Country Intelligence: Report

Turkey

REPORT PRINTED ON 02 AUGUST 2012

Created on 02 Aug 2012

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Created on 02 Aug 2012

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This information was last updated on 20 JUL 2012, 1:20 PM EDT (17:20 GMT)

Outlook and Assumptions: Outlook

While the central bank's monetary policy is reducing the current-account deficit, risks to stability remain substantial. After more than a year of unorthodox and controversial monetary policy, the Central Bank of the Republic of Turkey (CBRT) finally began to see success in reducing external imbalances as 2011 came to a close and through the first five months of 2012. The ongoing success of the monetary policy, including a recent deceleration of inflation, suggests the CBRT will not deviate from its position in the near future. Even with the current-account deficit narrowing rapidly, the overall gap remains dangerously large, keeping Turkey vulnerable to a financing crisis should investor sentiment turn sour on the back of a major event such as the Greek exit from the Eurozone. Although the lira is now stronger, defending the Turkish currency earlier in 2012 depleted reserves, making the country even more vulnerable to a potential financing crisis. The Turkish economy has come in for a soft landing, with growth momentum strong compared with the rest of Europe. After surprisingly strong expansion in the first quarter of 2012, some deceleration may be noted in the second, but according to leading indicators, growth should remain relatively robust in relation to the rest of Europe. In the second half, with interest rates potentially easing somewhat at home, growth could pick up once again. Although overall expansion for 2012 as a whole will be slow in comparison to recent years, it will almost certainly be one of the top rates of expansion across Turkey. Export gains to Iraq and the rest of the Middle East will continue to fuel the expansion. The recent passage of a new incentive scheme to help buoy intermediate good producers will help to boost investment expenditures in the short term, further buoying overall GDP growth. The CBRT will be careful to not allow domestic demand to grow too rapidly, however, for fear of undermining the continued progress on narrowing the current-account deficit. Sustained strong fiscal spending remains a concern, however. In its effort to facilitate its economic recovery, the government has maintained a high level of spending, a position from which it is only slowly moving. Even with its spending still strong, the government budget balance narrowed sharply in 2011, primarily owing to soaring revenues coming from a rapidly expanding tax base. This surge of tax revenues allowed the government to avoid potentially painful spending cuts in an election year. So far in 2012, the government has allowed spending to continue to surge, a position that it must reverse moving forward to help alleviate the demands on needed financing. Given the uncertainty in the Eurozone situation and the potential negative contagion, it is more critical than ever that the government demonstrate a clear commitment to greater fiscal austerity in order to mitigate potential investors worries.

Outlook and Assumptions: Domestic Assumptions

The Central Bank of the Republic of Turkey (CBRT) maintains its current monetary policy as the current-account deficit continues to narrow. The gap remains dangerously large in 2012 and 2013, but adequate financing for the shortfall is found. The ongoing crisis in the Eurozone does not substantially turn investor sentiment away from Turkey. With its public debt and overall external debt well within manageable ranges and its financial system is in many ways more stable than many of those in Europe, Turkey avoids a strong contagion effect of the ongoing problems in Europe. The Justice and Development Party (AK) increase their control over the government and the economy, but do not overstep their bounds in the foreseeable future. Already, the central bank governor is thought to have close ties to the government, resulting in its more pro-growth stance. In spite of the blurring of the separate powers, the government does not abuse its position too much and maintains defensible policies.

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Unrest from radical Kurdish groups does not negatively affect the economy as a whole.

Outlook and Assumptions: Alternative Scenarios

The Eurozone crisis intensifies further, providing a greater challenge and financial drain on the region as a whole, eventually overwhelming the Turks' relatively healthy financial indicators, pushing the country into a debt crisis. Already, the country is facing too-rapid expansion of credit and heavy external financing demands. An evaporation of capital inflows in the wake of the Eurozone debt crisis could jeopardize stability in the country. The Justice and Development Party (AK) push through a much more aggressive centralization of power than currently anticipated. While the AK Party does not have a Constitutional majority, it nonetheless has great political power in the country. Its biggest detractors worry that it will ultimately undo much of the secular nature of the state while at the same time centralizing greater power in the leadership. Should politics develop this way, some free-market mechanisms could be threatened. Turkeys EU accession bid is suspended, either by Brussels or by Ankara. If either side breaks off negotiations completely, the Turkish economy could destabilize, although we believe this disruption would be limited. Turkey would become more intimately involved with the countries of the Middle East and, more broadly, the Muslim world. Widespread terrorist attacks spread throughout the country following the PKK's ending of its cease-fire, severely jeopardizing vital tourism revenues and inflows of foreign capital.

Economic Growth: Outlook

Although growth may further decelerate from its first-quarter level, the Turkish economy has likely come in for a relatively soft landing. In the second quarter, GDP expansion could be slower than was noted in the first quarter, according to leading indicators, but as compared with the rest of Europe, growth will remain as one of the stronger rates noted for that time. Growth momentum has been maintained by substituting European demand with increased exports to Iraq and the Middle East. Domestic demand was relatively depressed in the first quarter and will likely be slow to recover as the central bank has not been overly eager to loosen monetary policy. Nonetheless, with favorable current-account numbers being noted through the first half of the year, some easing of monetary policy in the second half can be expected, which should help to buoy domestic demand. Overall, we anticipate GDP will growth around 3% for 2012 as a whole. While this rate of growth will be quite slow compared with the booming recovery noted in 2010 and 2011, it will nonetheless be one of the strongest rates of growth noted throughout all of Europe.

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In the medium term, annual growth rates will remain elevated vis--vis the rest of Europe, although annual gains will remain much lower than they were in both the 200207 stretch and again in 201011. Rates were restrained by structural damage to the economy from the 200809 crisis and the current sovereign risk threats, but also because of the need to deleverage public debt, which will add a headwind through the medium term. In particular, continued European problems are constraining growth projections for 201314, although growth of around 4% will be quite substantial compared with the rest of Europe. Thereafter, assuming Europe begins to grow again, growth should push closer to 5% annually for Turkey throughout the medium term as exports receive a boost and investment activity improves.

Economic Growth Indicators 2009 Real GDP (% change) Real Consumer Spending (% change) Real Government Consumption (% change) Real Fixed Capital Formation (% change) Real Exports of Goods and Services (% change) Real Imports of Goods and Services (% change) Nominal GDP (US$ bil.) Nominal GDP Per Capita (US$) -4.8 -2.0 7.8 -19.0 -5.0 -14.3 614.6 2010 9.2 5.9 2.0 30.5 3.4 20.7 731.1 2011 8.5 7.2 4.5 18.3 6.5 10.6 773.1 2012 2.9 1.6 2.2 3.3 7.6 -0.8 802.2 2013 4.2 4.1 2.3 5.9 4.0 4.8 806.1 2014 4.1 3.5 3.1 5.4 4.9 4.8 2015 5.0 4.2 3.3 5.0 5.0 4.2 2016 5.3 4.6 3.6 5.6 4.7 4.3

945.6 1,103.7 1,238.6 14,333 15,921

8,554 10,050 10,498 10,766 10,697 12,411

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

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Economic Growth: Recent Developments

