage indexation), and to financial stability With geographical advantage, strong trade links with the EU and (such as improving the macro financial regulatory environment), having started decarbonizing the power sector, Türkiye can be a will make the transmission mechanism work better and thus first mover and use the comparative advantage by decarbonizing help achieve macroeconomic stability faster. Reforms aimed at its industry, to secure competitiveness gains and boost productivity. ensuring flexibility in the labor market, improving the business Also, in a broader context, addressing climate change challenges and investment environment, enabling digital transformation, and constitutes an important opportunity for Türkiye in achieving a deepening trade opportunities, will all help to increase the resilience sustainable and resilient future.11 11. Transatlantic Policy Quarterly, Addressing Climate Change in Türkiye: An Opportunity for a More Sustainable and Resilient Future - Vol. 22 · No. 3 · Fall 2023; http://transatlanticpolicy.com/issue/90/addressing-climate-change-in-turkiye-an-opportunity-for-a-more-sustainable-and-resilient-future TÜRKİYE ECONOMIC MONITOR < 29 B. Several risks can affect the path of economic growth and poverty reduction While the new macroeconomic policy mix represents a position while strong, is vulnerable to rising borrowing costs, the significant change in a positive direction, it is important high share of FX-denominated debt, growing current and capital to remain committed to pursuing these policies. The new expenditures related to earthquake recovery, increasing rigidity direction in macroeconomic policies following the May 2023 of public expenditures, and pressing needs to support vulnerable elections has been welcomed by domestic and foreign investors, groups during the disinflation phase. Moreover, despite an as reflected in the significant reduction in CDSs and the increase in FX reserves and a decline in the current account change in the outlook by credit rating agencies, with one rating deficit in the second half of 2023, external risks still remain given upgrade, which are important initial achievements. However, the the relatively high current account deficit and the high external authorities’ commitment to these policies, which will determine financing requirements. Further, in a global context where the the nature and duration of the necessary macroeconomic global growth is expected to further decelerate in 2024, the adjustment will be crucial. Staying the course with the policy external demand will contribute to a domestic slow down due normalization would further strengthen the confidence in the to the projected stagnation in global trade and the increased economy. overall uncertainty associated with geopolitical tensions (GEP January 2024). Also, the period ahead distinguished Moreover, there are several downside risks in the near by monetary tightening and slowing growth prospects may term. While the new macroeconomic policy mix will return the trigger vulnerabilities in the corporate sector which may have economy to a macro sustainable path, vulnerabilities to domestic repercussions on financial sector (see Section III). Each of these and external shocks remain elevated. The government’s fiscal areas of risk are elaborated below. Fiscal risks accumulate on earthquake related expenditures, contingent liabilities, wages   Rising contingent liabilities and rigid expenditures may the burden of the scheme on the fiscal side. Also, steps taken by increase fiscal risks going forward. The main priorities of the central bank helped the initiation of destocking of the scheme, Türkiye’s debt management policies are the sustainability with the value of FX protected deposits falling to around US$90 and reduced sensitivity of the debt stock to macroeconomic billion at the end of 2023, from its peak of around US$140 billion variables. Nonetheless, the high share of FX-denominated debt in August. Additional risks relate to wages of public servants (64 percent as of December 2023) makes further depreciation and retirees, and to the changes in the retirement system. The of the lira a major risk to the public debt burden (Figure 27). wage adjustments were expected to be in line with the expected Rapid exchange rate movements can also adversely affect the disinflation path as mentioned in the MTP, however, together with fiscal position through lending to SOEs to cover import bills the inflation differences, the wages increased by 49.3 percent (primarily energy), PPP debt assumption commitments, and in January 2024. Moreover, in addition to the approval of the PPP guarantees, for which the allocated appropriations in the early retirement scheme in 2023, the recent plans to shorten the central budget law may fall short if the depreciation exceeds retirement eligibility criteria for self-employed will further increase the projected level. The transfer of the FX-protected deposits the risks fiscal expenditures. Meanwhile, the expected slowdown originating from TL deposits to the central bank helped reduce in economic activity will highlight the risks on fiscal revenues. 