December 2014 98248  Economic growth disappointed in the third quarter, due to a Headline inflation is peaking. Twelve-month inflation increased shift to inventory destocking. We downgrade our growth slightly to 9.15 percent in November, as food prices continued rising at estimate for the full-year 2014 to 3.1 percent. a high pace. Food prices surged 14.7 percent year-on-year in  The outlook for inflation and the current account has improved November, up from 12.7 percent in October. Non-food inflation eased substantially due to the sharp decline in oil prices. by 0.4 pps to 7.5 percent still well above the official target of 5 percent, while the annual core inflation measure, the CPI-I index, remained  Renewed weakness in the currency showed, once again, that unchanged at 9 percent in November. In seasonally adjusted terms, Turkey is vulnuerable to changes in investor sentiment; the however, monthly inflation has slowed substantially, suggesting 12- room for maneuver on monetary policy thus remains limited. month inflation is set to decline in the absence of shocks. Seasonally The economic outturn disappointed in the third quarter, as a shift adjusted (SA) annualized inflation slowed to 3.8 percent in November from inventory accumulation to destocking more than offset the from 13.7 percent in July, while the annualized core inflation (SA) recovery in other components of domestic demand. Real GDP dropped to 6.0 percent from 10.2 percent. The sharp decline in oil expanded 0.4 percent q-o-q in Q3 2014, after a 0.5 percent contraction prices, the expected mean reversion in food prices, and the favorable in the previous quarter (Figure 1). The year-on-year expansion was 1.7 base effect will support disinflation in early 2015. The renewed percent, the lowest since Q4 2012. Despite a disappointing headline depreciation trend in the Lira is the main downside risk on the positive number, the composition of growth became more balanced. Private inflation outlook. consumption and private investment recovered markedly, and government spending expanded at a reasonable rate. Moreover, net External adjustment continued through October, thanks to the exports continued to support growth. Turkey’s growth rate resilience of exports. The 12-month rolling current account deficit outperformed that of Brazil, South Africa, and the Euro Zone, but fell declined to 5.7 percent of GDP in October from 6.5 percent in June. behind in comparison to Hungary, Poland, Romania, China, UK, and Gold trade accounted for 0.2 pps of the adjustment, while the remaining USA. We revise down our estimate of GDP growth in 2014 to 3.1 0.6 pps came from non-gold components. Despite a slowdown in the percent from our October forecast of 3.5 percent. second half of the year, exports to the EU remained the main drivers of export performance in 2014. Weak domestic demand led to a decline in Despite strong job creation, unemployment increased as the labor imports which contributed to the adjustment. We expect weaker export force expanded rapidly. Supported by industry and services, in performance going forward, mainly because of weak EU growth and September the economy created 113 thousand non-farm jobs in geopolitical tensions, while imports should increase as domestic demand seasonally adjusted terms, compared to 94 thousand in August and 2 recovers, though the increase will be moderated by lower energy prices.i thosaund in July. Industry, construction and services sectors created 49 We estimate the current account deficit at 5.6 percent of GDP in 2014. thousand, 15 thousand, and 49 thousand new jobs, respectively. At the Net FDI inflows amounted to only 16.1 percent of the year-to-date same time, the non-agricultural labor force increased by 210 thousand financing whereas the share of net portfolio inflows, net other in September pushing non-agricultural unemployment up by 97 investment inflows and net errors and omissions stood at 46.6 percent, thousand (Figure 2). The seasonally adjusted unemployment rate in 32.8 percent and 17.9 percent, respectively. Because of the sizable non-agriculture rose to 12.8 percent in September from 12.5 in August. adjustment in the current account deficit, Turkey`s total external The sharp increase in the labor force reflects both demographic change financing requirement over the next 12 months eased to $210 billion (24 and increases in labor force participation among women, both of which percent of estimated GDP). are expected to continue and contribute to raising Turkey’s growth potential over the medium term. Figure 1. Contributions to Quarterly GDP growth – 3Q 2014 Figure 2. Monthly Change in Non-Agricultural (NA) Unemployment Selected Economic Indicators 2013 2014 2015 2016 2017 Real GDP growth rate (percent) 4.1 3.1 3.5 3.7 3.9 Consumer price inflation (end period, in percent) 7.4 9.0 6.7 5.0 5.0 Central government primary balance (in percent of GDP) 2.0 1.3 0.8 0.8 1.2 Gross public debt (in percent of GDP) 39.8 40.9 38.3 35.4 