The Turkish economy managed to grow relatively strongly in the first quarter of 2012. In JanuaryMarch 2012, GDP expanded 3.2% year-on-year (y/y). Although growth was the slowest it had been since the country exited its 200809 recession, it nonetheless surprised observers on the upside, far outstripping growth rates noted across most of the rest of Europe. Sustained, strong export gains were the primary engine for overall economic expansion. Strong gains in shipments to Iraq and the rest of the Middle East more than offset the loss of European demand, allowing the exports of goods and services to grow 13.2% y/y, the strongest such gain since 2007. Meanwhile, imports of goods and services fell 5.0% y/y in the first quarter, driven downward by the continued dampening of domestic demand by the Central Bank of the Republic of Turkey (CBRT). Tight monetary policy kept household consumption from growing much at all (up just 0.3% y/y in the first quarter) and depressed gross fixed capital investment expansion as well (up just 1.6% y/y). Although growth decelerated in each successive quarter, GDP expansion remained vigorous in 2011 as a whole. After soaring by 11.9% y/y in the first quarter, GDP growth slowed to 9.1% y/y in the second, 8.4% y/y in the third, and 5.2% y/y in the fourth quarters, respectively. Overall for 2011, however, GDP expansion remained strong at 8.5%. Domestic demand propelled the economy forward in 2011. In particular, gross fixed capital formation soared by 18.3%, vigorous credit expansion propelling ahead growth. Expansion in fixed capital investment did decelerate sharply as the year advanced, however, with growth tumbling from 33.9% y/y in the first quarter to only 2.4% y/y in the fourth quarter. Similarly, household consumption growth also decelerated as the year progressed, with the improvement dropping from 11.4% y/y in the first quarter to a mere 3.2% y/y in the fourth. For 2011 overall, though, household consumption grew by 7.2%. Meanwhile, the Turkish economy managed to keep its exports growing rapidly. Although base effects sharply reduced growth in the second quarter, exports managed to expand by 6.5% for the year as a whole, inclusive of a 6.7%-y/y expansion in the fourth quarter as a whole. However, net exports were a strong contributor to growth even as export growth slowed in the second half of the year because import growth slowed even more sharply. After soaring by 22.6% y/y in the first half, imports of goods and services edged up just 0.6% y/y in the second half of the year. Real GDP Changes 2010 GDP Household Consumption Government Consumption Fixed Capital Investment Exports of Goods and Services Imports of Goods and Services
Source: Turkish Statistical Institute

2011 9.2 5.9 2.0 30.5 3.4 20.7 8.5 7.2 4.5 18.3 6.5 10.6

The economic recovery in 2010 was the strongest in Europe. In 2010, GDP soared 9.2%, more than recovering what had been lost due to the global economic crisis in 200809. With the 2010 recovery surpassing the 2009 downturn, the economy was the largest it has ever been, both in real and nominal terms. As in 2011, the economic recovery in 2010 was domestically driven. The Turkish banking and financial system survived the 200809 crisis in much better shape than many of its counterparts in Europe, thus allowing for a vigorous expansion of credit. This strong revival bolstered both household consumption and fixed capital formation. Strong domestic demand, however, did have a negative knockdown effect on the economy, as imports grew much more rapidly than did exports, leading to a negative contribution of net exports on headline GDP.

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Economic Growth: Consumer Demand - Outlook

Consumer confidence will resume a slow climb, although strong headwinds will continue to temper the potential gains. Although consumer confidence is still around four-year highs, the anticipated deterioration of confidence occurred in the second quarter due to tightening credit conditions, high inflation, and increasing worries about contagion from the likely Greek exit. In particular, worries that the banking system may have expanded credit too rapidly in the past few years may result in a much more conservative future of credit. Looking forward, confidence is likely to face periodic losses; in particular, should the recent improvement of labor markets stall because of a slowdown of industrial production. Nevertheless, it should resume an upward trend, even if it does not quite reach the 100-point demarcation line in the near future. Historically, Turkish consumers continue to spend even in the face of strong headwinds. The Turkish population is large and young, and remains relatively underserved by banking practices and credit. The market is seen as having great potential for retailers in the longer term because of these favorable demographics. However, in the short and medium term, the outlook for consumer demand remains guarded.

Economic Growth: Consumer Demand - Recent Developments

Consumer confidence remained weak in the second quarter of 2012, down from prior quarter. After averaging 93.1 in the first quarter of 2012, the consumer confidence index averaged just 91.7 in the second quarter, well below its year-earlier levels. Rising problems with inflation, concerns of tightening lending conditions, and the worsening of the Eurozone crisis raging just outside of Turkeys borders contributed to the second-quarter deterioration. Even after the second-quarter correction, however, the index remains well above its level throughout most of 2007 through 2010. The global economic crisis sent this index tumbling to a historical nadir of 68.9 as of November 2008. Aggressive interest-rate cuts by the Central Bank of the Republic of Turkey (CBRT) from late 2008 through late 2009 and expansionary fiscal policy aimed at reviving consumer borrowing helped to slowly build the index back up from late 2008 through late 2009. After a period of some slippage toward the end of 2009 due to growing worries regarding labor markets, the index was

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again generally strong in 2010. In 2011, the index reached a recent peak in June, at 96.4, the highest it had been in four years. It deteriorated throughout the bulk of the second half of the year before finally turning back upwards in the fourth quarter of the year and spilling over into early 2012. Stronger consumer confidence has paralleled the revival of household consumption activity. At the peak of the global crisis, Turkish household consumption was plunging by double digits. The CBRT's aggressive actions to restore consumer confidence, however, and the general strength of the Turkish financial sector helped limit the period during which Turkish consumer activity contracted. As a result, as early as fourth-quarter 2009, household consumption was reviving strongly, up by nearly 5% year-on-year (y/y). In 2010, with domestic credit expanding rapidly, household consumption also continued to grow, up by 6.0% for the year as a whole. By the first quarter of 2011, the strength of the recovery of household consumption was actually becoming a concern, up 12.0% y/y, raising worries of overheating. CBRT actions to temper domestic demand decreased growth, eventually to only 3.2% y/y as of the fourth quarter of 2011 and even further, to just 0.3% y/y in the first quarter of 2012.

Economic Growth: Capital Investment - Outlook

The vigorous gains in capital investment noted through mid-2011 will not be re-attained in the near future. Efforts to contain a gaping current-account deficit, troubles brewing in the banking sector, and the potential contagion from the Greek exit from the Eurozone all suggest that capital investment activity in Turkey will grow much more tepidly in 2012 and 2013 than it has in recent years. Growth rates similar to what was noted in the fourth quarter of 2011 and the first quarter of 2012 will be more the norm. A loss of export demand will drive up the amount of idle productive capacity, undermining the needs for capital improvement. In the longer term, however, capital investment prospects will remain relatively strong. A large, educated, young population with low labor costsas compared with the EUa central geopolitical location, and a cooperative government intent on expanding infrastructure development and attracting foreign investors would all provide a strong impetus for investment activity once the macroeconomic position of Europe returns to more normal conditions. The country is still in need of significant capital improvement, particularly its infrastructure. Once investment conditions improve internationally, the country should once again enjoy a strong increase in investment activity.

