Turkey’s national income fell 1.8% y/y in the third quarter, marking the first contraction in GDP in seven years, led by a slump in consumption, weak investment and poor export performance.

The sharper-than-expected growth figure sent the lira lower, prompting J.P. Morgan to revise downwards its GDP forecasts for this year and next. The bank slashed its 2016 growth estimate to 2.5% from 2.8% and cut the 2017 growth forecast to 2.6% from a previous 2.8%.

Most economists expect some recovery starting Q4, but they still believe full-year growth will remain below the government’s estimate at 3.2%. “Economic growth is unlikely to pick up in a meaningful way until political uncertainties are eliminated,” J.P. Morgan analysts wrote in a research note.

Getting richer overnight

Statistics office TUIK also said it has changed the way it calculates GDP, switching to the National Accounts System (SNA2008) and the European Accounting System (ESA-2010).  TUIK now uses 2009, not 1998, as the base year to estimate the country’s national income.

As a result of this change, 2015 growth was revised up to 6.1% from a previously announced 4%, while per capita income was updated to $11,014 from $9.257. GDP was not $720bn last year, but $861bn, said TUIK, a 19.6% upward revision in national income. According to the new methodology, R&D and weapons systems expenditures are now classified as fixed investment.

“A more detailed classification of the financial sector has been introduced and improvement will likely be secured in estimating the non-observed economy, agricultural output and non-profit organizations. Although this sounds like a step taken in the right direction, the absence of detailed information - such as historical quarterly data, seasonal adjusted data and even detailed data regarding 3Q16 - makes it very difficult to draw sound conclusions from the latest announcement,” J.P. Morgan said.

With the introduction of the new calculation method, average annual growth in the last six years was revised up from 5.2% to 7.3% and the current account deficit improved to 4% of GDP from 4.5%.

“But these don’t change anything on the ground: the lira has been one of the most vulnerable EM currencies to shocks and the economy still has a productivity problem”, commented William Jackson at Capital Economics.

Q1 and Q2 growth were also revised to 4.5% from a previous 4.7% and 3.1%, respectively.

Consumption and investments suffer

Household consumption, which makes up nearly two-thirds of the economy, fell 3.2% in the third quarter from a year ago, after rising 3.7% in the previous quarter and 0.2% in Q1, while fixed investments contracted 0.6% y/y in Q3 versus a 4.7% increase in Q2 and a 7.8% y/y expansion in the first quarter, reflecting the impact of the coup attempt in July 15 on consumer and business sentiment.

The only thing that prevented a much deeper decline in national income was the staggering 23.8% y/y rise in government spending that followed a 13.7% y/y increase in the second quarter and a 11% rise in Q1.

The government’s revised medium-term programme forecast that private consumption will increase 5% this year and at a slower 4.3% in 2017. Private investments will contract 0.8% in 2016, but they will increase 4% next year, according to the programme.

Public fixed investments are projected to increase 3.5% this year and 8.9% in 2017.

On the production front, agriculture declined by 7.7%, industry saw a 1.4% fall in output, with manufacturing production falling 3.2% and services shrinking 8.4%. Construction was the only major industry that grew in the third quarter. It expanded at 1.4% y/y in Q3, but this was below the previous quarter’s 15.7% y/y increase in construction output.

Goods and services exports were down as much as 7% y/y, after staying unchanged in Q2, while imports growth slowed to 4.3% y/y from 9.1% y/y. This mainly reflected weaker tourism that has taken a hit from tensions with Russia, geopolitical risks and several terror attacks in Turkey since the beginning of this year that have kept foreign holidaymakers away from the country.

Uncertainties and challenges

“We do not expect to see a major improvement in confidence until the referendum, which will likely take place in April/May,” said J.P. Morgan analysts.

Pressure from politicians, especially from President Recep Tayyip Erdogan, may increase on the central bank to cut rates to stimulate economic activity in the run-up to the popular vote on the constitutional reforms that, if approved, will move Turkey towards an executive presidency.

