98250 July 2015  Public spending offset weaker private demand to keep Turkey`s current account deficit narrowed since January, growth solid in the first quarter thanks to gold exports. However, the gold adjusted deficit, a more accurate measure of external demand, deteriorated due to  Despite declining food prices, lira depreciation and persistent weaknesses in Turkey’s trading partners. The energy increases in oil prices pushed inflation higher. import bill continued to decline despite the rebound in global oil prices since January. As a result, the 3-month rolling gold  Political uncertainty continues after the parliamentary adjusted current account deficit (SA) increased by $2.3 billion to election, creating downside risks to our 2015 growth $12.6 billion in the three months through April. On the financing forecast of 3 percent. side, short-term financial inflows significantly slowed due to election uncertainty, while long-term inflows remained strong. Growth remained resilient in Q1, thanks to public spending Particularly, nonresidents sold portfolio assets as the risk and lower imports. Seasonally adjusted (SA) GDP expanded by premium increased. However, net errors and omissions showed 1.3 percent q-o-q in Q1, a surprisingly strong outcome. The an inflow of $7.8 billion. This, together with a drawdown of expansion of production continued the upward trend since Q3 of foreign exchange reserves by $5.7 billion financed most of the 2014. On the expenditure side, private consumption lost current account deficit. The Central Bank of the Republic of momentum and investment spending declined, this was more Turkey (CBRT) efforts to defend the local currency via daily FX than offset by a rise in public spending and a positive contribution auctions and direct FX sales to public energy importing from net exports. Export performance was strong on the back of companies reduced gross foreign reserves by $9.9 billion to exports of gold, which has been imported in 2014 and drawn $120.7 billion in the five months from January through May 2015. from inventory in Q1. Moreover, significant inventory accumulation in 2014 and weak demand led to a decline in Inflation is likely peaking. Exchange rate depreciation amplified imports in Q1 of 2015. the impact of the oil price rebound since January and outweighed the relief from lower May food prices. Food prices had remained Job creation recovered in Q1, driven by services and high since bad weather in the spring of 2014 led to a poor industry. The economy created 254 thousand new jobs (SA) in harvest, but this effect is slowly disappearing as the 2015 harvest the non-agricultural sector in Q1, while 154 thousand people sets in. Higher local energy prices fed into transport costs, which entered the labor force (SA). The services and industrial sectors together created substantial upward pressure on prices. Against created 222 thousand and 78 thousand new jobs, respectively, this backdrop, the annualized 3-month inflation (SA) increased to while employment in construction sector dropped by 46 12.1 percent in May, from 5.5 percent in March. In parallel, 12- thousand. As a result, non-agricultural unemployment (SA) fell by month headline inflation escalated to 8.1 percent by May. 100 thousand in Q1. However, recent datapoints to a slowdown Looking forward, favorable weather and a better harvest will help in job creation by 92 thousand in the three months through April, bring food inflation down. Under the assumption that further although the decline in unemployment continued thanks to a pressures on the exchange rate can be contained, 12-month slower increase in the labor force. The non-agricultural inflation is likely to decline to 7 percent by December 2015. unemployment rate (SA) dropped to 12.1 percent by April (from 12.2 in Q1). Figure 1. Contributions to Quarterly GDP growth – Q1 2015 Figure 2. Foreign Financial Flows to Turkey (3-Month Sum) Selected Economic Indicators 2013 2014 2015 2016 2017 Real GDP growth rate (percent) 4.2 2.9 3.0 3.5 3.5 Consumer price inflation (end period, in percent) 7.4 8.2 7.0 6.5 6.5 Central government primary balance (in percent of GDP) 2.0 1.6 0.5 0.8 1.1 General government debt (in percent of GDP) 36.1 33.5 31.8 31.1 30.4 Current account balance (in billions of US dollars) -64.7 -46.5 -34.7 -40.2 -44.7 Current account balance (in percent of GDP) -7.9 -5.8 -4.6 -5.1 -5.5 Gross external debt (in percent of GDP) 47.3 50.3 51.0 51.0 51.2 Source: World Bank staff projections, TURKSTAT, CBRT, Undersecretariat of Treasury The CBRT maintained an unchanged policy stance.The CBRT We keep our full year 2015 growth forecast at 3.0 percent. decided to leave its interest