Economic Growth: Capital Investment - Recent Developments

The vigorous recovery of capital investment has given way to more modest gains in the face of the central banks tight monetary policy. In 2010, gross fixed capital formation was in the midst of particularly strong recovery, growing 29.9%. In the first nine months of 2011, it grew even more vigorously, up 25.4% year-on-year (y/y). With strong domestic demand fueling a rapid deterioration of the current-account deficit, the Central Bank of the Republic of Turkey (CBRT) took more aggressive actions to try to correct the imbalances. As a result, both household consumption and gross fixed capital formation began to decelerate sharply in the latter portion of 2011. In the final quarter, gross fixed capital formation managed to grow, but only by 2.4% y/y. In the first quarter of 2012, growth was even weaker at just 1.6% y/y. Despite an abundance of idle manufacturing capacity in the manufacturing sector as a whole, the private sector utilized extremely low interest rates and abundant credit to finance sharp increases in the stocks of their machinery and equipment and undergo long overdue modernization and streamlining. The tightening of credit conditions towards the end of 2011 and into 2012 helped to stem the strong increases. The public sector, constrained by a need to trim the fiscal gap, has been increasing investment with more restraint. This revival of capital investment began from a low base. In 2009, fixed capital formation collapsed, plunging 19.0% for the year as a whole. Higher costs of borrowing and a surge in idle capacity triggered the drop. The 2009 downturn built on a

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6.2% contraction already recorded in 2008. The downturn in 200809, triggered primarily by the shock of the global economic downturn, was an anomaly to recent trends. From 2002 through 2006, fixed capital formation grew by double digits annually, before finally slowing in 2007, when a peak of domestic political uncertainty and elevated interest rates curtailed further gains. Investment growth had actually been accelerating once again in 2008 before the onset of the global economic recession. However, by the end of 2010, investment had regained what had been lost, and any further expansion in 2011 represented new capital investment highs.

Labor Markets: Outlook

With the Turkish economy growing more slowly in 2012 and 2013, the recent strong recovery in the labor market is expected to backslide somewhat in the near future. While the country's industrial recovery is helping to return many previously laid-off workers to their jobs, hiring is somewhat guarded as uncertainty regarding future conditions remain strong. Having laid off thousands of workers from late 2008 through early 2010, Turkish manufacturers are attempting to boost their productivity levels and guard against future economic downturns by re-hiring workers slower than they dismissed them. With another economic slowdown in the offing, this reticence in re-hiring will intensify further in the near future. Nevertheless, we do not expect a major worsening, but rather more of a flattening of employment growth. As such, the downward push of unemployment should cool in the second quarter of 2012 and beyond before once again pushing downward in subsequent years. Nevertheless, the improvement in the longer term will be slow, not returning jobless rates to pre-crisis levels until around 2016 or so. In the longer term, the greatest challenge for the Turkish labor market will be creating enough jobs to deal with an expectedly sharp rise in labor participation. Although the official unemployment rate in Turkey is similar to the rates noted throughout the rest of Europe, its labor-force participation rate is significantly lower. According to a World Bank study, job creation going forward will be limited by the current large employment in the agricultural sector and unusually stringent labor regulations. The first of these problems is relatively unavoidable. In its economic development, Turkey will shed agricultural jobs and add industrial and service jobs. On the latter point, the World Bank urged sweeping reforms to address high severance packages, limitations on temporary work, and high social security costs. The country must also combat its pervasive shadow economy, against which potential legitimate employers must compete. Finally, with female labor-force participation far below the European average, enough jobs must be created as the government pushes to increase participationfrom 26% in 2009 to 35% in 2023, according to the June 2010 National Employment Strategy.

Labor Markets: Recent Developments

The vigorous economic recovery undid much of the damage done to employment markets by the 2009 downturn. Even as economic growth slowed, past strong gains continued to drive unemployment down in the first quarter of 2012. The officially registered jobless rate stood at 10.4% in JanuaryMarch 2012, down from 11.5% a year earlier. In 2011 as a whole, this same rate had averaged 9.8%, 2.1 percentage points down from its 2010 level. The average annual jobless rate was the lowest it had been since 2001. Total employment increased by 6.7% over the course of the year, driving the number of those out of work downward by 14.2%. Total labor force participation improved from 48.2% in 2010 to 49.1% in 2011. When combined with surveys suggesting why people were out of the labor force, it seems the gray economy was reduced in 2011. When measured using EU standardized methodology, the jobless rate was even lower than the officially reported data, suggesting an unemployment rate of only 8.8% for 2011 as a whole. While the addition of jobs and reduction of unemployment did deteriorate slightly in the fourth quarter of 2011, it did so only modestly.

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Labor-force participation remains below the EU average, particularly among women, of whom less than one-quarter are employed outside of the house. Unemployment rates would be significantly higher than currently noted if labor-force participation was at the EU levelthose that are now out of the labor force would instead be listed as officially unemployed. According to a 2010 National Employment Strategy, an emphasis through the medium term is being placed upon an increase of women in the workforce, although as 2012 began, little progress was yet noted. As that participation rate increases with more women entering the labor force, pressure might build for emigration to the EU if job creation is not significantly accelerated in Turkey.

Inflation: Outlook
Monetary policy is working more effectively than we had anticipated, although we believe a further deceleration will be difficult. The lowering of global energy price forecasts has helped to reduce the upward pressure on Turkish inflation in the near term, but we believe that low interest rates will fuel greater domestic demand, undermining the countrys ability to further reduce annual inflation rates. Additionally, potentially new hikes to excise duties will further confound efforts to drive annual inflation rates down further. In the third quarter of 2012, annual inflation is projected to remain in the high single digits. By the fourth quarter, in large part because of favorable base effects, annual inflation could come down much more rapidly, likely reaching or even surpassing the central banks end-year inflation forecast of 6.5%. The central bank, in fact, has indicated it would downwardly revise this figure soon, potentially to around IHS Global Insights own end-year forecast of 5.7%. Despite the drop-off of inflation at the end of the year, annual average consumer price inflation will remain up from 2011, thanks to strong expansion in the first part of the year. In 2013, annual inflation could trend upwards as domestic demand returns.

Inflation Indicators 2009 Consumer Price Index (% change) Wholesale-Producer Price Index (% change) 6.3 1.2 2010 8.6 8.5 2011 6.5 11.1 2012 8.8 6.6 2013 6.5 6.3 2014 5.7 6.4 2015 4.9 5.5 2016 4.5 4.7

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

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Inflation: Recent Developments

Inflation is decelerating, yet remains elevated in 2012 vis--vis 2011 levels. The restrictive monetary policy of the Central Bank of the Republic of Turkey (CBRT) has found success in finally driving down elevated annual inflation rates. In June 2012, annual consumer price growth was down to 8.9%. Although still elevated as compared with the 6.2% rate noted as of the same time in 2011, it nonetheless represents a sharp cooling from two months earlier when the inflation rate had topped 11%. Throughout the first three quarters of 2011, annual inflation had been at historical lows of between 4% and 6% for the country. Over the final quarter of last year, however, annual inflation accelerated, eventually ending 2011 at 10.4%, far surpassing the 5.5% end-year CBRT target. Elevated global energy prices, uncertainty over the CBRTs flexible monetary policy, and stronger domestic demand all contributed to the run-up of inflation late in 2011. In 2012, however, the energy price outlook has come down, and the CBRTs monetary policy has gained some comfort, allowing inflation to trend downward. After reaching a plateau in late 2011, annual producer price inflation is weaker. From April 2011 to late in the year, annual producer price inflation steadily accelerated. The negative external shocks on prices at the beginning of 2011 had a direct effect on producer price inflation. Specifically, annual producer price growth jumped from 8.9% as of end-2010 to 10.9% as of February 2011. After easing slightly in subsequent months, inflation began its steady march upward in April, reaching to 13.7% as of November. Since that milestone, inflation has generally eased, standing at 6.4% as of June 2012.