30 < TÜRKİYE ECONOMIC MONITOR > > > > > > Figure 27: Currency composition of government debt poses risks Figure 28: The share of rigid expenditures in the budget is high Share in Central Government Debt Stock Rigid expenditures in Budget 100% 80% 80% 60% 60% 40% 40% 20% 20% 0% 2023* 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 0% 03 June 04 Sep 05 Dec 06 08 June 09 Sep 10 Dec 11 13 June 14 Sep 15 Dec 16 18 June 19 Sep 20 Dec 21 23 Eyl-05 Ara-06 Eyl-10 Ara-11 Eyl-15 Ara-16 Eyl-20 Ara-21 Mar-03 Mar-08 Mar-13 Mar-18 Mar-23 Haz-04 Haz-09 Haz-14 Haz-19 Personnel exp. Social security contr. March March March March March Purchase of g&s Current transfers Capital expenditures Cap ital transfers TL FX Lending Interest exp. Sources: Ministry of Treasury and Finance. Sources: MTOF, WB Staff estimates. *2023 first 9 months. Moreover, the increase in the share of rigid expenditures around three-fourths of budget expenditures are considered in the budget significantly reduces the flexibility of fiscal as rigid, significantly leaving a smaller room for reprioritizing spending. Recent estimates suggest that, despite being close expenditures. In addition, capital expenditures, a large proportion to historical averages, the rigidity of the budget expenditures of which is considered as flexible, will also exhibit additional has increased in 2023, primarily due to heightened personnel rigidity in the near term due to earthquake related investments. expenditures and interest payments (Figure 28).12 Accordingly, External imbalances continue despite a recovery in reserves Despite a modest return of capital inflows and recovering the central bank (Figure 29). There could be a risk of competing reserves, Türkiye’s external balance sheet remains demand for FX between the Central Bank and commercial vulnerable amid high external financing needs and banks in the event of a future shock. Moreover, gross external continued lira depreciation. Non-resident net portfolio inflows financing requirements (GEFR) are expected to increase in turned positive for nine consecutive weeks following the May 28 the coming months. Excluding foreign exchange currency, the elections after a net outflow of US$1.6 billion between January deposits of non-residents, and trade credits, the monthly GEFR and the elections, and have been volatile since, with net inflows is estimated at around US$8.9bn between up to October 2024 totaling US$5.5 billion since the elections (as of February 9 (Figure 30). A large proportion of debt maturing is expected to 2024). As a result, central bank net reserves have started to be rolled over, resulting in a much lower net external financing recover, albeit slowly, reaching US$28.8 billion in early-February requirement. However, continued depreciation of the lira would 2024 from US$–5.7 billion in early June 2023. But swaps with put additional pressure on external balances, as according to other central banks and domestic banks continue to make up the Central Bank’s March Survey of Market Participants, the lira a significant portion of foreign currency reserves , as well as13 is expected to continue to depreciate over the next 12 months, commercial banks’ FX-denominated required reserves held at reaching 42.8 TL/USD. 12. An approach to classify the rigid expenditures in Türkiye is proposed by Çebi (2015). Instead of classifying the expenditures by entire categories, the study determines the share of flexibility of each major spending item in the budget. Using this approach, the rigidity in the budget has been calculated for the recent period. 13. As well as other aggregate short and long positions in forwards and futures in currency markets. TÜRKİYE ECONOMIC MONITOR < 31 > > > > > > Figure 29: Swaps and FX required reserves make up a Figure 30: External financing needs are increasing in the significant portion of foreign currency reserves coming months International Reserves and Short-term Gross External Financing Requirement Drains as of Feb. 9, 2024 (billion USD) (billion $) 200 20 Other 150 12m public 10 Other debt service 0 100 Gold FX required reserves -10 Şu Jan 25 24 24 4 24 M Apr 24 4 24 4 24 4 24 Aug 24 Ek Sep 24 Oct 24 50 M Feb March H May TeJune Ağ July FX 4 24 4 4 24 Swaps -2 l- 2 -2 -2 i-2 -2 -2 b- i s- u- ar ay ca m az Ey N O - Non-interest CAB Fin. co rp. Non-fin. corp. Assets Short-term drains Government Pub lic b anks Source: CBRT Source: CBRT, Ministry of Treasury and Finance, WB staff