98247 October 2014  Economic activity weakened in the second quarter, as European Turkey`s current account deficit continued to decline, but growth faltered and geopolitical tensions grew. external financing needs remain high. The current account deficit,  External adjustment continued but imbalances remain. which widened to 7.9 percent of GDP in 2013 due to large gold imports, sharply declined to 6.5 percent in the 12-months through  Headline inflation remains well above the Central Bank target. June 2014. About 0.8 pps of the adjustment was due to a decline in  Turkey needs to implement structural reforms to strengthen its gold imports. Exports lost momentum in the second quarter, mainly growth potential over the medium term. because of the slowdown in the EU and the disruption in exports to Iraq, while declining imports continued to support the external Economic activity weakened in the second quarter, as net exports adjustment process, as domestic demand remained weak. FDI inflows turned negative and all components of domestic demand – except were lower at $3.7 billion between April and July compared to $4.2 for inventory accumulation – fell. The economy contracted 0.5 billion in the first quarter, as investment appetite weakened on the percent q-o-q in Q2 2014. Private consumption and private back of global growth concerns and growing geopolitical tensions. investment continued to decline, though at a slower pace, and shaved On the other hand, net portfolio inflows picked up to $16.3 billion as off a total of 0.4 pps from GDP growth. Government consumption the risk premium improved following the local elections, whereas net subtracted another 0.5 pps. Lower economic momentum in Europe other investment recorded $2.6 billion inflows. Despite the ongoing together with rising geopolitical tensions caused a fall in demand for external adjustment, risks remain, given the high corporate sector Turkey`s exports. As a result, net exports subtracted 0.5 pps in the open FX position in Turkey (equivalent to 22 percent of GDP) and second quarter of 2014, after adding 2.4 pps in the first quarter. The large gross external financing needs (27 percent of GDP). lack of demand for domestic goods led to inventory build-up, the only driver of economic activity in the second quarter, and added 1.0 Consumer prices continued to increase at rates above historical pps to overall GDP growth. We maintain our 2014 and 2015 growth averages. Annual inflation accelerated to 9.5 percent in August, up forecasts at 3.5 percent, but with increased downside risks. from 7.4 percent in December 2013. Food prices, which have the largest share in consumer basket, surged 14.8 percent in August, Labor market developments paralleled the slowdown in compared to the historical 12-month August average of 9.1 percent. economic activity in the second quarter. Seasonally adjusted Though elevated food prices were the main driver of rising inflation, unemployment increased from 9.1 percent in March to 9.9 percent in the majority of the main groups of the consumer basket observed June. Unemployment in the non-agricultural sector had been price increases above historical averages and added further pressure increasing since September 2012, mostly because the number of new on inflation. The core inflation measure, CPI-I, which excludes food, entrants to the labor force outnumbered the number of jobs created, alcohol, energy, and gold prices, remained high at 9.68 percent in reflecting both demographic factors and the continued increase in August. According to the CBRT`s survey of expectations, year-end female labor force participation rates. Employment creation slowed annual consumer inflation expectations deteriorated rapidly in the last substantially in the second quarter, leading to the highest annual two months, and median expectation increased from 8.30 percent in increase in non-agricultural unemployment (384 thousand) since July to 8.90 percent in September. We revise our end-year annual October 2009. Employment in industry and construction declined in inflation projection up to 9 percent (from 8.2 percent) for 2014, and April-June, while the employment creation in services slowed down. up to 7 percent (from 6.2 percent) for 2015. Figure 1. GDP growth and contributions Figure 2. Annual Change in Non-Agricultural (NA) Unemployment Selected Economic Indicators 2013 2014 2015 2016 2017 Real GDP growth rate (percent) 4.1 3.5 3.5 3.7 3.9 Consumer price inflation (end period, in percent) 7.4 9.0 7.0 5.0 5.0 Public sector primary balance (in percent of GDP) 0.9 0.4 0.6 0.6 1.0 Gross public debt (in percent of GDP) 39.9 40.3 38.2 35.7 32.6 Current account balance (in billions of US dollars) -65.1 -49.9 -52.2 -54.5 -55.4 Current account balance (in percent of GDP) -7.9 -6.1 -6.0 -5.9 -5.6 Gross external debt (in percent of GDP) 47.2 48.1 48.6 48.4 47.8 Foreign exchange reserves (in billions of US dollars) 110.9 112.6 113.4 116.0 116.7 Source: TURKSTAT, CBRT, Undersecretariat of Treasury, and World Bank staff projections. Reflecting