Exchange Rates: Outlook

We anticipate that the Turkish lira will continue to remain relatively strong vis--vis the US dollar in 2012. Any nominal depreciation will be modest and represent a relative stability or even strengthening in the real effective exchange rate. However, the regional concerns regarding the Eurozone crisis will cause some lira losses, even as the countrys own sovereign risks slowly improve (mainly because of the narrowing of the current-account deficit). With the success of the

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central banks monetary policy, there will be no shift to a more orthodox policy. The continued improvement of the current-account deficit will help to buoy the lira nonetheless. In the longer term, the lira will be stable and strong. Assuming that the CBRT and the government succeed in taming domestic demand and eventually begin to reduce the countrys external obligations, we anticipate that the Turkish lira will once again resume gaining value in the longer term. Previous worries that the lira might be overvalued have been dissipated due to the sharp losses noted since 2008. Gains in productivity from increasing capital inflows and the general push towards greater EU integration should bolster the strength of the lira.

Exchange Rate Indicators 2009 Exchange Rate (LCU/US$, end of period) Exchange Rate (LCU/US$, period avg) Exchange Rate (LCU/Euro, end of period) Exchange Rate (LCU/Euro, period avg) 1.49 1.55 2.15 2.15 2010 1.54 1.50 2.06 1.99 2011 1.91 1.67 2.47 2.33 2012 1.82 1.80 2.28 2.30 2013 2.00 1.97 2.30 2.30 2014 1.77 1.85 2.32 2.31 2015 1.72 1.75 2.36 2.34 2016 1.70 1.71 2.43 2.39

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Exchange Rates: Recent Developments

With the success of monetary policy, the Turkish lira has found stability and remains stronger than it had been at the beginning of the year. As 2012 opened, the Central Bank of the Republic of Turkey (CBRT) was in the midst of a strong defense of its currency. In December 2011, worries had mounted that the CBRTs policy mix had not done enough to stem domestic demand and begin to correct the countrys growing external imbalances, compromising the liras stability.

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By 30 December 2011, the Turkish lira had dipped to a historical low, falling below 1.911 per US dollar. This fall triggered an aggressive reaction from the CBRT, which flooded the foreign-exchange market with more than USD3 billion of dollar sales in the final trading day of 2011 and another USD650 million of sales in the first trading day of 2012. In all, this helped push the lira back to 1.881 per US dollar at the close of 3 January. In the month and one-half that followed, the lira continued to steadily rally, so by late February, the lira was up to 1.738 per US dollar. Since then, the lira has been generally strong in spite of some temporary setbacks, showing particular resiliency in recent weeks and months as the CBRTs monetary policy has begun to find more and more success in reducing the current-account deficit. By mid-July, the lira was trading at 1.806 per US dollar, 5.5% stronger in nominal terms than it had been at the close of 2011. The turn-of-the-year defense drew down official reserve levels, but since that initial foray, the bank has had to be less active, stemming the sharp drawdown. The lira was generally weaker in the latter portion of 2011. At the outset of 2011, the CBRT had intended to weaken the currency by pushing interest rates downward to reduce the inflow of foreign capital. By the end of the first half, the lira exchange rate was down to TRY2.350/EUR1.000, nearly 20% weaker than when the CBRT initiated its policy in December 2010. In the second half, however, the lira depreciated more rapidly than the CBRT would like because of mounting worries of overheating and the CBRTs poor policy responses to those concerns. In general, from July until the meltdown in late December, the lira went through periods of sharp depreciation followed by a stabilizing of the exchange rate in response to CBRT actions.

Economic Policy: Monetary Policy and Outlook

The Central Bank of the Republic of Turkey (CBRT) is unlikely to waver from its current, unorthodox monetary policy in the foreseeable future. The most likely interest-rate move sometime in 2012 will be a further reduction in the interest-rate spread for overnight lending/borrowing, given its success in reducing the current-account deficit and inflation, in hopes of discouraging too much of an influx of hot portfolio capital. Specifically, the top rate will almost certainly come down from 11.5% sometime in the next few months. Along with a slight expansionary effect of the lower rate, reducing the spread would also alleviate some day-to-day uncertainty in what interest rates might be in use. Nevertheless, there is little indication that the bank will abandon its approach altogether, and the headline policy rate will almost certainly remain unchanged for several more months. With the continued success of both reducing external imbalances as well as inflation, it is becoming less likely that the CBRT will need to revert to a more orthodox approach to monetary policy, instead likely standing by its current monetary policy throughout the remainder of 2012 and into 2013. For now, the biggest failure of the current approach is sticky inflation, an outcome that the CBRT may be willing to live with given the success in reducing

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external imbalances and the fact that at least inflation is now in high single digits instead of low double digits. The CBRT would only acquiesce to a shift away from the current approach if the countrys financial markets and foreign investment inflows are indeed eventually threatened by shifting sentiment.

Monetary Policy Indicators 2009 Policy Interest Rate (%, end of period) Short-term Interest Rate (%, end of period) Long-term Interest Rate (%, end of period) 6.50 17.65 17.20 2010 6.50 15.27 14.99 2011 5.75 14.22 14.19 2012 5.75 15.40 15.50 2013 5.75 13.41 14.43 2014 5.50 11.01 13.08 2015 4.75 9.17 11.86 2016 5.25 8.00 9.30

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

Economic Policy: Monetary Policy - Recent Developments

The Central Bank of the Republic of Turkey (CBRT) is currently in a cautionary monetary position, while still maintaining flexibility in its approach. The hallmark of the current approach to monetary policy has been a shift in interest-rate policy from reliance upon its main policy rate to the overnight interest-rate corridor between lending and borrowing rates. The CBRT has left its main policy rate unchanged at 5.75% since August 2011. We do not anticipate any change to this policy rate in the near future. The CBRT currently is putting more emphasis on the spread between the overnight lending and borrowing rates. At its 21 February 2012 meeting, the CBRT reduced the top of this spread (the overnight lending rate) from 12.5% to 11.5%, while the bottom of the spread (the overnight borrowing rate) remained at 5.0%. The CBRT is allowing interest rates to fluctuate within this corridor in order to try to achieve exchange-rate stability. Depending on demand for the lira, the CBRT releases funds somewhere either towards the top or bottom of this corridor.