estimates Notes: Other assets includes IMF reserve position and SDRs. Swaps and calculations. include aggregate short and long positions in forwards and futures in Notes: Does not assume any changes in foreign exchange deposits and foreign currencies vis-à-vis the domestic currency (including the forward excludes trade credits. leg of currency swaps). FX required reserves include other contingent liabilities. Other short-term drains include collateral guarantees on debt falling due within one year and other accounts payable and receivable. > > > Box 2: Measuring the international reserve position of the CBRT When assessing a central bank’s reserves, several terms are used to describe the nature and composition of the reserves. These include: • Gross reserves – Gross reserves represent the total holdings of foreign currency and gold (or other precious metals) by a central bank as well as IMF reserve position and SDRs. Gross reserves are used to manage the value of the domestic currency and to cover international debt obligations, among other purposes. In early-February 2024, gross reserves of CBRT amounted to US$134.9 billion. • Net reserves – Net reserves are gross reserves minus short-term foreign currency liabilities and forward commitments. In other words, net reserves show the amount of reserves that are readily available without any impending liabilities, and thus is a more accurate measure of the ability to deal with external economic shocks. In early-February 2024, net reserves amounted to US$28.8 billion. • Liquid reserves – Liquid reserves, which refer to those assets that can be quickly and easily converted into cash or other liquid assets without significant loss of value, usually consist of cash, Treasury bills, and other highly liquid assets. These are crucial for countries and institutions to meet their short-term obligations and to intervene in the foreign exchange markets if needed. In early-February 2024, liquid reserves are estimated by World Bank staff to be US$41.1 billion. 32 < TÜRKİYE ECONOMIC MONITOR Global economy is on a low-growth trajectory with amplified geopolitical tensions Global growth is expected to experience a significant but have deteriorated notably, reflecting weaker indicators for decline in 2023, with a further slight downturn in 2024. The employment growth and order backlogs. While the United States impact of tight monetary policy and weakened trade persists, experienced robust growth due to strong domestic demand, the alongside the long-lasting damages from the COVID-19 crisis euro area growth remains sluggish, and economic momentum and the shock from the Russia’s invasion of Ukraine. Over the weakened in emerging and developing economies (EMDEs). past months, global activity has continued to slow with global Growth is expected to decelerate in advanced economies in industrial production (excluding China) decreasing slightly at the 2024, while EMDEs aggregate (excluding China) is projected end of 2023 Q3 (Figure 31). The manufacturing sector remains to rebound modestly from a cyclical low. However, the outlook weak, with elevated financing costs and decelerating global goods remains challenging in many countries facing elevated financing demand. PMIs for services sectors continue to signal expansion costs, high debt, and geopolitical conflicts. > > > > > > Figure 31: Global IP slightly decreased in Q3 Figure 32: Euro area activity is still weak 1.0 Industrial Production, percent change, 3- PMI and Industrial Production (percent m average 58 change, 3-m av.) 3.0 0.5 54 1.5 50 0.0 0.0 46 -1.5 -0.5 42 -3.0 July 22 Sep 22 Nov 22 Jan 23 March 23 May 23 July 23 Sep 23 -1.0 May 22 July 22 Sep 22 Nov 22 Jan 23 March 23 May 23 July 23 Sep 23 Industrial production, rh s May-22 Tem-22 Eyl-22 May-23 Tem-23 Eyl-23 Oca-23 Mar-23 Kas-22 Manufacturing PMI Composit e PMI Sources: Haver Analytics; World Bank. Sources: Haver Analytics; World Bank. Sluggish euro area growth may restrain Türkiye’s export Despite the monetary policy tightening cycle approaching performance. Growth decreased slightly by 0.1 percent (q/q to an end, global interest rates are likely to remain high sa) in 2023Q3, and to the same extent in Germany, Türkiye’s for a longer period. Global headline and core inflation are main export destination. Manufacturing activity in particular decelerating, reaching both 4.3 percent in October, in the context remains lackluster, with manufacturing PMI in contractionary of a slow decline in commodities prices–but with levels still above territory-below 50- as of November (Figure 32). The subdued the 2015-2019 average. Inflation remains above the targets in growth outlook in the euro area puts risks on Turkish exports many countries. Higher-for-longer path of policy rates than was and economic activity since the EU is the main trading partner of expected in June 2023 and lagged effects of the tight monetary Türkiye and the income elasticity of exports to EU is higher than policy will continue to prevent a more dynamic recovery, most of other main export regions. 