MIND THE (CURRENT ACCOUNT ) GAP / ROUBINI GLOBAL ECONOMICS WEDNESDAY NOTE ( HIGHLY RECOMMENDED READING )

MIND THE (CURRENT ACCOUNT ) GAP

Greetings from RGE!

We've been examining Turkey's widening current account deficit, a trend that looks new but is actually a post-recession return to business as usual. Amid last year’s sharp economic contraction, Turkey’s current account deficit receded to 2.3% of GDP, and the issue largely faded from the spotlight. However, the issue is now coming back to the fore, given the fast expansion of the deficit, and we explore the structural deficiencies behind it in a new RGE Analysis, available exclusively to clients. RGE believes the 2009 narrowing was due to exceptional circumstances—i.e., a plunge in domestic demand during the global financial crisis—and we expect the deficit to reach 4.4% of GDP in 2010.

Turkey’s persistent current account deficit reflects structural issues related to the country’s trade composition, heavy dependence on imported energy and low savings rate. Turkish exports have high import dependence, as does its domestic manufacturing industry. Consequently, export and import growth tend to move hand-in-hand, making it difficult for Turkey to rely on export growth to narrow the deficit. Even in 2009, when the synchronized collapse of global and domestic demand caused imports to plummet by over 30%, exports also plummeted, and Turkey’s current account remained in deficit.

Meanwhile, dependence on foreign sources of energy makes Turkey’s current account vulnerable to rising oil prices. Turkey’s large manufacturing sector depends on imported energy for production, and rising oil prices push imports higher. In June 2008, when oil prices averaged over US$130 per barrel, Turkey’s deficit hit a record high, exceeding US$5.5 billion for the month. Though the relationship between oil prices and the current account balance broke down in late 2008 and most of 2009, the exceptional circumstances of the global financial crisis were to blame: The collapse in external and domestic demand caused Turkey’s current account deficit to narrow despite oil prices regaining some ground. As Turkey remains reliant on foreign energy, the strong correlation between oil prices and the current account balance will re-emerge.

While the rapid expansion of the deficit is a concern, the real issue is the deterioration in the quality of its financing. FDI—among the most stable sources of inflows—is below 2009 levels. A significant uptick in FDI in 2011 looks unlikely as more than 80% of Turkey’s FDI comes from European countries, and RGE foresees a sluggish, below-trend recovery there (as we recently reiterated in our Europe Weekly). Moreover, RGE envisages the global recovery losing momentum in late 2010 and early 2011 amid fiscal retrenchment and the waning of positive inventory effects (see RGE's Q3 2010 Global Outlook), suggesting the FDI picture is unlikely to brighten in the coming months. At the same time that net FDI has declined, more volatile sources of financing—like portfolio investment (specifically debt securities)—have picked up.

Given the structural issues at work, Turkey’s current account deficit is unlikely to show a sustainable decrease without significant reforms, meaning the country needs to keep attracting sufficient capital flows from abroad to finance the shortfall. Shorter-term capital flows, which have increased of late, raise Turkey’s vulnerability to sudden shifts in global risk appetite. The danger is that an increase in risk aversion could place upward pressure on interest rates to attract the necessary external financing. RGE expects Turkey to easily meet its financing needs in the near term, but the deteriorating quality of external financing is a medium-term risk that requires attention.