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Normal days see the CBRT releasing funds at the countrys main policy rate. Exceptional days have the CBRT releasing funds at a rate of around 11%. The CBRT also regularly changes the value of its repo auctions to also attempt to stabilize the currency. Unfortunately by pursuing this strategy, interest-rate planning is sacrificed, a negative impact on potential investors in the country. This policy approach previously garnered criticism for not being effective enough in addressing the countrys massive external deficits, although in more recent months, much of that critique has been counteracted by the surprising success in driving down the current-account imbalance and a downward drift of inflation. More emboldened than ever, the CBRT shows little signs of retreat from its current position and held all policy rates unchanged at its July meeting. The Monetary Council even began showing signs of relaxing monetary policy somewhat, although it remains restrictive overall. Although perhaps equally controversial, the CBRT's policy position is nonetheless evolving from its approach in the first half of 2011. Beginning late in 2010, the CBRT launched a policy mix of low interest rates and tighter reserve requirement rates (and other administrative measures). The CBRT had hoped that by maintaining low interest rates, the influx of "hot" portfolio investment that had previously driven great financial sector instability would be limited. These inflows had also boosted the Turkish lira, limiting Turkish export competitiveness and boosting import demand. Meanwhile, to counter the expansionary nature of low interest rates, tighter restrictions on lira holdings would help drain the domestic economy of excess liquidity, encouraging a sharp slowdown of credit and monetary growth. Through the first half of 2011, the policy mix had little impact on credit growth or stemming the rapid deterioration of the current-account deficit. In the third quarter, however, progress was noted. The annual rate of growth of domestic credit, persistently running at around 35% through the first half of the year, finally dropped below the CBRT's unofficial 25% target in September, where it has remained below since. Meanwhile, the deterioration of the current account eased significantly in the third and fourth quarters, just as the CBRT had anticipated.

Economic Policy: Fiscal Policy and Outlook

While the governments 2012 budget plan is relatively strict, markets may force the government to eventually cut spending more substantially. As adopted, the government budget deficit is planned to be TRY21.1 billion for 2012 as a whole, or what IHS Global Insight estimates would be around 1.5% of GDP. In line with a fairly small fiscal deficit, Finance Minister Mehmet Simsek stated that public debt could ease from 39.8% of GDP in 2011 to 37.0% of GDP in 2012. However, the 2012 budget as adopted may be significantly altered before the end of the year. Growth will likely disappoint as compared to the budgets assumption, undermining potential revenue gains. Moreover, there remains an unwillingness by the government to significantly cut spendingas demonstrated by the continued sharp rise of expenditures through

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May 2012relying instead on increasing revenues. In fact, the government plans to increase state employment by 90,000 in an effort to ward off the potential deterioration of the labor markets as the negative ramifications of the Eurozone debt crisis hits Turkey. A more substantial effort to cut spending would help calm markets that remain jittery over the countrys dangerously large external imbalances. However, we expect that even with the fiscal problems, the countrys primary budget balance will remain firmly in surplus in 2012, with interest spending estimated to be around TRY50 billion.

Economic Policy: Fiscal Situation - Recent Developments

The leading, cash-budget indicators show that the government continues to allow spending to rise quickly. Through the first five months of the year, these cash-budget data indicate a 16.3% year-on-year (y/y) increase in non-interest expenditures. Even with the still-strong gain in spending, the overall primary budget balance improved y/y in JanuaryMay 2012, to 20.221 billion lira (up from TRY16.166 billion in the same period of 2011). Although economic growth is presumed to have slowed in the first quarter of 2012, budgetary revenues nonetheless grew rapidly in JanuaryMay 2012, up 17.6% y/y. The booming economy pushed Turkeys consolidated budget deficit downward to 1.3% of GDP in 2011, a five-year low and easily besting the 2.8%-of-GDP target. Budgetary revenues boomed due to the strong economy, rising by 16.3% on the back of a 20.5% surge in tax revenues. Meanwhile, expenditures grew much more modestly, up 6.4%, allowing for the sharp improvement in the headline fiscal balance. Although the government did keep spending from growing too rapidly, the slow gain in overall expenditures was much more a reflection of lower interest paymentsdown 12.6%than any excessive austerity measures by the government. Non-interest expenditures still grew 10.1%. Thus, the overall primary balance did not improve as dramatically as the consolidated headline figure did. Nevertheless, the country posted a primary surplus of 1.7% of GDP for 2011 as a whole. After a disastrous 2009, the Turkish government re-tightened fiscal policy in 2010. In 2010, Turkey posted a consolidated budget deficit equivalent to 3.6% of GDP. The shortfall represented a sharp correction as compared with 2009, when the government ran a shortfall of 5.5% of GDP. In addition, for 2010 as a whole, the fiscal deficit came in below the government's earlier projection of TRY44 billion, or 4% of GDP. The critical primary budget balancethe overall budget balance minus interest expendituresfor 2010 was in surplus by TRY6.215 billion, a positive turnaround from the TRY4.371-billion shortfall posted in 2009. The country's fiscal state was aided by a strong surge in tax revenues, the result of the strong domestic demand recovery. Further contributing to the sharp improvement in the state's finances, the government also successfully limited spending increases, and interest expenditures were alleviated by falling rates.

External Sector: Outlook

For 2012, we project that the current-account deficit will dip close to 8.0% of GDP for the year as a whole. While that gap still represents a major risk to continued stability in the country, it nonetheless represents a significant improvement against the 2011 level. The improvement of the current-account deficit in the final months of 2011 and early 2012 was much more substantial than we had previously anticipated. This sharp narrowing of the current-account deficit gives some hope that the overall deficit may be substantially reduced in 2012, at least as a share of GDP. The Central Bank of the Republic of Turkey (CBRT) is seemingly choosing to address the current-account deficit as its top priority rather than battling inflation, although the latter has even begun to drift downward. With global energy prices now forecast to be lower than previously expected, further strong gains in the current account can be expected over the remainder of 2012. Some improvement will be moderated as the CBRT will likely ease monetary policy at home, preventing the current fall of imports to continue unabated. Even with the strong improvement in the current-account deficit, the gap remains

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large enough to put immense strain on the countrys ability to find financing given the risk aversion that remains strong in the shadow of the Eurozone debt crisis.

Trade and External Accounts Indicators 2009 Exports of Goods (US$ bil.) Imports of Goods (US$ bil.) Trade Balance (US$ bil.) Trade Balance (% of GDP) Current Account Balance (US$ bil.) Current Account Balance (% of GDP) 109.6 134.5 -24.8 -4.0 -13.4 -2.2 2010 120.9 177.3 -56.4 -7.7 -46.6 -6.4 2011 143.5 232.9 -89.4 -11.6 -77.2 -10.0 2012 157.1 237.5 -80.5 -10.0 -66.6 -8.3 2013 168.3 251.2 -82.9 -10.3 -66.0 -8.2 2014 179.8 266.2 -86.4 -9.1 -68.2 -7.2 2015 191.7 280.2 -88.5 -8.0 -68.9 -6.2 2016 204.3 294.9 -90.6 -7.3 -73.8 -6.0

Source: Historical data from selected national and international data sources. All forecasts provided by IHS Global Insight. Table updated on the 15th of each month from monthly forecast update bank (GIIF). Written analysis may include references to data made available after the release of the GIIF bank. Download this table in Microsoft Excel format

External Sector: Recent Developments

The gradual narrowing of the current-account deficit that began in late 2011 intensified through the first five months of 2012. In JanuaryMay, the current-account deficit dropped to USD27.051 billion, more than USD9.9 billion smaller than it had been in the same period of 2011. In the first five months of the year, merchandise imports fell 0.8% year-on-year (y/y), facilitating the decline in the overall current-account imbalance. In spite of weak demand from the EUTurkey's biggest trade partnermerchandise exports managed to grow a vigorous 13.3% y/y, buoyed by increasing demand from Iraq and the rest of the Middle East. While the current-account balance improved y/y, the net flow of non-debt-creating foreign capital worsened. Net foreign direct investment inflows dropped from USD4.748 billion in JanuaryMay 2011 to just USD3.833 billion in the same period of 2012, while the net inflow of portfolio investment plunged from USD15.039 billion to USD6.805 billion.