14 the advanced countries continue to tighten (Figure 33). The tight monetary stance in advanced countries both increases the cost of external borrowing for Türkiye and limits the inflow of financial funds putting pressure on Turkish lira. 14. Culha and Kalafatcilar (2014) find that the income elasticity of Türkiye’s exports to Euro area is higher than to other regions. TÜRKİYE ECONOMIC MONITOR < 33 > > > > > > Figure 33: Policy rates are rising in advanced economies Figure 34: Oil price remain high Policy rates, percent of ccountries 100 Brent Crude Oil Spot Price 80 (USD/barrel) 150 60 40 100 20 50 0 0 22Q3 22Q4 23Q1 23Q2 23Q3 22Q3 22Q4 23Q1 23Q2 23Q3 Dec 18 June 19 Dec 19 June 20 Dec 20 June 21 Dec 21 June 22 Dec 22 June 23 Dec 23 24 Dec 24 Ara-18 Ara-19 Ara-20 Ara-21 Ara-22 Ara-23 Ara-24 Haz-19 Haz-20 Haz-21 Haz-22 Haz-23 Haz-24 June EMDEs Advan ced economies Increased Unchanged Decreased Sources: Haver Analytics; World Bank. Sources: Energy Information Agency forecast, November 2023. Overall, risks to the global economy are still tilted to the impacts on financial markets, trade, confidence, and commodity downside. Stickier-than-expected inflation could trigger a further -primarily energy- prices (Figure 34). Other risks include financial tightening of monetary policies and a potential reversal in risk stress related to sharp increases in long-term yields, lower-than- sentiment in financial markets. The recent conflict in the Middle expected activity in China, trade fragmentation, and climate- East, coupled with Russia’s invasion of Ukraine, has significantly related disasters. heightened geopolitical risks, with potential adverse global Slowing economic growth poses risks to poverty reduction in the medium term   Türkiye has made considerable progress in reducing that slowing growth may limit the government’s ability to protect poverty, but recent developments pose challenges to the poorest due to lower fiscal revenues. More equitable continuing sustained poverty reduction. First, economic growth and prioritizing income inequality reducing policies are growth is slowing down. There will be less growth in incomes, needed to ensure sustained poverty reduction over the long which has been a primary driver of poverty reduction until now run. The protective capacity of the fiscal policies in Türkiye are (Figure 22). Second, increase in income inequality poses a risk to mainly channeled to protecting the vulnerable -through current sustained poverty reduction. International evidence suggests that transfers- rather than directly targeting redistribution.16 Social inequality deters poverty reduction.15 The recent policy changes assistance programs and pensions are well targeted, but should – such as increase in minimum wages in 2022 and 2023 - may be scaled up to mitigate income inequality. Also, the significant sustain poverty reduction in the short run, as in 2021. However, role of indirect taxes -which are regressive in nature- limits the such a reduction may not be sustainable, especially considering potential benefits of taxation in correcting income inequality. 15. For instance, Lakner et al. (2019) find that reducing each country’s Gini index by 1 percent per year has a larger impact on global poverty than increasing each country’s annual growth by 1 percentage point above forecasts. 16. According to OECD, redistribution plays a limited role in Türkiye compared to OECD averages. https://www.oecd-ilibrary.org/economics/income-redistribution-across-oecd-countries_3b63e61c-en 34 < TÜRKİYE ECONOMIC MONITOR > III. Special Topic Corporate vulnerability in Türkiye and linkages to financial sector The corporate sector represents the dynamic part of the borrowing costs, and partly due to buoyant domestic demand economy which has proved its resilience against various helping the corporates improve their profitability (Figure 35). shocks over the years. Since the currency shock in 2018, the Concurrently, the corporate sector has significantly lowered its corporate sector has enjoyed an improvement in its profitability open position to reduce the exchange rate risk in their balance and capacity to cover interest payments, partly due to loosened sheets (Figure 36).17 These have helped strengthen the resilience monetary policy and selective credit policies which lowered of the corporate sector. > > > > > > Figure 35: Interest coverage and profitability of corporate Figure 36: Corporate sector has lowered its open position sector increased Selected ratios of the corporate sector 300 Corporate sector open position 