rate corridor unchanged at its April, The stronger than expected growth in Q1 is balanced by the May and June meetings. However, the CBRT tightened its uncertain political environment in the aftermath of the June liquidity stance further as a response to FX volatility in the market elections. Leading indicators point to moderate growth in Q2. due to the risks concerning the inflation outlook. The share of Industrial production growth slowed in April, but the momentum is overnight lending in the CBRT`s total lending increased to around still strong. Moreover, consumption spending continued at a good 30 percent by mid-June, from around 15 percent in early April. As pace through April, with greater demand for consumer goods a result, the average cost of CBRT funding has risen, while the despite weak consumer confidence. However, we expect private interbank lending rate remained at the upper end of the policy consumption to lose momentum and investment to remain corridor. The expected FED lift-off will lower the returns on carry depressed in the second half of the year, as households and trade and is likely to put emerging market currencies under corporates are likely to postponekey spending decisions until pressure. The CBRT will thus have limited room to be political uncertainty is resolved. Going forward, the nascent accommodative whilst maintaining financial stability. recovery in the EU and real exchange rate depreciation should support industrial activity and exports in the remainder of the Fiscal balances remained solid in the run-up to the June year. Thus, we maintain our growth forecast at 3 percent for elections. Tax revenues recovered notably in the first five months 2015, with the current account deficit falling to 4.6 percent of GDP of the year, allowing for strong budget spending without a and inflation easing to 7 percent. However, we downgrade our deterioration in fiscal balances. The year-to-date tax revenues growth forecast for 2016 and 2017 to 3.5 percent, against the increased by 14.7 percent y-o-y in May, while non-interest backdrop of uncertain political outlook in a gradually tightening expenses surged by 12 percent in this period. Especially, real global financial environment. spending on goods and services rose by 8 percent y-o-y and supported economic activity in this period. Thanks to strong Developments since the release of the April Turkey Regular revenues, budget balances remained robust with the year-to-date Economic Note issue have changed the distribution of risks budget deficit declining to TL2.4 billion in May, from TL2.8 billion to the growth outlook. Risks are now evenly balanced. On the a year ago. downside, an extended period of political uncertainty, due to failed attempts to form a stable government, may negatively affect The outlook for 2015 depends on the resolution of the investment sentiment and consumer confidence, resulting in political uncertainty following the June 7 parliamentary increased volatility in financial markets. The main upside risk is a election. The AK Party lost its parliamentary majority and recovery in private demand as a result of the quick formation of a coalition building efforts are likely to dominate Turkey’s political stable government. scene for the coming weeks. The outcome is far from certain, and new elections in the coming 12 months cannot be ruled out. Restoring investor confidence is key to growth over the Investors’ initial reaction to the election results was sharp. Turkish short to medium term. Private investment has been weak for the stocks lost 8 percent of their value, and the Turkish Lira last three years and started the year with a decline in Q1. Investor depreciated almost 5 percent to touch 2.81 per USD on the sentiment heavily depends on how the political process resolves morning of June 8. However, financial markets stabilized itself. Structural reforms were on the political back-burner afterwards. Since the trough, the lira appreciated to 2.66 per USD throughout the recent electoral cycle, although the authorities had by June 26, bond yields eased by 65 basis points, and stock been preparing to re-launch structural reforms after the elections. prices rose by 7.4 percent. There is an urgent need for a stable, inclusive government and the return to implementation of the structural reform agenda to restore investor confidence. Over the medium-term, greater political checks and balances would likely be seen as positives by investors, and thus contribute to rebooting economic growth. 1 For the April issue, please see: http://www.worldbank.org/tr/country/turkey Contacts: Ulrich Bartsch: ubartsch@worldbank.org Ayberk Yılmaz: ayilmaz@worldbank.org