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The current-account deficit reached 10% of GDP in 2011, a historically large shortfall for the country. The current-account gap had been rapidly widening vis--vis year-earlier levels throughout the first 10 months of 2011, with the countrys overall shortfall nearly doubling in nominal US dollar value. However, in the final two months of the year, the efforts of the Central Bank of the Republic of Turkey (CBRT) to reduce the current-account deficit finally began to show dividends, the headline current-account deficit narrowing first by 8.5% y/y in November and then by 12.8% y/y in December. The USD77.089-billion current-account deficit for 2011 is equivalent to right at 10% of GDP. The shortfall is dangerously large and is the highest such gap ever recorded for Turkey. As the year came to a close, the deterioration of the merchandise trade deficit slowed, facilitating the turnaround in the headline current-account balance. Import growth slowed sharply in the final months of the year in response to an effort to stem domestic demand. This slowdown would have had an even greater impact if not for a similar deceleration of export growth due to the worsening of export conditions to the rest of Europe. Also contributing to the narrowing of the current-account deficit in the final months of the year, income outflows dropped off precipitously in the latter stages of 2011. While Turkeys current-account deficit worsened substantially in 2011, inflows of non-debt-creating financing improved to offset some of the increased danger. The net inflow of foreign direct investment (FDI) and of portfolio investments both soared vis--vis their 2010 levels. Nevertheless, the improvement in non-debt-creating capital inflows was only enough to offset about one-third of the worsening in the current-account deficit. As such, the difference was made up by a rise in debt and a reduction in reserves (whereas in 2010, the country added significantly to its reserves). Additionally, the countrys errors and omissions line was much larger in 2011 than in the previous year, a reflection of greater inflows of previously foreign-sheltered capital back to the country.

Economic Structure and Context: Development and Strategy

Economic Development Until the turn of the century, Turkeys economy struggled through years of dichotomy, torn between a dynamic private sector and a laggard quasi-public sector. Economic policy was caught between a deeply rooted tradition of government control and market-oriented economic reforms. Remnant influences of state control proved to be problematic, evident in the multiple crises the economy endured over the past 1020 years. State-directed lending through banks regularly flooded the economy with liquidity, causing endemic inflation and undermining the value of the currency. A

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combination of subsidization and public-sector banks triggered excessive bad debt and chronic government indebtedness, characterized by double-digit fiscal deficits. The economic system was further compromised by political instability within the country. Torn between conservative Islamists, the fiercely secular military, and economic reformers, no politician or political party had the unity to stand behind much-needed economic reforms until after the turn of the century. The economy was characterized by a spate of stop-and-go economic development. Recession was repeatedly experienced. Rising trade, current-account, and budget deficits, high foreign-currency borrowings by banks, and a government at its domestic borrowing limits all put pressure on the lira, which triggered several administrative devaluations. In 2001, the lira crisis delivered the government into the arms of the International Monetary Fund (IMF) with a huge bailout package, accompanied by a raft of promises toward fiscal austerity and reforms, including the establishment of a free-floating lira. The Turkish government continued to receive IMF support until 2008, following the successful completion of a final stand-by agreement. Since the 2001 bailout, economic policy provided the foundation for much more sustainable economic recovery. Key to the success has been the measure of political stability afforded the country by the rise of a single-party government controlled by the moderate Islamic Justice and Development (AK) Party. The AK Party, for their part, embarked upon IMF-mandated reforms that have bolstered the independence of the financial sector and slowly have begun withdrawing the government from the economy. Investors slowly began returning to the economy as the lira crisis faded, leading to equity and bond price rises. Economic Strategy The coming to power of the AK Party solidified a reformist program aimed at breaking decades of corporate mismanagement and ingrained, inflationary expectations. Those policies activated by the AK Party include: A free float of the currency that redistributes stress on inflation control elsewhere among monetary authorities and provides an early warning to potential balance-of-payment crises. The central bank has been granted operating authority over interest-rate policy. The government has maintained a large primary fiscal surplus, even though it has waned somewhat in recent years. The interest costs of debt servicing exact a heavy burden, demanding ambitious surplus targets. Inflation has been falling, now generally running at its lowest levels in over 30 years. Widespread structural reforms have been undertaken, most particularly in the banking system. Economic reforms were conducted in close consultation, if not always in exact harmony, with the IMF. Even given the impressive progress made since 2001, the country remains vulnerable to international crises and relapses of its crisis-prone history. In fact, reforms initiated since 2001 have helped to limit the severity of economic disruption. In addition, with both a comfortable reserve base and flexibility within the currency, the authorities are much better equipped to defend against exogenous shocks than they had been previously. This level of advancement was demonstrated during the 200809 global economic crisis and the ongoing Eurozone debt crisis. While the country has been hurt by the weight of the international downturn, enacted reforms have helped avert a larger collapse of the type seen in many other countries of the region.

Economic Structure and Context: Demographics and Labor Markets

The Turkish population increased from 66.5 million in 2000 to an estimated 75.7 million in 2010 and is projected to reach 83.9 million by 2020. Turkey has the second-largest population among European Union (EU) members or candidate countries, after Germany. Nevertheless, despite its large size, the density of the population will remain considerably lower (90 persons per square kilometer) than the average of the EU countries, estimated at around 118

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people per square kilometer. We expect that the process of urbanization will continue at similar rates to those witnessed in the last several years. For comparison, the urban population reached 44 million people in 2000, or 65% of total population, up from 60% some 10 years earlier. The Turkish population is and will continue to be one of the youngest in Europe, with 58% of the population below 30 years of age. According to a 2000 census, 32.8% of the population was under 14 years and 62% was in the age group of 15-64 years. The number of elderlyrepresented by the population aged above 65 yearsgrew to 5.3% of the total population. The number of people below 30 years of age is projected to increase to 41.7 million by 2015, but their share of the total population will decrease to 51%. From 1999 to 2015, this represents a total fall of 14% in this age bracket. Official unemployment in the country is given at around 1015% of the workforce. There are those who believe the true level of unemployment within the country is underreported and the real level is actually five percentage points higher. On the other hand, extensive black market operations may make actual unemployment much lower that what is officially reported, with many workers operating outside of official measure. Another potential cause for the difference in unemployment rates is accounted for by differing estimates in the labor participation rate. At a little less than half the total population, Turkey has one of the lowest labor participation rates in the Organisation for Economic Co-operation and Development (OECD), a figure that has actually been in decline over recent decades. This low participation rate is primarily due to the lack of female participation in the economy, a problem that is only slowly being addressed. As more women enter the labor force, demand for employment will rise, putting further stress on the countrys lack of job creation. Unemployment levels have been slow to fall with public-sector restructuring, particularly with reference to state and quasi-state concerns.

Economic Structure and Context: Monetary System

The central bank works in autonomy to meet government inflation targets. The governor is appointed to a five-year term by the prime minister, as approved by the president. With the appointment of the previous governor, Durmu Yilmaz, in early 2006, worries were high that the central bank might fall under too much control of the government. Yilmaz proved to be an able governor, earning extremely high marks for guiding the country through the 200809 global financial crisis. The Central Bank of the Republic of Turkey (CBRT) was among the most aggressive central banks in the world in acting to offset the negative effects of the global economic crisis in 200809.The current governor, Erdem Bai, has faced greater scrutiny given the central bank's more unorthodox monetary policy in 2011 to address overheating concerns. Worries have once again arisen that the CBRT governor is operating under too much pressure from government quarters. Nonetheless, institutionally, the bank remains strictly independent. The central bank maintains the Turkish currency, the lira, on a free float. Nevertheless, it will intervene against what it regards as unjustified corrections regarding the lira. The central bank utilizes interest-rate manipulations as well as a whole breadth of monetary policy tools to affect the lira's value.