30 8 6 200 20 4 100 10 2 0 0 0 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09 Mar-10 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19 Mar-20 Mar-21 Mar-22 Mar-23 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Profit before interest and tax / Interest expenses Net profit / Total assets (%) Billion USD Net profit / Net sales (%) % of 4-quarter rolling GDP, rhs Sources: CBRT Sectoral Accounts Sources: CBRT A closer look at the soundness of corporates can be traced with corporate vulnerability for all firms, after declining in 2010 increased corporate vulnerability indicators. Using the detailed sectoral in 2016 and peaked in 2018, both years featured an exchange rate balance sheets provided by the CBRT, a corporate vulnerability shock and a contraction in the economy (Figure 37). Afterwards, the indicator comprising of five subcomponents has been generated.18 corporate vulnerability has declined, more significantly in 2022 amid The indicators are generated both for sectoral balance sheets strong economic activity and falling cost of borrowing, potentially containing all firms, and for different firm sizes.19 Accordingly, the enabling firms to act countercyclically and to rebuild some financial buffers. 17. In a recent study, Pienkowski (2023), investigating the exposure and interconnectedness of the FX balance sheets of sectors in Türkiye, argues that despite considerable deleveraging pursued by non-financial corporations, they still play an important role in the FX network. 18. The corporate vulnerability indicator builds on the methodology used in the ECB Financial Stability Report, November 2020 by Gardó et al. (2020). The indicator aims to track the time-varying impact of several driving factors of the financial soundness of the corporates. The indicator combines relevant factors under five different components with the following sub indicators: Debt service capacity (interest coverage ratio and revenue generation); leverage/indebtedness (debt-to- equity and net debt-to-EBIT ratios); financing/rollover (short-term debt-to-long-term debt ratio, quick ratio -defined as current financial assets/current liabilities-, overall cost of debt financing and credit impulse -defined as the change in new credit issued as a percentage of GDP); profitability (return on assets and profit margin); activity (sales growth, trade creditors ratio and change in accounts receivable turnover). The sub indicators are standardized with mean zero and standard deviation of one. Then, for each component, the average of standardized indices is calculated for each sector. All the subcomponents are then equally weighted and summed to produce the corporate vulnerability indicator for the sector. For the aggregate measures, sectoral level vulnerability indicators are aggregated by weighting with the size of total assets. For the indicators, positive/negative values refer to an increase/decrease in the corporate vulnerability. 19. The sectoral accounts data provides an aggregate measure for sectors at different levels of disaggregation. For the sector total, three-digit NACE classification is used. For the size disaggregation, sectoral classification at two-digit level is used. In the size breakdown, different aggregates for large, medium, small and micro firms in each sector are available. The classification of firms into categories are as follows: Micro, small and medium firms have less than 10, 50 and 250 employees respectively. Meanwhile large firms have more than 250 employees. TÜRKİYE ECONOMIC MONITOR < 35 The evolution of the corporate vulnerability differed across reduction in corporate volatility in the last two years; meanwhile firm sizes. Large firms have the least volatile corporate micro firms’ vulnerability has declined significantly only in 2022 volatility; large, medium and small firms have enjoyed a similar (Figure 38).20 > > > > > > Figure 37: Corporate vulnerability has declined… Figure 38: …but to a different extent by size 2.0 Corporate Vunerability, All Firms Corporate Vulnerability by Size 2.0 1.0 1.0 0.0 0.0 -1.0 -1.0 -2.0 -3.0 -2.0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 -3.0 Large Medium Small Micro 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Sources: CBRT Sectoral Accounts, WB Staff calculations. Sources: CBRT Sectoral Accounts, WB Staff calculations. By the construction of the indicator, it is possible to follow corporate vulnerability in micro firms has increased in 2021 the sources of the changes in corporate volatility for before declining in 2022 to a lesser extent than other firms. different firm size groups. Large firms have enjoyed a steady The micro firms’ debt service capacity has improved over the decline in corporate vulnerability backed by all subcomponents recent years despite their