Risk drivers and outlook

  • Turkey has come a long way since it was struck by a devastating financial crisis in 2001. In fact, it has become a totally different country over the past decade by tackling its traditional sources of fragility.
  • Contrary to expectations, Turkey weathered the global economic and financial crisis with relative ease and staged a major economic expansion over the past three years, which caused the Turkish economy to overheat, reflected by building inflation, fast credit growth and a sizeable current account deficit.
  • A rebalancing has been underway, passing rather smoothly so far given the extent of overheating seen last year. How Turkey copes with this correction will provide another important test after the 2008-09 resilience.
  • A further reduction in the perennial current account deficit would be the most important development, as it would render Turkey much less subject to global financial whims than is currently the case.

Facts & figures


  • Geographic location
  • Young and fast-growing population
  • Dynamic SMEs
  • Large expanding domestic market


  • Energy import dependency
  • Rigid labour market
  • Too low domestic savings
  • Lingering Kurdish conflict

Main export products

  • tourism (13% of export receipts), food (7.5%), transportation (4.2%)

Income group

  • upper middle income

Per capita income (USD)

  • 10,522


  • 74 mn

Description of electoral system

  • presidential: 7-year term; next election: 2014;
  • legislative: 4 -year term; next election: 2015

Prime Minister

  • Tayyp Erdogan

Head of State

  • Abdullah Gül

Country risk assessment

Erdogan and AKP gained upper hand in battle with secular factions

Turkey has been governed since 2002 by PM Tayyp Erdogan and his moderate islamic Justice and Development Party (AKP). By landing 50% of the votes in last year’s general election the AKP secured its third sweeping victory in a row. No wonder as the successive AKP governments have brought Turkey unprecedented political stability and economic expansion. Besides, opposition parties fail to provide a credible alternative for the AKP at the moment. But while Mr Erdogan brought his country prosperity, each electoral victory seems to push him towards a more autocratic stance.

While this may be true, over the past decade he has gained the upper hand in a long-lasting battle with the country’s Kemalist secular establishment, which forms the so-called ‘deep state’. The latter is represented in the first place by the Turkish generals – who have toppled four elected governments since 1960 – and their traditional allies in the judiciary who in 2008 came very close to banning the AKP, as had happened with a predecessor party in 1997. When the generals threatened to intervene in 2007, Erdogan called a snap election, which his AKP easily won, sending the army back to the barracks. Army privileges have been rolled back and the generals have been put under control of the democratically elected government, unimaginable just ten years ago. How things have changed became clear last year when, in protest to the imprisonment of hundreds of serving and retired officers in the Ergenekon/Sledgehammer case (cf. infra), the military leadership resigned en masse, hoping to provoke a crisis that would force the government to back down. The plan backfired as the military leaders were swiftly replaced. In the end, the generals’ move only underscored that the balance of power has definitively tilted in favour of the politicians.

Since the beginning of the year, an internal power struggle has surfaced between PM Erdogan’s entourage and the controversial Gülen movement of Islamic preacher Fethullah Gülen, whose adherents have acquired profound influence over police forces and the judiciary over the past decade. In fact, it are Gülenist prosecutors who are assumed to be behind the high-profile Ergenekon and Sledgehammer  cases. The Ergenekon investigation has been on-going since 2007 and has led to the detention of hundreds of secular nationalists – often staunch critics of the Gülen movement – for trying to create chaos across Turkey through terrorist attacks in order to justify a military coup. The alleged planning in early  2003 of an army coup has been the subject of the Sledgehammer case, initiated in 2010. However, evidence produced in both cases of a deep conspiracy has been weak with indications of fabricated evidence. On 21 September the verdict in the Sledgehammer case was announced. 34 of the 365  suspects were acquitted, while the others were sentenced to prison terms, including twenty years imprisonment for three retired generals.