Economic Structure and Context: Financial System

The banking sector had been the economy's Achilles' heel until 2001, but it has since been exactly the opposite, a source of strength. Prior to 2001, state-controlled (or more accurately, party-controlled) banks bankrolled nationalized industries to the cost of growing bad debt. The creation of the Banking Regulation and Supervisory Agency, in line with the International Monetary Fund (IMF), put the cost of cleaning up the banking sector's bad debt at a little short of USD50 billion in 2001, around one-third of GDP at that time. After significant privatizations and asset-sheet clean-ups, the banking

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system under the country's credit package with the IMF is in a position of much better health. By 2005, non-performing loans (NPLs) as a percentage of total loan assets were down to below 10%well under the near-30% level that NPLs reached in 2001. To achieve such improvement, the government allowed a significant influx of foreign participation, although unlike many of the other countries of Central and Eastern Europe, the majority of banking assets remained in Turkish hands, limiting the country's exposure to the European banking debt problems of 2009 and 2010. In fact, the country's financial system came through the global crisis with flying colors, providing a source of potential growth for the near future. In 2011 and now into 2012, there are worries that the banking system is once again facing troubles, with asset quality rapidly deteriorating because of the sustained, rapid expansion of the system. However, compared with the banking systems of Europe, Turkeys remains relatively worry-free. The bourse is relatively young, with the Istanbul exchange being founded in 1985. Although it remains extremely small and of little impact on the economy as a whole, it is one of the livelier among emerging markets, with over half of stock traded being held by foreigners. Foreigners have been able to trade unrestricted on the exchange since 1989. Indeed, one of the weaknesses of the exchange has been a lack of domestic funds for investment, stifled by the heavy presence of banks within the economy. Thus, during times when global capital is averse to riskier economies, the bourse takes a heavy hit. In keeping with the nature of the rest of the economy, the exchange suffered from notable volatility in its beginning, although it has been much steadier in recent years. There is the belief in the country that as banking reform continues, deeper capital markets will provide a more solid financing base to further future growth.

Economic Structure and Context: Key Sectors

Turkeys industrial sector is well developed. Main areas of specialization include textiles and clothing, ceramics and glass, steel, chemicals, and light consumer goods. The production of automobiles is a leading growth sector. Turkey's vibrant manufacturing sectors complement well the energy-rich, new markets to its northeast around the Caspian Sea, as well as established markets in the Middle East and Europe, to which it is uniquely positioned. While the country's agricultural dependence is easing, it remains a significant source of value added to GDP. Moreover, given the country's fertile and vast area, it will likely remain a significant contributor to the economy as a whole for some time to come. The sector could benefit from greater technological transfers and improved infrastructure, and it remains vulnerable to shifting weather conditions. For other energy resources, Turkey is heavily dependent on imported oil and gas. Power capacity is set to increase, but Turkey is not yet self-sufficient in electricity. The country hopes to become a key energy middleman between the markets of Europe and the production of Russia and Central Asia. Services are growing fast on the back of the media, transport, and tourism sectors. The tourism sector, in particular, has been instrumental in helping the economy find greater balance on the external accounts, becoming a key earner of foreign currency. Turkey: Top-10 Sectors Ranked by Value Added 2011 Level (Bil. US$) 1. Agriculture 2. Real Estate 3. Retail Trade - Total 4. Wholesale Trade 5. Business Services 6. Communications 7. Construction 77.4 55.3 48.2 44.4 42.5 41.3 34.0 2012 Percent Change (Real terms) 1.6 2.5 1.3 2.7 2.7 0.2 3.5 Percent Share of GDP (Nominal terms) 10.5 7.5 6.6 6.1 5.8 5.6 4.6

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8. Public Admin. and Defense 9. Education 10. Land Transport Top-10 Total

33.1 24.9 21.1 422.1

-0.9 0.4 2.5

4.5 3.4 2.9 57.6

Source: World Industry Service, IHS Global Insight, Inc. Updated: 17 Jul 2012

Economic Structure and Context: Natural Resources

Agricultural resources in the country are relatively rich in a series of diverse cereal, cash, and fruit crops. More specifically, the country's agricultural production is greatest in tobacco, cotton, grain, olives, sugar beets, and citrus fruits. The country is also the leading exporter of hazelnuts. Substantial mineral reserves exist in copper, zinc, lead, and gold. The country is a leading global exporter of chrome. Some oil deposits exist within the country, but are not enough to meet domestic demand. Natural gas deposits only supply around 2% of domestic consumption. The country is developing itself to become a key transit point for Russian and Central Asian raw energy products. More resources are being poured into further development of energy refining. The country has substantial reserves of coal, estimated at around 1 billion tonnes. Tourism potential in the country is considerable. Its diversity includes beach resorts to spectacular countryside, numerous antiquities, and cosmopolitan cities.

Economic Structure and Context: Trade Profile

Turkeys trading patterns are undergoing significant changes. The evolution of Iraq in recent years has led to a rapid resumption of trade with that country. The Iraqi market is fast becoming a key destination for Turkish exports. Additionally, the country has been aggressive in building up its markets in both the Middle East and Africa, attempting to broaden its export base. As a result, trade with the United Arab Emirates has soared. Turkey is trying to mimic its success in sending goods to the United Arab Emirates with the other countries throughout the Arab world. Otherwise, the countries of the European Union (EU) and the United States are the countrys primary trading partners. On the import side, cheap Chinese imports are securing an increasing share of total imports into the country. In addition, new energy pipelines from Russia and Central Asia are causing trade with those countries to grow rapidly. The makeup of Turkeys commodities trade is also evolving. Chinese imports received a boost at the beginning of 2005 with the cessation of textile and apparel restrictions. The ending of these international restrictions have undermined Turkeys ability to export its own apparel and textiles to the rest of Europe and the world, with it now facing greater international competition. Prior to the current economic crisis, the country had been rapidly increasing as an automotive exporter. Energy imports and exports are growing rapidly, as Turkey is positioning itself to be a key trading point between the crude energy providers of Russia and Central Asia and the Middle East and the markets of Europe. Turkey: Major Trading Partners, 2010 EXPORTS Country Germany Billions of USD 11.5 Percent Share 10.1 IMPORTS Country Russia Billions of USD 21.6 Percent Share 11.6

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United Kingdom Italy France Iraq Russia United States Spain United Arab Emirates Iran
Source: IMF, Direction of Trade

7.2 6.5 6.1 6.0 4.6 3.8 3.6 3.3 3.0

6.3 5.7 5.3 5.3 4.1 3.4 3.1 2.9 2.7

Germany China United States Italy France Iran Spain South Korea United Kingdom

17.5 17.2 12.3 10.2 8.2 7.6 4.8 4.8 4.7

9.5 9.3 6.6 5.5 4.4 4.1 2.6 2.6 2.5

Turkey: Major Trading Partners, 2000 EXPORTS Country Germany United States United Kingdom Italy France Netherlands Spain Israel Belgium Russia
Source: IMF, Direction of Trade

