The current account deficit and growth

The rise in inflation and interest rates as a result of the volatility on the financial markets in May and June did not result in the economy slowing as much as had been anticipated and, instead of falling as expected, the current account deficit increased during the summer months. This resulted in discussions about the current account deficit, which we had forgotten about over the previous four months, topping the agenda once again.

The reason for the fear of the current account deficit in Turkey is no secret. Most of the crises that Turkey has experienced over the last half century have been preceded by an explosion in the current account deficit. The increase in the current account deficit in 1951-53 triggered the crisis of 1954-58, the rise in 1975-77 the crisis of 1978-80. There were large current account deficits in 1993 before the crisis of 1994 and in 2000 before the crisis of 2001.

The memories of the last two crises in particular are still very fresh. As a result, as the current account has begun to rise again since 2003 some economists have become obsessed with the prospect of an imminent crisis. Over the last two years the current account deficit has risen to unprecedented levels and, although we have not had a crisis, but we are still haunted by the fear of one. Many economists argue that as long as this current account deficit continues, a crisis is inevitable sooner or later and they are urging that measures be taken immediately in order to reduce the current account deficit.

The results of a study
But people disagree about the impact that measures taken to reduce the current account deficit will have on growth. Some, led by Ege Cansen, a journalist with Hürriyet newspaper, argue that the economy will grow faster with a low current account deficit. Others hold the view – which we also share -- that it is impossible to have high growth with a low current account deficit.

Last month, those in the first camp received an important boost from a study prepared by three economists at the IMF and presented at a conference in the USA (Eswar Prasad, Raghuram Rajan ve Arvind Subramanian, “Foreign Capital and Economic Growth”, A Symposium Sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 24-26, 2006). The results of this study, which examined the relationship between foreign investment and growth, show that there is a positive relationship between the current account and growth. As you can see from the graphic on page 2, according to this study, developing companies which have a current account surplus grow more rapidly. Developing countries which have a current account deficit grow more slowly.

The situation in Turkey is different
But according to our research, the situation in Turkey is different to the one in the study. For example, the graphic that we have prepared based on data in Turkey for 1970-2005 and which is also shown on page 2 shows that there is a negative relationship between the current account and growth in Turkey. I mean, when Turkey posts a current account deficit then growth accelerates and when there is a surplus growth slows.

The reason the situation is different in Turkey is the structure of the economy. Production in Turkey is dependent on imports, which means that there has to be an increase in imports in order for the economy to grow. Because production is primarily for the domestic market, exports do not rise enough to finance imports. In such a situation, a deficit with the rest of the world is inevitable.

If Turkey is to grow without a current account deficit then the structure of production in the economy must change. Most importantly, sectors which produce intermediate goods must be developed and the dependence on imports must be decreased. Moreover, it is essential that there is also a rise in production for export. But it is impossible to realise these goals in the short-term. Even within a comprehensive plan and programme it looks as though it would take at least 10 years to change an economy in which the production structure is dependent on imports.

We have to grow rapidly
So are we currently in a possession where we can tolerate a lower rate of growth, reduce the current account deficit and save ourselves from this nightmare that haunts us?

Unfortunately, the prevailing demographic processes in Turkey do not allow such a possibility. The population of young people in Turkey is growing rapidly. Every year around 500,000 young people complete their schooling or their military service and join the workforce. The studies that have been conducted show that in order just to provide jobs for these young people the economy must grow by 6 percent a year.

Given that the current rates of demographic change are expected to continue until 2020, we do not have the luxury of slow growth for at least another 15 years. Because in such a situation unemployment will rise rapidly. While focusing on rescuing ourselves from the nightmare of the current account deficit, we would be faced with

the fear of a social explosion.
In such a situation there does not appear to be any solution except continuing high growth and increasing the current account deficit. But in the short term we should now try to improve the quality of the financing of the current account deficit and in the long term change the structure of the economy to one in which production is less dependent on imports.

The quality of financing is rising
In any case, over the last year there has been an improvement in the quality of the financing of the current account deficit. Foreign capital inflow, which in previous years had not exceeded more than a few billion dollars, reached US$ 8.7 billion last year. In the first seven months of this year direct foreign capital inflow totalled US $9 billion and it looks as if it will exceed $12 billion by the end of the year. Direct foreign investment is seen as the soundest way of financing the current account deficit.

But we still do not see any development in terms of changing the structure of production of the economy from one which is dependent on imports. On the contrary, sectors such as automotives in which there are a lot of imports are taking a higher share of production and the dependence of the economy on imports is rising still further. In order to make progress in this regard, it looks as if the government must introduce an incentive mechanism which is neither supine nor degenerate.

Inflation Is Now Within The Cb’s Forecast Band
The Central Bank’s most recent forecasts for inflation were published on 28 July in its third Inflation Report. But the first of its predictions, which was the inflation figure for July, was not realized as expected. Inflation was higher than anticipated in July and right out the outset was already higher that the Central Bank’s forecast band.
But in August inflation was much lower than expected and this allowed annual inflation was within the Central Bank band. Moreover, annual inflation fell to close to the lower limit of the Central Bank’s forecast band.

Inflation in August was expected to be around 0.4 percent but actually came in at minus 0.44 percent. The main reasons for negative inflation were the significant falls in the prices of the foodstuffs and clothing. Last year tax increases resulted in a rise of 16.97 percent in the prices of tobacco and alcoholic beverages, whereas this time the prices remaining stable which contributed to inflation being low.
There may be an increase in inflation in September as a result of seasonal factors and the impact of Ramadan. But there is currently no sign of any developments which could fuel a rapid increase in inflation in the final quarter of the year. For this reason, it looks as though there is a strong possibility that annual inflation, which declined to 10.26 in August, could close 2006 in single figures.