The bank is now caught between a rock and hard place: It is struggling to contain inflation as the lira, one of the worst performing emerging market currencies, is fast losing its value, a decline accelerated by the US Fed’s decision to raise rates on December 14. The currency has weakened more than 19% against the US dollar and nearly 17% against the euro this year so far.

The central bank’s job will get even harder next year when the global economic environment becomes more challenging and less predictable and as the country heads towards a referendum on whether to change to an executive presidency.

Most analysts say the plunging lira argues for a rate hike to shore up the currency. But such a move may provoke the wrath of the government that is now investing a lot of political capital in the executive presidency and does not want to lose the referendum because of poor economic growth.

If the people say “yes” to the presidential system, Erdogan will accumulate more powers and he could stay in power until 2029 if he wins the elections in 2019 and 2024.

According to the constitutional bill submitted to parliament last week, the prime ministry post will be abolished, the president will pick cabinet ministers and appoint two vice presidents. The president will issue decrees, and prepare the state budget. He or she will appoint five of 12 members of the Supreme Board of Judges and Prosecutors (HSYK).

The number of seats in parliament will increase to 600 from the current 550.

The government has long argued that there is nothing to fear about the executive presidency, as it will bring only bring more political stability by avoiding fragile coalitions and ensuring better management of the economy.

Government to the rescue

The main concern of investors in the short run is that the government will spend much of its energy on the referendum campaign and it will not focus enough on economic reforms. But, Prime Minister Binali Yildirim said, as he unveiled a number of  measures to boost investments and employment, that a schedule was being prepared for structural reforms next year.

The economic package includes a TRY250bn (€68bn) new credit facility to SMEs under the Credit Guarantee Fund, support for exporters, and a VAT refund for the construction sector.

“The measures as a whole are expansionary through both fiscal and monetary channels, and so are likely to put further pressure on inflation and the budget balance in the medium term, while providing support to economic activity and employment,” Morgan Stanley commented.

Indeed, many analysts welcomed the package unveiled on December 8 as they see it supporting economic activity in the short to medium term, but some think the package failed to address a more immediate problem: the volatility in the lira. A weak and volatile currency is creating problems for local companies that have accumulated large amount of foreign debt over the past decade.

The private sector’s long-term foreign debt increased to at $207.64bn as of the end of October, from $195.4bn at end-2015, data from the central bank showed.

Despite pressure from politicians, BNP Paribas thinks Turkey’s central bank is left with no other option but to raise. “The CBRT is likely to continue hiking rates if the TRY remains under pressure, but in our view by less than the 200bp implied by forward rates for the next five months,” the bank said in a research note.

Political noise will continue until this summer, but if Erdogan wins the referendum, one big uncertainly will be eliminated. What kind of Turkey emerges once the executive presidential system installed is another question.  

After the popular vote on the presidential rule, attention will turn to the economy once the dust is settled.

What should be expected in 2017 then? There is consensus that next year may not be worse than 2016, even though growth will likely remain below the country’s long-term potential.

One major worry is the currency. “The uncomfortable fact remains that the external deficit is widening despite very weak economic activity. A deteriorating external balance at a time of weak economy will continue to undermine TRY,” analysts at Nomura wrote in a note, citing the prospects of higher oil prices as a result of oil-producing countries’ decision to cut output. Turkey is a net energy importer and higher oil prices will have adverse effects on its economy. Nomura still expects GDP growth to accelerate to 3% next year from 2.7% in 2016.

The expansionary measures the government announced this month, more government spending next year, an expected recovery in tourism following the sharp recovery in relations with Russia, all this will support the economy and keep GDP growth in the 2.5-3% range in 2017, says J.P. Morgan. But it warned that Turkey could get hit by the reduced global risk appetite and the resulting weakening in capital inflows, trends likely to continue after the US Fed’s guidance on three more rate rises in 2017.