Drafting new constitution dominates political agenda

While Turkey is no longer the coup-prone country it was only a decade ago, democratic institutions have not developed automatically. A sweeping reform of the judicial system is for example long overdue given the general lack of checks and balances. Critical journalists, lawyers and politicians (currently eight MPs serve jail sentences) are often detained for years pending trial. Especially with regard to the freedom of expression Turkish authorities show little tolerance. While the constitution formally grants Turks freedom of expression, infamous Article 301 of the Penal Code makes it illegal to insult the Turkish nation, ethnicity or government institutions. This vague law has been used to prosecute citizens who dare to label the well-documented Armenian genocide in the end-days of the Ottoman Empire as genocide, still a taboo subject in Turkey. The country’s struggle to come to terms with events that happened almost a century ago does not only stand in the way of normalized diplomatic relations with neighbouring Armenia – the border between both countries is sealed off – but also Turkey’s fully-fledged transformation into a modern, European nation.

Back in July the parliament passed a judicial reform package, taking measures to speed up the judicial process, reduce arbitrariness and bring punishment more in line with the alleged offence as, currently, anyone partaking in a pro-PKK manifestation or singing pro-PKK songs can land a long time behind bars on charges of membership of a terrorist organisation, as has been the fate of thousands of students. The proof of the pudding is of course in the eating, but the adoption of several rounds of reforms is a positive evolution nevertheless and stems hopeful that the rule of law will be gradually harmonized towards EU standards.

The state of the justice system highlights the need for a modern constitution centred on individual civil rights, and replacing the current authoritarian base law that was adopted under military rule in 1982 and focused on state rights. Adopting a new and balanced constitution as it has repeatedly promised, is the AKP’s most important challenge at the moment. As the AKP lacks the majority needed to unilaterally push through constitutional changes, a political compromise will have to be reached though. This will be an important test for the party’s preparedness and ability to compromise with often dogmatic opposition parties. While parties have started discussions, the parliamentary drafting committee needs to reach unanimity over each single article, no easy task given the polarized nature of Turkey’s politics.

PM Erdogan has been seeking to empower the office of president in the new constitution, turning Turkey into a French-style presidential republic. With PM Erdogan forbidden by his party’s rules to seek another term as PM, he is expected to try get elected president when Turkey will hold its first presidential elections in 2014. If he becomes president and gets re-elected in 2021, he will be able to preside over the centennial celebrations of the Turkish republic in 2023, by which time he aims to turn Turkey into one of the world’s  ten biggest economies. But whether he decides to run for president or not – he would have to convince current president and fellow AKP member Abdullah Gül not to run – no politician has dominated Turkey’s political scene as much as Mr Erdogan has since the founder of modern Turkey, Mustafa Kemal Atatürk.

Long-running conflict with PKK rekindled since June 2011 elections

The lingering Kurdish question poses probably the main threat to domestic stability in Turkey. The armed conflict started back in 1984 and has its roots in the search for autonomy by the country’s 14 million Kurdish minority – the wider region harbours some 30 million Kurds. Tens of thousands of people have been killed on both sides over the past decades. The PKK has stated that it no longer strives for an independent Kurdistan, but would settle for autonomy within Turkey. Violence has escalated over the past year with severe clashes between PKK militants and Turkish troops in the Kurdish south-east corner of Turkey, along the Iraqi and Iranian borders.

During the 2011 electoral campaign, the AKP adopted a hard-line nationalist stance towards the PKK, deserting the moderate stance of earlier elections when it vied for the Kurdish vote. Secret talks with the PKK to end their uprising were abandoned and following the June 2011 elections the PKK officially ended its brittle unilateral ceasefire. As a consequence, the past year has been one of the bloodiest in the recent history of the long-running conflict, claiming over 700 lives since the elections and marking the deadliest period since PKK leader Abdullah Öcalan was captured in 1999. The severe and often well-coordinated attacks have only led Ankara to tighten its staunch anti-terror stance. Ambushes and attacks on military targets have been met with airstrikes on PKK mountain bases, many of them located in the Kurdistan region in the north of neighbouring Iraq, which enjoys a semi-autonomous status. Ironically, Ankara has been fostering good relations lately with the autonomous Kurdish regional government in northern Iraq as Turkey has started importing the region’s oil and Iraqi Kurd authorities have tacitly sanctioned the bombing of PKK bases on its territory.

