A plumper Turkey

By bne IntelliNews November 6, 2006

Ben Aris in Istanbul -

It's been a nasty year for Turkey. After years of volatility, the country was basking in the sunshine of five years of unbroken growth when investors' confidence in emerging markets collapsed in May during a sell-off on global equity markets.

From the outside Turkey's economy looks a mess. The government has been living a hand-to-mouth existence for most of the last decade, financing big trade and current account deficits with short-term debt. The debt hasn't gone away, but as the incoming money becomes longer term and committed to investment, Turkey's fortunes are now looking up.

The poor state of Turkey's fundamentals meant that the local stock market got clobbered during a sharp sell-off in global equity markets in May.

Investors all headed for the door at once, forcing the central bank to hike interest rates and so undo much of the progress of the last few years. But bankers in Istanbul have shrugged off the fall in the markets, arguing there has been a fundamental change that makes the country less vulnerable to the vacillations of portfolio investors. Improving fundamentals and burgeoning foreign direct investment (FDI) mean everyone is expecting the economy to bounce back from a blow that would have sparked another crisis only a few years ago.

Turkey was a basket case for decades as its economy swung between years of 8% GDP growth followed immediately by an 8% contraction. The government played Russian roulette by relying on the whims of foreign investors, who funded a crushing debt burden that was larger than the value of the entire economy. Hot money flowed into short-term, high-yielding treasury bills – money that left just as quickly at the first sign of trouble.

The debt was the economy's Achilles heel. However, five years of steady growth means the public finances have improved to the point where the government is able to start paying this debt down: this year Turkey became a net payer of debt for the first time in a decade thanks to the prudent policies of the central bank, which have reduced inflation and the real levels of debt.

Turkey is not out of the woods yet, but the World Bank's Turkey Director Andrew Vorkink called the country a "rising global power." investment bank Morgan Stanley agreed, advising its clients at the start of October to go "overweight in Turkey" as its prospects improve.

"Turkey is more predictable these days as we have political stability," says Mehmet Sami, the board member of ATA Invest in charge of investment banking. "The average life of a government used to be 18 months during the previous run of coalitions governments. Now the train is on the track."

Foreign direct investment

The big change is in the type of money flowing into Turkey. The country is weaning itself off its addiction to stop-gap hot money, replacing it with huge amounts of foreign direct investment (FDI) over the last couple of years. The World Bank estimates that the proportion of hot money as a share of incoming capital has fallen by 80% this year compared with last year.

Headline FDI in 2005 topped $10bn against an average of $1.5bn a year the country attracted in the preceding years. And the headline figure doesn't paint a complete picture. Many of these deals are being paid in instalments, so the value of the investment is up to three times higher. Sami says if you tot up the total value of recent deals signed in the last year, then the FDI number is closer to $35bn.

The trend will continue this year as direct investors are showing a lot more confidence in the economy's long-term prospects than portfolio investors: Turkey received another $9bn in FDI over the first six months of this year, and both ATA Invest and the World Bank expect FDI to reach $18bn-$20bn by the end of the year.

"Last year's was the highest amount of FDI ever received and compares favourably even with China, which boasts a single year FDI record of about $50bn," says Sami.

Most of this capital is going into one of two places: financial services and large privatisations. There has been a string of bank takeovers in the last year worth more than $10bn, which has brought the foreign share of banking sector capital up to 20%.

Economic growth

"Amazing" is how ATA describes Turkey's return to economic health after the economy put in an average of 7.4% growth over the last four years, at the same time as consumer prices sank from hyper-inflated levels to a more manageable 10.6% by the middle of this year.

"The average growth over the last 15 years has been 4.4%, including the dips, which easily beats out the OECD average of 2.2% growth," says ATA. "The problem in the past is growth came with volatility."

Businessmen and investors have been on a white-knuckle rollercoaster ride as GDP growth would sometimes swing from an 8% contraction during a crisis to 8% growth in little more than 24 months. The economy contracted by more than 5% in crises in 1994, 1999 and 2001, but on most occasions rebounded to over 6% the next.

However, the wax of long-term investment and wane of hot money means economic growth has settled down to a less dramatic rhythm. The economy has grown consistently for several years now, turning in an impressive 8% rate last year and forecast to end this year with 6% growth.

ATA says the volatile phase is over thanks to what he calls Turkey's "double anchors." The government has agreed to follow the austerity package imposed by IMF, while at the same time it must clear a second set of reform hurdles set by the EU as part of its bid to join the club.

Good reforms, no matter what

Turkish people are becoming increasingly frustrated with the slow pace of their country's bid to join the EU. Polls show support for membership has been sliding steadily. The parliament's speaker, Bulent Arinc, summed up the feelings of many on October 5 when he accused the EU of applying "double standards" to Turkey, in the same week that French Interior Minister Nicolas Sarkozy said Turkey's entry into the EU would "be the end of political Europe."

On the ground, the rhetoric of EU Accession Commissioner Olli Rehn has been very aggressive; one of the latest rows is over article 301 of the Turkish penal code, which has been used to prosecute two writers in the last month for denigrating the father of the nation, Mustafa Kemal.

"We signed up to the accession programme 40 years ago and we still have not been admitted," says ATA Invest's Sami. "It is humiliating. It is not about financial gain – Athens received billions of euros in investment but Turkey will receive nothing – it is about having a modern lifestyle like the other countries around us."