leverage/indebtedness remaining in 2021 and 2022, while improved activity, debt service capacity as a constraint. Also, over the covid period of 2020-21, these and profitability played a big role (Figure 39). Medium and small firms have experienced a significant drop in their profitability, firms benefited from higher profitability only in 2022, where they contributing to the vulnerability. Looking at the earlier episodes, have enjoyed the largest reduction in corporate vulnerability. while the corporate vulnerability peaked in 2016 in medium and Overall, the widespread reduction in corporate vulnerability in small firms, large firms’ vulnerability has peaked in 2018, when 2022 was mainly driven by lower cost of borrowing backed by the open positions of the corporates reached a very high level loose monetary policy and the strong domestic demand boosting (Figure 36). activity and profitability of the corporate sector. Meanwhile, the 20. This methodology enables a comparison over time, detecting the episodes of vulnerability above or below the mean value for the time period considered. Accordingly, the figure suggests that corporate vulnerability was 1.1 standard deviations higher than the sample mean in 2018, while 2.1 standard deviations lower in 2022. A recent similar analysis for the Euro area shows that vulnerability was around 1.3 and 1.5 standard deviations higher than the sample average in 2009 and 2020, respectively, while around 0.8 standard deviations lower in 2022 (ECB Economic Bulletin, Issue 2/2022). 36 < TÜRKİYE ECONOMIC MONITOR > > > Figure 39: The evolution of vulnerability differs by firm size 2.0 Large Firms 2.0 Medium Firms 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 -1.0 Activity -1.0 Activity -1.5 Profitability -1.5 Profitability Financing/rollover Financing/rollover -2.0 Leverage/indebtedness -2.0 Leverage/indebtedness -2.5 Debt service capacity -2.5 Debt service capacity -3.0 Corporate Vulnerability -3.0 Corporate Vulnerability 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2.0 Small Firms 2.0 Micro Firms 1.5 1.5 1.0 1.0 0.5 0.5 0.0 0.0 -0.5 -0.5 -1.0 Activity -1.0 Activity -1.5 Profitability -1.5 Profitability Financing/rollover Financing/rollover -2.0 -2.0 Leverage/indebtedness Leverage/indebtedness -2.5 Debt service capacity -2.5 Debt service capacity Corporate Vulnerability -3.0 Corporate Vulnerability -3.0 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Sources: CBRT Sectoral Accounts, WB Staff calculations. However, the upcoming period characterized by higher the macroeconomic stabilization policies envisage a change in cost of borrowing, a depreciated Turkish lira and growth the growth composition by lowering the contribution of domestic slowing down may pose challenges to the soundness of demand, limiting the possibility of passing through of cost the corporate sector. Recent changes in the macroeconomic increases onto consumers.21 policy framework following the May elections, with the new economy team prioritizing disinflation and reducing external Specifically, to investigate the sensitivity of corporate imbalances, have been changing the rules of the game for the vulnerability to exchange rate and commercial loan interest corporates. The monetary policy is now on the tightening cycle, rate panel VAR models are estimated.22 In this setting, the the interest rate of commercial loans has been increasing in impact of exchange rate and commercial loan rate shocks are parallel, and the depreciation of around 50 percent observed analyzed through the impulse response functions, which suggest since the elections has further increased the cost of imported that both exchange rate and loan rate shocks significantly inputs. In the meantime, economic growth is slowing down, and increase the corporate vulnerability across all sizes (Figure 40). 21. The recent targeted credit policies supporting the exporting firms’ access to finance, and incentivizing companies to export, and availability of companies’ liquid foreign currency assets and their ability to hedge themselves might alleviate some of the impact of the exchange rate shocks on corporate vulnerability. 