falling risk premia the Central Bank (CBRT) cut Turkey’s slowdown in 2014 is not dissimilar to many other interest rates in several steps. The Monetary Policy Committee emerging markets. Reduced growth expectations in China, the (MPC) cut the one-week repo rate by 175 bps between May and July struggling recovery in the Europe and rising geopolitical tensions and and reduced the overnight lending rate by 75 bps to 11.25 percent in risks have all weighed on investor sentiment and led to downward August. As a result, the weighted average cost of CBRT funding revisions in the short term global outlook. Five out of the six largest declined to 8.29 percent in August from 10 percent in mid-May. In export markets for Turkey experienced an economic downturn in the August, with the US dollar strengthening the Turkish lira started to second quarter, which constrained export performance. Economic depreciate again, reaching TL 2.28/USD end September, down 8.6 activity indicators point to continued weak domestic demand in the percent since late July. As a response to increased FX volatility, the third quarter of 2014. Consumer confidence deteroriated in the third CBRT increased the daily foreign exchange selling auction amount quarter by 3.1 percent from a quarter earlier, and the seasonally from a mimimum of $10 million to $40 million on September 29. In adjusted real sector confidence indicator is also below its second addition, CBRT`s tight liquidity management led to an increase in the quarter level, with mild improvements in both indicators in September. share of funds provided through the overnight lending facility. As a Consumer credit growth remains weak as of mid-September; result, the weighted average cost of CBRT funding increased to 8.72 outstanding credit card debts have been declining, supported by macro percent, while the weighted average overnight rate in the BIST prudential measures in place since October 2013. Nonetheless, we interbank repo market rose to 11.24 percent as of end-September. expect a modest recovery in domestic demand in the fourth quarter, as Tighter global liquidity conditions leave little room for the CBRT to a result of recent interest rate cuts. We maintain our growth forecast for support economic growth without putting price and exchange rate 2014 at 3.5 percent, with current account deficit stabilizing at 6.1 stability at risk. percent of GDP in 2014. Downward risks weigh on this forecast, given regional uncertainties, while prospects of monetary tightening in the Fiscal targets are attainable, despite weaker revenue US limit the room for domestic stimulus. And while the authorities performance so far in 2014. The year-to-date central government have some fiscal space to boost domestic demand, this risks budget deficit reached TL2.7 billion in August, compared to a surplus exacerbating external imbalances. Growth prospects through 2015 thus of TL0.2 billion a year ago. Meanwhile, the year-to-date primary remain moderate in our view. surplus amounted to TL30.9 billion in August, down from TL37.9 billion in August 2013. The somewhat weaker fiscal outturn was Structural reforms and stronger economic institutions would lift mainly due to underperforming tax revenues. Year-to-date tax Turkey’s potential growth and could stimulate greater revenues and total revenues grew respectively by 7.6 percent and 8.9 investment. Turkey’s main assets include a young, dynamic percent y-o-y, whereas the expenses were up by 10.1 percent y-o-y in population, a large domestic market, and a strategic location, August. Weak private consumption weighed on indirect tax revenues. combined with strong infrastructure and much improved public In fact, year-to-date value added tax revenues increased only 0.4 services. However, domestic and foreign investors remain deterred by percent y-o-y, while special consumption tax revenues increased 4.2 the unpredictable business climate, and concerns over the strength of percent y-o-y in August. Although income and corporate tax revenues key economic institutions. An increase in investment in innovation as performed strongly, these improvements could not compensate for well as in education and skills is needed to boost productivity growth the deceleration in indirect tax revenues. Still, the end year primary and create enough high productivity jobs to accommodate Turkey’s surplus and budget deficit targets (1.1 percent and 1.9 percent rapidly rising labor force. In the face of less favorable global respectively) are well within reach. In the medium-term, measures to conditions and remaining external vulnerabilities, the drivers of balance the composition of revenues away from cyclical components, along with the measures to downscale the share of non-discretionary Turkey’s growth need to come from inside—a reform boost would do spending would enhance fiscal sustainability. much to restore Turkey’s luster as one of the most dynamic emerging market economies. Contacts: Kamer Karakurum Özdemir: kozdemir@worldbank.org Ayberk Yılmaz: ayilmaz@worldbank.org