Unlike Ireland and Greece, which both received large amounts by way of structural transformation grants to improve things like roads, the cost of joining the EU will be entirely borne by the Turkish people. However, the experience of the newly acceded Central European states suggests membership is still worthwhile, as it leads to increased confidence in the future of the country, which can spur cross-border investment and trade. After arriving in Central Europe, investors discovered that these "emerging markets" were really not so different from those at home.

Yet the real value of Turkey's EU accession bid – irrespective of whether it succeeds or not – is that it sets clearly defined reform goals that are set externally. Governments either meet the demands or abandon their bid to join the European club.

"We will not necessarily join the EU, but what is important is to do everything needed to qualify for membership," says Dr Atif Cezairli, head of research at EFG Istanbul Securities.

The devil is in the details and spelled out in the 35 chapters of the EU accession treaty. While progress has been made on meeting the conditions in many of the chapters and deals have been struck to delay compliance with others, Ankara is still a long way from a completed deal that would allow accession.

Of the various economic sectors, Turkey's capital markets have made the most progress and only another estimated two years of reform is needed to meet the EU requirements. However, in areas like education and agriculture the work has only just begun. And it will be a hard slog: despite the recent progress the state is still hostage to enormously powerful unions, who cynically trade political support for subsidies and thus remain a huge drain on the budget and smother efficiency gains.

The face of Turkey is changing, though. The old established family businesses are giving way to entrepreneurs, who are setting up modern companies to compete in the international market place. Good government connections used to be the prerequisite for success; now simple business nous is enough to make a fortune.

The country is already well endowed with industry. Turkey is the 13th largest steel producer in the world, second largest cement producer, second also in ceramics, and the fourth largest white goods producer. However, it is the small and medium-sized enterprises, or SMEs, and consumer goods-orientated companies that are increasingly driving growth.

Outstanding Problems

Turkey is maybe on the right track, but it is still grappling with two very big problems. The first is the huge sovereign debt that hangs like a millstone around the country's neck. The second is the large, and growing, current account deficit.

For most of the past decade, Turkey has been like a household trying to live on a credit card. The government paid for growth by borrowing and the debt levels reached a peak of 110% of GDP about five years ago. Thanks to prudent economic policies by the new reformist government and strong growth, the debt has begun to fall and is now around 70% of GDP. Yet the debt is still too big, above still the 60% of GDP upper-limit the signatories to the Maastricht treaty set as a workable maximum.

The second problem is that the country is still running a large current account deficit. Imports are greater than exports, so the gap is continuing to grow.

Current account deficits are a plague for all fast-growing economies, as the emerging middle class starts to buy imported luxury goods that domestic industry is unable to provide. However, Turkey's problem is made worse by many international companies using the country as a cheap manufacturing base; a large and growing chunk of the imports are semi-finished goods and Turkish industry is proving slow to invest and create full-production cycle factories that would take the pressure off the current account.

In the meantime, the problem for the government is how to finance the $22bn gap. Swelling amounts of FDI have done a lot to relieve the pressure: over the first seven months of this year 43% of the deficit was financed by the incoming $9bn of FDI, while the $800m of portfolio investment covered only 4% of the deficit. At the same time, the hard currency reserves of the central bank were up $3.8bn over the same period. The sums don't quite add up, especially after the equity market sell-off in May, and so the year-end deficit estimates were revised up from 6% of GDP to 7% of GDP this summer. However, many economists in Istanbul say a current account deficit is the price that the economy has to pay for strong growth.

"The key question is: if we can't generate enough domestic savings to cover the deficit, then how are we going to pay for our development in? In the last decade we used short-term debt and hot money. Now we are seeing more and more long-term sources of financing like FDI," says Dr Adnan Buyukdeniz, the general director of Albaraka Turk bank.

The government is still being forced to use short-term borrowing to make ends meet, although maturities are starting to lengthen. Treasury bills have maturities of about a year and carry heavy yields of up to 20%. Yields were falling at the start of this year and dipped below 14%. But the May sell-off pulled the rug out from under the feet of investors, who had been growing increasingly confident in the country's future, and sent yields rising again as the central bank hiked interest rates. Now the worst is past, analysts expect both interest rates and yields to start falling again.

"The structure of the Turkish economy is very different to what it was four to five years ago. Turkey is becoming more resilient to external shocks, the public finances are getting stronger and the country is running a strong primary budget surplus. The country would be in robust health if it wasn't for the debt," says Sami.

Slower growth would immediately reduce the deficit, but GDP growth also reduces the debt if the government is not forced to borrow more to pay for the expansion. The trick is to find a balance between the two; if the sovereign debt interest payments are taken out of the budget, then the primary surplus is a robust 6% of GDP.

"Turkey can afford a large current account deficit as long as inflation is falling – despite the high commodity prices -- and productivity is rising," says EFG's Cezairli.

The underlying economy is strong. What is needed now is tight discipline to chip away at both the sovereign debt and current account deficit. The central bank and the government are working together to set economic targets, but the central bank enjoys a great deal of independence and has won praise for sensible policies that are slowly bearing fruit.

There is a palpable confidence among businessmen and bankers in Istanbul, but when pressed they still can't promise things will get better.

On November 8, the EU will publish a report card on the progress of Turkey's accession bid, which could lead to a further deterioration in relations with the rest of Europe. Worse, the current reform-minded government may fare badly in the general election slated for 2007. Populist parties have been playing on the people's growing disillusionment with the EU project, appealing to Islamic sentiment that could force changes in policy if not the leadership. In the worst-case scenario, the military may step in as protectors of Ataturk's promise of a secular government in Turkey.

"The elections represent choppy waters for Turkey next year," says ATA Invest's Sami.

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