22. The panel VAR includes USD/TL exchange rate, average commercial loan interest rates, corporate vulnerability, and controls for GDP growth, inflation, and oil prices in USD, with all variables in stationary forms. The panel VAR allows for controlling for sector specific unobserved fixed effects. Moreover, lags of the variables are used as instruments to alleviate endogeneity concerns, and the models are estimated with one lag, covering the period 2009-2022. The sectoral accounts are available at yearly frequency. Separate models are estimated for sectoral information covering all, large, medium, small, and micro firms. When sectoral data for different sizes are considered, the panel VAR models are estimated with two-digit level disaggregation. TÜRKİYE ECONOMIC MONITOR < 37 > > > Figure 40: Exchange rate and loan rate shocks and corporate vulnerability Sources: CBRT Sectoral Accounts, WB Staff estimations. Notes: The figures show the response of corporate vulnerability to exchange rate and interest rate shocks for different firm sizes using panel VAR estimated at sectoral level estimated for 2009-2022. The pass-through coefficients calculated from the large and medium firms, the impact of an exchange rate shock impulse responses help gauge the impacts more easily. (10 percent depreciation) is higher than 10 percentage point A 10-percentage point shock to credit loan rates increase the increase in the average loan rate.24 Meanwhile, especially for vulnerability of large and medium corporates by 1.9 standard micro firms, the impact of the interest rate shock overweighs the deviation, and that of small and micro corporates by 1.6 standard impact of exchange rate shock, suggesting that micro firms are deviations. Meanwhile, a 10 percent depreciation of the lira relatively more vulnerable to interest rate shocks. Similarly, large increases the corporate vulnerability by 2.2, 2.6, 1.5, and 1.2 and medium firms are more vulnerable to exchange rate shock. standard deviations (Figure 41). 23 What is striking is that for > > > Figure 41: Cumulative response of corporate vulnerability to exchange rate and loan rate shocks by firm size 3.0 Response of Corporate Vulnerability to Exhange rate and Loan rate shocks 2.0 1.0 0.0 Large Medium Small Micro 10 pp increase in loan rate 10% depreciation of TL Sources: CBRT Sectoral Accounts, WB Staff estimations. Notes: The columns show the cumulative response of corporate volatility (in standard deviation units) to 10 percentage point increase in commercial loan rates and to 10 percent depreciation in the USD/TL exchange rate, which are calculated by using the impulse response functions from the panel VAR estimation described above. 23. Considering that the levels of corporate vulnerability range between -2.5 and 1.5, according to Figure 39, the estimated effects of these shocks are sizeable. 24. The finding that large firms are less vulnerable than medium firms to exchange rate shock could point to better ability of large firms to hedge themselves and to reduce their open positions. 38 < TÜRKİYE ECONOMIC MONITOR The changes in corporate vulnerability reflect the changes for medium, small and micro firms respectively (Figure 42).26 in the financial soundness of the firms which is directly Therefore, the corporate vulnerability shocks in manufacturing related with their ability to pay back their loans. Therefore, industry more adversely affect the bad loans for micro firms. an increase in corporate vulnerability is expected to have impact on non-performing loans of the banking sector. To investigate With the tightening cycle of the monetary policy, a this link, another set of panel VARs are estimated.25 The results depreciated Turkish lira and slowing down growth suggest that one standard deviation increase in corporate perspective, corporate vulnerability is expected to be higher vulnerability increases the share of bad loans in total by 0.4 in 2023 and 2024 compared to 2022 figures. Furthermore, percentage points in the services sector and 0.9 percentage micro firms are relatively more affected by changes in the point in manufacturing sector. interest rates, standing out as the most vulnerable portion of the corporates.27 In addition, the increase in corporate vulnerability is In the manufacturing sector, a corporate vulnerability shock likely to impact the non-performing loans of the banking system. has different impacts by firm size. Specifically, one standard Therefore, the fiscal policy measures in support of vulnerable deviation increase in corporate vulnerability increases the share businesses will be crucial in the upcoming period. of bad loans in total loans by 2.5, 2.7, and 7.5 percentage points > > > Figure 42: Cumulative response of the share of bad loans in total loans to corporate vulnerability shock by firm size in manufacturing industry Response of the share of bad loans to corporate vulnerability shock, 10 Manufacturing industry 5 0 Large Medium Small Micro One standard deviati on increase in corporate vulnerability Sources: CBRT Sectoral Accounts, WB Staff estimations. Notes: The columns show the cumulative response of the share of bad loans in total loans to a shock to corporate volatility (in standard deviation units). 25. This set of panel VARs include the non-performing loans calculated at the sectoral level (as the share of bad loans in total cash loans) and the corporate vulnerability, controlling for the growth rate, inflation, and oil price as a proxy for external conditions. The models are separetely estimated for different sizes, and for services and manufacturing sectors. 