Aside from the failure of the Turkish authorities to appease Kurdish demands, the recent surge in PKK activity is understood to be linked as well to the conflict in neighbouring Syria, where the clout of the Democratic Union Party (PYD), an ideological affiliate of the PKK, has been growing amid the civil war. Turkey currently hosts 80,000 Syrian refugees, as well as the political and military opposition that coordinates resistance against the regime of Bashar al-Assad. It is also assumed that Turkey has provided the rebels with arms, as other countries in the region have done. Presumably as a reprisal for this support of which many Turks seem to disapprove out of security concerns, control over a number of Kurdish- dominated border towns has been given up by Damascus, allowing the PYD to seize control. Ankara has stated plainly that it will not allow a PKK safe-haven to emerge in northern Syria and that it could initiate military actions to counter any such development.

Any durable solution to the bloody Kurdish conflict will have to address the root causes behind the PKK insurgency. This will involve regional economic development and granting the large Kurdish population some fundamental rights, along the lines of those enjoyed by Iraqi Kurds. The latter’s substantial degree of autonomy will only radicalise demands by Turkish Kurds over time if Ankara continues the discredited military approach, pushing Kurds only closer to the PKK. The Kurdish issue will have to be tackled in the new constitution. Cultural rights for minorities are one of many thorny issues its drafters are facing.

EU membership long way off in spite of strong economic links with the bloc

In December 2004 Turkey became a candidate member of the European Union. Obtaining this
long-sought status served as a forceful driver of domestic reforms. Effective membership negotiations with the EU were initiated in October 2005 but came to a halt a year later with Turkey unwilling to move on the Cyprus issue as it refuses to open its ports and airspace to Cypriot ships and airplanes. Turkey has no diplomatic relations with the small EU member state as a consequence of the division of the island since the Turkish invasion of 1974. The island is a major stumbling block as it will be impossible for Turkey to ever join the EU without recognising all of its existing member states. But even if negotiations ever progress, it is questionable whether all European countries would eventually consent with Turkey joining their ranks. The current impasse is likely to continue for some years, after which Turkey may decide to withdraw its application all together, settling for a deep economic integration with Europe. Despite the chilly political relationship, economic relations have been flourishing. Between Turkey and the EU a custom union for goods has been existing already since 1995 and Europe is the country’s first trading partner (the EU represents over 40% of Turkish trade) and by far its biggest source of foreign investment and funding.

As membership of the EU became a distant feature, Turkey has been trying to brand itself as the dominant regional force by fostering better relations with Middle Eastern countries and exercising soft power in the region based on cultural and religious affinity. As these ambitions go often hand in hand with idolizing the lost Ottoman glory, it is easy to see why Arab countries regard Turkey’s ambitions with suspicion. In fact, relations with Arab neighbours as well as Iran and Israel are challenging to put it mildly. But while efforts to bolster its role as a political heavyweight may bear little immediate effect, the country’s strong economic performance is gradually transforming Turkey into the regional economic powerhouse to reckon with. Over the past year, exports towards the Middle East and North Africa have grown fast, more than offsetting the weakness experienced across European trading partners, so that the region is almost as important at the moment as the European market. Though the durability of this evolution needs confirmation, the list of large construction contracts that Turkish companies have secured in the Middle East looks impressive.

What a difference a decade makes

PM Erdogan’s AKP unquestionably deserves credit for the economic transformation Turkey has gone through under its watch since 2002. Back in 2001 Turkey was hit by a major financial crisis and the country had to seek recourse to prolonged IMF assistance – the last programme ended in May 2008 and the last credit tranche is to be repaid in 2013. Under auspices of the IMF, the Turkish authorities consolidated public finances and reformed the battered financial sector. The Turkish economy grew by an average of 6.8% during 2002-07 on the back of strong productivity gains, thereby allowing income per capita to rise strongly, from USD 3,002 in 2001 to USD 10,522 last year.