IMPORTS Billions of USD 5.2 3.1 2.0 1.8 1.7 0.9 0.7 0.7 0.6 0.6 Percent Share 18.6 11.3 7.3 6.4 6.0 3.1 2.6 2.3 2.3 2.3 Country Germany Italy United States Russia France United Kingdom Spain Belgium Japan Netherlands Billions of USD 7.2 4.3 3.9 3.9 3.5 2.7 1.7 1.7 1.6 1.6 Percent Share 13.2 7.9 7.2 7.1 6.5 5.0 3.1 3.0 3.0 2.9

Medium- and Long-Term: Outlook

A protracted malaise in the European Union will slow Turkish economic growth in the next several years. Merchandise exports and capital investment inflows will be subdued in 201214 as Turkeys major partners in Europe dig out from the current Eurozone debt crisis. Not all forward growth momentum will be lost, however. Turkey has diversified both its trade and investment partnerships to include more of the Middle East. Thus, a collapse of demand and investment from the European region does not leave Turkey devoid of activity, although it does severely reduce these levels. Moreover, as of mid-2012, the central bank seems to have successfully navigated a soft landing for the economy, avoiding the crash that might have accompanied the correction of the current-account deficit. After this short-term economic slowdown, however, the Turkish economy remains relatively well equipped for sustained, strong expansion in the longer term. With a well trained and underutilized labor market, an advantageous geopolitical location with warming, albeit sporadically, ties with Europe, low interest rates, and an improving bureaucracy, fixed capital investment growth should recovery relatively robustly in the medium and longer term. Additionally, consumer

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credit penetration is still relatively low in the country, particularly the use of credit cards. The banking sector is stable and eager to expand consumer credit opportunities, so once the current regional malaise lifts, consumption growth could revive rapidly. This comparatively strong medium-term outlook for domestic demand has a rather large drawback in that it will prevent a rapid improvement in the dangerously large current-account deficit. The government will need to do a better job attracting more stable foreign direct investment inflows to help financing the sure-to-be large gap through the next several years. To address the current-account deficit, structural reforms are needed to make the country less import dependent, while a greater effort to contain domestic demand is needed. The government is promising such reforms, but much must be done before a meaningful change is noted. For now, financing the current-account deficit is a major risk for the country, particularly as incoming capital will be diverted in the short and medium term to finance still-large fiscal gaps and onerous debt-repayment obligations. Turkey's longer-term economic outlook remains clouded by continuing doubts regarding the country's prospects of membership in the EU. When the accession process formally began in October 2005, it was widely assumed that the path would be long and fraught with problems. Final accession was initially widely assumed to come no earlier than 2015. Nevertheless, even these relatively guarded assessments of the process have proven to be extremely optimistic, as rumors of potential derailment of the process have persisted in both Brussels and Ankara. Right now, it is unlikely that the country will actually achieve EU membership for the foreseeable future (certainly not any sooner than 10 years out). In recent annual reports regarding Turkish accession, the European Commission criticized a lack of movement on several key reform areas. The 200809 global crisis and ongoing Eurozone crisis only served to derail needed reforms further, particularly privatization efforts. Moreover, continuing institutional crises within Turkeybetween the government and the military, between the government and the judiciaryfurther undermine forward momentum, suspending potential progress in reforms. Although EU-based reports have remained relatively optimistic about both the overall movement toward accession and the prospects, an impasse over Turkeys refusal to recognize Cyprus has created a significant stumbling block. Even without the Cyprus issue, doubts from within the EU, particularly France, are growing, potentially forcing an early ultimatum as to the accession process. It is now increasingly possible that the accession process might be terminated from either the EU or the Turkish side, as Turkish citizens are growing disaffected from the movement, largely as a reaction to EU hesitation. If the overall accession process is derailed, the medium-term economic forecast would be affected. Nevertheless, our baseline expectation is that these negotiations will indeed continue, although not necessarily to ultimate fruition. In any case, the general push of reforms that we assume will happen to facilitate EU accession will likely continue, regardless of the official EU prospects for Turkey. If accession is formally off the table, we expect that the Turkish economy will continue to become integrated with that of the EU. In fact, denial of full membership, which politically could be severely damaging, may free the Turkish economy somewhat, allowing the country to avoid some of the more restrictive or burdensome reforms demanded by the EU. As the economy evolves to become more integrated with the EU, the value-added contribution to GDP will shift significantly. Services are expected to grow the most rapidly over the medium and longer term, as the countrys tourism undergoes a radical transformation and evolution. The country is aggressively attempting to de-emphasize agricultural production, hoping to relocate agrarian workers into higher-technology and higher value-added manufacturing sectors. The 200809 economic downturn set this process back somewhat, with a loss of industrial employment once again pushing agricultural employment upwards. Nevertheless, we anticipate that the push towards higher technology will once again resume, driving down the influence of low-tech sectorsin particular textiles and clothing. Economic development will center on Istanbul but increasingly push to the east. The countrys position as an energy middleman will continue to develop, with investment flows heavy in developing new energy pipelines to bring in raw energy products from the East and to export refined energy products to the West. As such, Ankara has been aggressive in signing deals that deliver Central Asian gas to European markets. As discussed previously, the substantial current-account deficit will present severe downside risks to the country's sovereign debts throughout the short and medium term, only slowly easing in the longer term. Although the recovery in import demand in the short term will be sharply stronger than the subsequent revival in exportspartly due to the stronger lirawe nonetheless expect export growth to recover fully further out, contributing to a slow narrowing of the current-account deficit in the longer term. Nevertheless, given that the deficit will remain fairly large for quite some time

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at 3.0% of GDP or more until around 2025, financing will remain a major threat to Turkish stability. As such, external debt will remain a constant threat, potentially running up rapidly if investment inflows are ever compromised. Slowly, an influx of more substantial foreign direct investment inflows should help alleviate the country's reliance on debt financing. These foreign investment inflows will also help to buoy longer-term economic growth, bringing with them technology transfers that should help boost the country's productivity levels.

Analyst Contact Details:

Andrew Birch

Turkey: Country Reports - Recent Analysis

Sovereign Risk - Economic

1. Surging Gold Exports to Iran Contribute to Sharp Reduction in Turkish Trade Deficit in H1 01 AUG 2012

Economic

2. Turkish Leading Production Indicators Support Soft Landing Expectation 26 JUL 2012

Economic

3. Turkish Central Bank Keeps Interest Rates Unchanged But Increases Domestic Liquidity 20 JUL 2012

Economic

4. Turkish Consumers Remain Wary Despite Modest Labour Market Gains 17 JUL 2012

Sovereign Risk - Economic

5. Turkey's Current-Account Deficit Continues to Narrow Sharply, Buoying Domestic Markets 12 JUL 2012

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Economic

6. Turkish Growth Indicators Continue to Surprise on the Upside Although Budget Data Disappoints 10 JUL 2012

Economic - Country

7. Turkey's GDP Growth Surprisingly Strong in Q1 03 JUL 2012

Economic

8. Leading Production Indicators Suggest Significant Turkish Slowdown in Q2 26 JUN 2012

Economic

9. Turkish Central Bank Keeps Interest Rates Steady Once Again in June 22 JUN 2012

Economic - Sovereign Risk

10. Moody's Upgrades Turkish Sovereign Risk Rating to One Notch Below Investment Grade 21 JUN 2012

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