32.0 Current account balance (in billions of US dollars) -65.0 -44.9 -38.4 -44.9 -50.3 Current account balance (in percent of GDP) -7.9 -5.6 -4.5 -4.9 -5.0 Gross external debt (in percent of GDP) 47.2 48.8 48.6 48.0 47.0 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. Budget performance in the first eleven months of 2014 was We expect private consumption to pick up and become the main weaker than last year, but in line with fiscal targets. The year-to- driver of growth again in 2015. In our baseline forecast, we expect date central government budget deficit reached TL11.3 billion in growth to rise marginally to 3.5 percent in 2015, while the current November 2014, equivalent to 34.1 percent of the full year target of account deficit narrows to 4.5 percent of GDP, and inflation moderates TL33.3 billion (1.9 percent of GDP). Meanwhile, the year-to-date to 6.7 percent at year end. Private consumption is expected to continue primary surplus amounted to TL37.1 billion, compared to the official to recover thanks to falling inflation and accommodative fiscal and year-end target of TL18.7 billion (1.1 percent of GDP).ii Weak monetary policies ahead of the June 2015 General Elections. However, consumption spending weighed on tax revenues which increased by despite the positive impact of lower oil prices, political uncertainty and just 7.4 percent y-o-y, compared to 17.1 percent y-o-y in November volatility in global financial markets will continue to weigh on investor 2013. Indirect tax revenues expanded by only 4.7 percent y-o-y, sentiment. The contribution of net exports will turn negative again, as down from 21.8 percent y-o-y in November 2013. While spending the recovery in domestic demand will boost real import growth while traditionally increases in the final month of the year, and despite sluggish EU growth and geopolitical challenges constrain real export lower revenue growth, the government’s fiscal targets for 2014 are performance. Our baseline forecast is predicated on the assumption that attainable. the Federal Reserve and Bank of England will start gradually increasing the interest rates only in the second half of 2015. An earlier The Central Bank (CBRT) reacted to changes in investor than expected tightening of international liquidity presents a downward sentiment by actively managing liquidity. The fall in oil prices, and risk, particularly if it leads the recent turn of investors away from more dovish statements from the US Federal Reserve sparked a mini- Emerging Markets to be sustained. rally in Turkish assets until late November. The benchmark equity index rose 14.5 percent, while the benchmark bond yield dropped 234 Over the medium-term Turkey`s growth prospects depend on the bps in this period. The Turkish Lira was the best performing currency recovery of private investment and this in turn is linked to the against the US dollar among major Emerging Market currencies until implementation of structural reforms. Bewteen 2002 and 2007, November 27. As the pressure on the Lira softened, the CBRT eased private investment was one of the main growth drivers, contributing 2.9 liquidity and the cost of CBRT funding and overnight interbank rates pps or around half of the average annual growth rate during this period. converged towards the policy rate. Since late November, most Since 2012, private investment has been subdued, however. This has Emerging Markets came under pressure once again, and the Lira constrained growth and persistent investment weakness would weigh depreciated 7.4 percent to 2.37 against the US dollar as of December down on the economy’s potential. The Government’s announced 25 17. The CBRT responded to the increased volatility in the FX market Transformation Programs provide an opportunity to regain the by providing less funding (compared to the demand) through the 1- momentum on structural reforms and signal the government’s week repo facility. The average overnight interest in the interbank commitment to a level playing field for all investors. Moving beyond market hit the upper-end of the corridor at 11.24 percent, while the announcements to implementation will be critical. average cost of CBRT funding jumped to 8.78 percent as of December 17. Recent currency volatility once more underscores the vulnerability of Turkey to changes in investor sentiment, which limits the room for maneuver of the CBRT to react to the improved inflation outlook and external adjustment with reductions in policy rates. ____________________________________________________________________________________________ i Please see the complementary Focus Note for a detailed discussion of the impact of falling oil prices on macroeconomic variables. ii Central government budget deficit and primary surplus year-end estimates are updated to 1.4 percent and 1.5 percent of GDP, respectively, in the 2015-2017 Medium Term Program. Contacts: Kamer Karakurum Özdemir: kozdemir@worldbank.org Ayberk Yılmaz: ayilmaz@worldbank.org