As a consequence of the structural reforms Turkey turned out to be much more resilient than anticipated when global crisis erupted late 2008. Bearing in mind past experience, it was widely assumed that Turkey, especially without the backing of the IMF, would fall victim to a confidence crisis, see capital flee the country and endure a currency crisis. The authorities were however able to implement countercyclical policies without provoking an exchange rate crisis thanks to the previous reduction in the deficit, the debt stock and inflation. This reflects a noteworthy improvement in policy credibility over the past decade.

Fundamentally, Turkey was limitedly affected by the 2008-09 global crisis and the ensuing flight to safety, especially when comparing to many other countries in the region. Admittedly, the economy stumbled between 2008Q4 and 2009Q3 due to the sharp and sudden recession across Europe, passed on to Turkey through the close trade links. Industrial activity plunged so that unemployment spiked.

Strong rebound following 2009 recession

Despite turbulence across its main export markets, Turkey put in exuberant growth in recent years so that lost ground was swiftly recovered. Since the end of 2009, Turkey has been the fastest grower in the  region, with a GDP that expanded by a massive 9.2% in 2010 and another 8.5% last year. The strong industrial growth realized over this period was carried by an army of dynamic Anatolian SMEs. The breath- taking expansion was unsustainable, however, as the Turkish economy went in overdrive with clear signs of overheating emerging. At the demand side, the hasty rebound was driven entirely by booming domestic consumption, underpinned by fast credit growth. The accommodative monetary stance in the developed world has provided countries like Turkey with cheap money. The latter was funnelled through domestic banks to Turkish consumers who started borrowing heavily, reflected in solid performance by the real estate and construction sectors. Turkey has a very young population – more than half of the population is under 30 – that is eager to consume and is growing fast.





Surging inflation, fast credit growth and widening current account deficit

A clear indication of overheating came in the form of building inflationary pressure, rising fast towards the end of 2011 and touching double digit territory at the beginning of 2012. However, instead of tightening monetary policy in the face of fast rising inflation and persistent credit growth, the Central Bank of Turkey (CBT) initially eased its policy further in order to discourage ‘hot money’ (cf. infra) from flowing in, while it simultaneously tried to push back credit growth through hikes in banks’ reserve requirements. As a consequence of this rather unorthodox policy the official inflation target of 5.5% was widely missed last year, raising questions whether the CBT was diverting from its past, successful strategy of disinflation. Also, with anxiety over the economy rising, the lira suffered, losing more than 10% against a USD/EUR basket over 2011.



Aside from inflationary pressure, sturdy domestic demand translated in a widening deficit on the current account, which hit a massive 10% of GDP last year following the record 6.5% shortfall in 2010. Not just its size, but also the way the deficit is financed is problematic as this has happened mainly through the build-up of short term debt in recent years. The latter currently represents 50% of foreign exchange revenues, while the CBT’s foreign exchange reserves no longer cover the entire short term debt stock. The fast deterioration of these indicators in recent years is noteworthy. Capital inflows, required to cover a current account deficit, consist thus mainly of volatile, portfolio inflows. This puts Turkey at the mercy of global risk appetite as these ‘hot money’ flows can abruptly reverse if confidence stumbles, as Turkey experienced during the second half of 2011 when financial markets shrivelled worldwide.

Turkey has too low a savings rate and attracts relatively little foreign investments

The dependence on foreign credit reflects Turkey’s insufficient domestic savings rate, at around 12% of GDP. As this is Turkey’s main exposure to external shocks, this is a problem that deserves policy makers’ attention. The most direct way to step up overall savings would be to increase the public sector’s structural surplus. Nevertheless, higher private savings will be needed as well in order to reconcile strong growth  with manageable external deficits. The government has recently announced actions to draw more personal savings into pension schemes, thereby developing the domestic market for longer-term capital and reducing the country’s reliance on (short term) external borrowing.

