17th July 2016

The military coup in Turkey last Friday night was over almost as quickly as it began. Political analysts have much explaining to do, such as what happened, and why; how President Erdogan’s appeal to democratic processes to bolster his anything-but-democratic style of government will play out; and what the geopolitical implications might be for a country, whose location straddles a fractious Europe and the troubled Middle East, and that is home to vital oil and gas pipelines and trade. Against a backdrop of a vicious and occasionally violent purge in Turkey in which more than 6000 people, including judges and more senior legal officials have been detained, what economists can add is a sense of the scale of Turkey’s vulnerability to instability. For it is clear that Turkey will not survive a sudden stop or abrupt reversal of capital flows, on which it is hugely dependent.

According to the Foreign Office, roughly 2.5 million British nationals visit Turkey each year, or about 7 per cent of total tourist arrivals, though both numbers have been declining because of security concerns. Turkey was until recently the world’s 6th biggest destination for tourists. Visitors know that Turkey is populous: it has a population of 78 million. It has a GDP of $720 billion (£554 billion at current exchange rates), and per capita income of around $10,500 (though some places such as Istanbul are wealthier). Turkey’s income per head is about the same as in China, though China’s GDP, at about $11 trillion is second only to the US.

The main thing about Turkey is its geo-strategic location, situated on the border of, but in so many ways outside, the EU, where it slots into European markets and supply chains, and also serves as a conduit into the Middle east and Russia. Turkey’s principal trade partner for exports and imports is the EU. Other big exports markets for Turkey are Iraq, Russia, the US, and Iran. For the EU, Turkey is the 5th biggest market for exports, and the 7th largest for imports. Turkey trades mainly in manufactured goods, and machinery and transportation equipment.

Coup or no coup, Turkey would have had a number of issues to address over the next few years, even without the influx of more than 2.7 million Syrian refugees, of which, according to the UN, only about a fifth have competed secondary education. These issues include high income inequality, with the country’s so called Gini co-efficient being about half as big again as the average of the OECD: an exceptionally low savings rate of 15 per cent of GDP, which means weak investment rates; very low female labour participation rate (30.5 per cent); 21% unemployment; diminishing trust in the rule of law; and low productivity, and weak regulatory and competition institutions which are retarding manufacturing relative to say, peers such as the Czech Republic, Poland and Mexico.

Yet, financially, in the weeks leading up to the failed coup, Turkey’s position was frail, but there were no klaxons going off. The Turkish lira, having fallen steadily along with other emerging market currencies in 2014-15, had actually been quite stable. New flows of credit, especially to companies, have dropped back from high double-digit to about 10 per cent growth since the start of this year. As a result, domestic demand, sales of big ticket items like cars, and construction permits and housing starts had been softening. Weaker imports, for example, and lower oil prices had brought about a respectable improvement in Turkey’s gaping external deficit. And last but not least, after a major borrowing binge since 2010, the liabilities of Turkey’s non-financial companies and banks were simply treading water in the first half of 2016.

Whether any of these recent signs of stabilisation would have persevered, we shall never know. The failed coup now raises the risk that either capital flows to Turkey will dry up or go into reverse, and or that the government, perhaps desperate to buy economic stability, will resort to monetary, credit and other stimulus measures, which foreign lenders would see as fundamentally destabilising.

A sharply rising share of private credit as a share of GDP (now 80 per cent) is not a great backdrop. Moreover, though Turkish banks are reasonably well capitalised, their financial vulnerability has been rising with steady increases in the ratio of their loans to to deposits, and in their net foreign liabilities. Most worrying of all is Turkey’s external or balance of payments deficit, which remains around 4.5 per cent of GDP. In other words, Turkey’s external debt, which amounts to about 58 per cent of GDP – about a half of which is short-term and has to be repaid or rolled over within a year – is predicted to carry on growing. In other words, Turkey is highly dependent on foreign capital flows to finance its external deficit, and the outflows attributable to the debt service payments on and amortisation of an expanding volume of foreign debt, run up mainly by non-financial companies and banks.

A week ago, Turkey needed $540 million a day of foreign capital to keep its balance of payments position, foreign currency reserves and the currency stable. Now, in the wake of the failed coup, if capital on this scale is not forthcoming and or of if capital fleesTurkey, the economy will probably succumb to a financial crisis, and grind to a halt. What happens politically in Turkey in the next days and weeks will not only play an important role in shaping economic outcomes, but also the confidence of foreign lenders, upon whom Turkey depends so much.

The Turkish lira fell by 5 per cent over the weekend to the lowest level since 2008, and the central bank has declared that it stands ready to provide liquidity in the even that that there should be unusual cash withdrawals or banks should otherwise have problems with maintaining orderly payments. But these are emergency measures, and Turkey will be hard pressed to assuage people’s fears about both the maintenance of security in cities and resorts, and to stem the sharp decline in tourist arrivals from Europe and Russia. The construction industry will be badly hit, with new doubts over the expansion of tower blocks and factory space, notably in Istanbul and Ankara. Any remaining expectations that Turkey might join the EU, let alone before 2020, will have died this weekend. And Turkish-US relations are, at least for now, in the balance, with tensions surrounding Erdogan’s demand for the extradition of Fethullah Gulen. There had been some anxiety about the situation at the important US nuclear air base in Incirlik, but unconfirmed reports that access had been blocked seem to haven quashed. This is the kind of background against which Turkey, post the failed coup, might find foreign capital flows less than adequate, the economy deteriorating, and the reasons to introduce capital controls and measures that could harm the country’s prosperity.