26. Assuming a normal distribution, estimation of the impact of one standard deviation increase in corporate vulnerability would be the impact for a sector with average vulnerability being as vulnerable as a sector at the 84th percentile. 27. For instance, the average net debt to EBIT ratio -weighted by total assets- for the entire sample of micro firms is 22.3; meanwhile this ratio is 2.7, 6.2, and 12.4 respectively for the samples of large, medium, and small firms, over the analysis period. In manufacturing sector only, this ratio for the sample of large, medium, small, and micro firms are 2.4, 5.1, 10.2, and 27.5 respectively. TÜRKİYE ECONOMIC MONITOR < 39 > References: Çebi, Cem. 2015. Budget expenditure rigidity. CBRT Research Notes in Economics, 2015/23. Culha, Olcay and Kalafatcılar, Koray. 2014. A glance at income and price elasticity of Turkey’s exports: the importance of regional disparities. CBRT Research Notes in Economics, 2014/05. Filiztekin, Alpay and Kent, Oya. 2023. Income distribution and Richness in Türkiye. BETAM Research Note, 23/274. Gardó, Sándor, Klaus, Benjamin, Tujula, Mika, and Wendelborn, Jonas. 2020. Assessing corporate vulnerabilities in the euro area. ECB Financial Stability Review, November. Lakner, Christoph; Mahler, Daniel Gerszon; Negre, Mario; Prydz, Espen Beer. 2019. How Much Does Reducing Inequality Matter for Global Poverty. Policy Research Working Paper; No. 8869. World Bank, Washington, DC. © World Bank. https://openknowledge. worldbank.org/handle/10986/31796 License: CC BY 3.0 IGO. Pienkowski, Alex. 2023. Foreign currency balance sheets in Türkiye, Exposure and interconnectedness. IMF Working Paper, 23/132. Ravallion, Martin, Gaurav Datt and Dominique Van de Walle. 1991. Quantifying absolute poverty in the developing world. Review of Income and wealth, 37(4), 345-361. 40 < TÜRKİYE ECONOMIC MONITOR > Annex 1: Medium-Term Outlook, Nominal Key Macroeconomic Indicators 2020 2021 2022 2023 2024 2025 Population (mid-year, million) 83.4 84.1 85.0 85.8 86.3 86.7 GDP (current US$, billion) 717.1 807.9 905.8 1024.5 1188.9 1216.3 GDP per capita (current US$) 8600.4 9601.3 10659.1 13110.0 13782.7 14028.8 CPI (annual average, in percent) 12.3 19.6 72.3 53.9 57.8 28.9 Real Economy Real GDP 1804.4 2010.8 2122.1 2217.9 2284.3 2366.6 Private Consumption 1076.0 1241.4 1476.1 1664.3 1702.6 1754.5 Government Consumption 259.0 266.9 278.2 292.7 300.0 306.4 Gross Fixed Capital Formation 473.2 507.4 513.9 559.5 575.9 592.8 Net Exports -6.6 84.2 98.1 32.4 37.7 44.8 Fiscal Accounts TL Billion, unless otherwise indicated Total Revenues 1637.2 2239.5 4180.7 6429.3 10543.2 13808.3 12705.6 Total Expenditures 1835.4 2430.8 4300.8 7751.9 15740.4 General Government Balance -198.7 -191.4 -120.1 -1325.5 -2162.4 -1932.1 Primary Balance -56.7 -0.6 204.6 -607.2 -309.8 310.7 Monetary Policy TL Billion, unless otherwise indicated Base Money (M2) 3325.0 5061.7 8218.2 13665.1 - - Average Funding Rate (annual average, in 10.5 17.8 13.0 20.7 - - percent) Gross Reserves (in US$ Billion) 93.6 111.2 128.7 140.9 - - o/w Gold Reserves 43.6 38.5 45.8 48.2 - - External Sector US$ Billion, unless otherwise indicated Current Account Balance -31.9 -7.4 -49.1 -45.5 -33.9 -29.0 Net Foreign Direct Investment 4.4 6.5 8.7 4.7 10.5 13.4 Source: TURKSTAT, CBRT, Strategy and Budget Presidency, WB Staff calculations. TÜRKİYE ECONOMIC MONITOR < 41 > Annex 2: Medium-Term Outlook, Percent of GDP Key Macroeconomic Indicators 2020 2021 2022 2023 2024 2025 Real Economy Annual percentage change, unless otherwise indicated Real GDP 1.9 11.4 5.5 4.5 3.0 3.6 Private Consumption 3.2 15.4 18.9 12.8 2.3 3.1 Government Consumption 2.2 3.0 4.2 5.2 2.5 2.1 Gross Fixed Capital Formation 7.3 7.2 1.3 8.9 2.9 2.9 Exports -14.6 25.1 9.9 -2.7 4.5 5.2 Imports 6.8 1.7 8.6 11.7 3.7 4.2 Fiscal Accounts Percent of GDP, unless otherwise indicated Total Revenues 32.4 30.9 27.8 26.4 26.2 26.2 Total Expenditures 36.4 33.5 28.6 31.8 31.5 29.9 General Government Balance -3.9 -2.6 -0.8 -5.4 -5.4 -3.7 Government Debt Stock 39.4 40.4 30.8 29.5 29.9 30.5 Primary Balance -1.1 0.0 1.4 -2.7 -0.8 0.6 Monetary Policy Percent of GDP, unless otherwise indicated CPI (annual average, in percent) 12.3 19.6 72.3 53.9 57.2 28.9 Base Money (M2) 65.9 69.8 54.7 - - - Gross Reserves 13.1 13.6 14.4 - - - In months of merchandise imports 5.4 5.2 4.5 - - - Percent of short-term external debt 83.4 93.6 86.4 - - - External Sector Percent of GDP, unless otherwise indicated Current Account balance -4.4 -0.9 -5.4 -4.1 -2.8 -2.4 Net Foreign Direct Investment 0.6 0.8 1.0 0.4 0.9 1.1 Source: TURKSTAT, CBRT, Strategy and Budget Presidency, WB Staff calculations. 42 < TÜRKİYE ECONOMIC MONITOR