Evidently, foreign direct investments (FDI) provide for a much more stable financing form than foreign credit. However, Turkey has been attracting not as much FDI as one would expect given its fast expansion and large market. Inflows have only covered about a fifth of the country’s current deficit. Furthermore, a large part of the strong pre-crisis foreign investments represented banking deals. This highlights the importance of an improvement in the business climate. While international benchmarks (such as the World Bank’s Doing Business) rank Turkey not too bad in comparison to the wider region, there’s still room for improvement. The further introduction of EU standards will go a far away in this, with unpredictable tax demands often cited as an important hurdle by investors. The rigid labour market is probably another important deterrent, with legislation discouraging temporary contracts for example. Official unemployment is chronically high as a consequence of this kind of regulation, despite the fact that the quality of education is slowly improving, even though it cannot compete with Eastern European standards yet.



Fears of hard landing have abated as Turkish economy rebalances

The severe overheating of the Turkish economy created fears that a painful correction was pending. However, this hard landing hasn’t materialized as the Turkish economy has been undergoing a gradual rebalancing since the end of 2011. Parallel to the global deceleration, growth has declined severely compared to previous years. Nevertheless, Turkey is doing better than just about all European countries. During the first half of 2012 Turkey grew by a modest 2.8%. Quite different from 2010-11, domestic spending has been lethargic, with construction way down from past years. If not for positive net exports Turkey would have hit recession. While imports have fallen for three consecutive quarters, exports have surged.

The same pattern is likely to apply to the next quarters, with a further deceleration in domestic activity  likely and growth depending on external demand. For 2012 as a whole 3-3.5% real GDP growth seems feasible, whereas the current consensus forecast for 2013 is 4-4.5%, a growth rate one should expect over the medium term as well. A more modest, but sustainable growth rate should be welcomed and will ease concerns that Ankara’s paramount priority is to deliver high growth, whatever the cost, in order to realize PM Erdogan’s 2023 pledge.

Sluggish domestic spending has resulted from tightened access to consumer credits as attempts by the CBT to curb credit growth have reaped effects with the latter slowing down markedly in real terms over the past year. Since the end of 2011, the CBT has rightly shifted its focus towards the deteriorating inflation expectations and the fall in the lira exchange rate. This tightening – and a general decrease in global risk aversion from its heights a year ago – has lured back capital, strengthening the lira in turn. At the moment, the CBT looks set to throw its monetary policy back into easing gear given the economic slowdown. This would be a risky move as inflation remains elevated at 8.9% in the 12 months to August, well above the central bank’s target of 5% for this year.



But the main concern is still Turkey’s current account deficit, which remains too high for comfort. The deficit has peaked in October 2011 and has shrunk since then. This trend has continued in recent months thanks to strong export growth and tax increases that slowed down domestic demand and hence import growth. The relatively stable oil price of late should help as well, even though energy prices remain elevated for heavy energy importers such as Turkey. The current account deficit is only narrowing slowly, however, leaving Turkey with very large external financing requirements amid shaky financial markets. This incorporates the risk of renewed volatility in the lira exchange rate. What’s more, the lira is unlikely to gain much more ground as long as the current account deficit remains as elevated as is currently the case.

Strong public finances underpin Turkey’s prospects over the medium to long term

Notwithstanding the current slowdown, Turkey’s longer-term fundamentals appear quite strong, especially when compared with historic parameters. For starters, there are the country’s public finances, which underwent a successful consolidation over the past decade. Total public debt was cut from almost 80% of GDP in 2001 to below 40% currently and is expected to continue its downward path. This had created a strong budgetary absorption capacity, as demonstrated in 2009 when Ankara was able to implement a substantial and effective stimulus package without creating anxiety across financial markets. On the contrary, domestic yields hit record lows and the authorities were able to issue for the first time 30y Eurobonds, reflecting the higher average maturity of Turkey’s lower public debt.

The fiscal deficit dropped below 1% of GDP last year thanks to robust growth, though it is set to widen again to about 2.5% this year, reflecting in part the fact that fiscal revenues are particularly growth- dependent. Indirect taxes represent over 50% of all revenues, as the extensive black market – estimated to account for up to 40% of activity – complicates the collection of direct taxes. Furthermore, the strong cyclical effect of past years masks an underlying budgetary relaxation with non-interest spending rising strongly since 2009. In fact, this reflects a too pro-cyclical fiscal stance as the authorities missed the opportunity to offset strong private spending through fiscal restraint during the boom years.

Despite quick growth, Turkey’s total external debt has improved little in recent years, hovering around 180% of export revenues, quite a high level. This is mainly the result of a build-up of external debt by Turkish banks, the flipside of the 2009-11 credit boom. Nevertheless, lower interest rates and a longer average maturity of the outstanding debt stock have improved the debt service ratio, coming down from worrying levels to much more manageable ones.



Fast credit growth hasn’t eaten into strong fundamentals of banking sector

As said, the Turkish banking sector has been an important driver behind the stern expansion in past years. Tight regulatory oversight, introduced following the 2001 crisis, made Turkish banks steer clear of the toxic assets taken on by many European banks. As a consequence they left the 2008-09 crisis unscathed. It will now be important to see how the banking sector digests the on-going slowdown. While growth and profits are likely to be modest this as well as next year, the sector’s overall fundamentals appear still resilient as banks are generally well capitalized. The average capital adequacy ratio has decreased, but with a ratio of 16.7% at the end of July, Turkish banks still have a considerable buffer, especially by international standards. While the ratio of non-performing loans stands at a historical low and provisioning is high, the modest level of impaired assets should be expected to rise somewhat given the economic slow-down.

While much of the recent lending concerns unsecured household loans, Turkish families are not allowed to take out credits in foreign currency so that lira depreciation does not affect the real burden of these credits.


Though deposits have been banks’ main funding source in the past, deposit growth fell short of lending growth, translating into a higher loans/deposits ratio. This ratio has surpassed 100% as banks have been relying more on external funding. The overall size of the Turkish banking system is still moderate with assets representing about 94% of GDP, much lower than the average across the European Union. The largest banks are all domestically owned and state banks are major players. Nevertheless, the under- penetration in terms of loans compared to overall GDP makes entering the Turkish market attractive for international banks. As a consequence, troubled Belgian-French Dexia bank had little difficulty to sell its Turkish daughter Denizbank to Russian Sberbank earlier this year. Also, it seems that Turkey has been among the few markets where European banks have continued lending over the past year, given the country’s large long-term potential.


Turkey has come a long way since it was struck by a devastating financial crisis in 2001. In fact, it has become a totally different country over the past decade by tackling its traditional sources of fragility. Contrary to expectations, Turkey weathered the global economic and financial crisis with relative ease and staged a major economic expansion over the past three years. This caused the Turkish economy to overheat, reflected by building inflation, fast credit growth and a sizeable current account deficit. A rebalancing has been underway, however, passing rather smoothly so far given the extent of overheating seen last year. How Turkey copes with this correction will provide another important test after the 2008-09 resilience. A further reduction in the perennial current account deficit would be the most important development, as it would render Turkey much less subject to global financial whims than is currently the case.

Provided the latter scenario does indeed materialize and other worries are put to rest, ONDD may very well upgrade its medium- and long-term political risk classification from the current 4/7 to 3/7 as the country’s long-term economic fundamentals show a sounder picture than short-term concerns may suggest. With a modest deficit and a debt stock below 40% of GDP, Turkey’s public finances are in good shape, especially when compared with the situation a decade ago.

While the once omnipotent army no longer pulls the strings, a new confrontation between the AKP and the secular factions in Turkish society cannot be excluded with a new constitution currently being drafted. The introduction of the latter is the AKP’s key political challenge at the moment. Worryingly, the Kurdish conflict has intensified again since last year’s elections. Following years of appeasement in the slipstream of negotiations with the EU, the government has chosen the military option lately, confronting PKK-militants head-on. However, the approach of the conflict as one that can be handled by military force has been discredited by past experience. Any lasting solution to this long-running, bloody conflict will be political in nature, not military, and will require granting greater rights to the large Kurdish minority. A continuation along the current lines incorporates therefore the risk of a sharp escalation of the conflict, with a further alienation of Turkey’s Kurds setting fire to the Kurdish-dominated south-east provinces.

Analyst: The Risk Management Team