East Capital in Stockholm -

Two recent newspaper headlines summarise the difficulties in Turkey today quite well: a Financial Times special report on investing in Turkey stated that "A chill wind blows in but the long-term looks good"; the Economist argues in an article that "Turkey's prime minister once promised big reforms to bring his country closer to the European Union. He seems no longer to be pushing them."

The global financial crisis has brutally exposed Turkey's short-term vulnerabilities, but has, at the same time, also made it very clear what is needed in order to achieve the country's full potential in the longer term. Like any country, Turkey needs macroeconomic and political stability and the country is arguably in a fundamentally better position on both fronts today compared with the last crisis in 2001. The problem is that the positive momentum has stalled, partially for domestic reasons, and this was exposed by the external global financial crisis. The postponement of necessary economic and structural reforms was blamed on the complicated domestic political situation during the past few years, which might be understandable and possibly even affordable during a global boom, but it is no longer sustainable. The good news is that there are still important external factors that could stimulate change in Turkey. The most important ones are the International Monetary Fund (IMF) when it comes to economic stability and the EU for political stability. The tools used by these multilaterals are different as the IMF relies on conditionality whereas the EU favours a carrot-and-stick method.

Economic stabilisation

Although Turkish politicians were hesitant and rather sceptical, the market welcomed the announcement that Turkey started to negotiate with the IMF in November. The reason for this is rather straightforward - previous experience, and the IMF and Turkey know each other well, has shown that these programmes help to stabilise the economy and the market, but that it comes with political costs in terms of conditionality requiring tight monetary and fiscal policy. A comparison of the Turkish economy in general and the banking sector in particular in 2001 and 2008 is very illustrative.

The macroeconomic recovery process had just started before the 2000-2001 crisis, following the 1998 Asian crisis, but the economy was still very fragile. The simple story was that the "crawling peg" exchange rate, which fixed the value of the lira against the dollar and allowed it to fall gradually at a predetermined rate, tempted the banks to borrow in foreign currency, convert to high yielding Turkish treasury bonds and enjoy the Turkish lira's high overnight returns while taking major open FX position risks. Triggered by a political crisis, the situation then worsened rapidly and resulted in a widespread currency and banking crisis. The financial crisis was followed by a set of strict regulations, which made the Turkish banking system much more immune to shocks compared to 2001, due to significant differences in the operating and regulatory environment, and an IMF stand-by agreement focusing on maintaining high real interest rates in order to attract capital as well as a tight fiscal policy aiming to reduce the systemic deficits.

The result was a fundamentally stronger and more stable economy (see table) and a banking sector that today looks quite healthy, with almost no direct mortgage exposure, no known "toxic" assets and a relatively low leverage ratio. Moreover, the Turkish banks loans/deposits ratio at the end of 2007 was still low, at 80%, and the banks are not very dependent on international borrowing.

EU-driven institutional reforms

The Turkish accession process to the EU is, perhaps contrary to popular wisdom, still on track. There are arguably a number of challenges and the reform momentum has slowed down, but there are good reasons to believe that the process will continue and intensify. The first reason to be optimistic is that the process is ongoing despite the political difficulties in Ankara and Brussels. The domestic political turbulence in Turkey has diverted attention from institutional reforms and EU accession at the same time as the enlargement process has been challenged by the Irish no to the EU constitution. The accession process has, however, continued throughout this period, with new negotiation chapters opened continuously. This is more of bureaucratic than political progress, but nevertheless important and necessary. Secondly, one should not have expected any significant political progress during the French presidency of the EU, given France's ambivalent attitude towards Turkish membership. The situation will change in 2009 when the Czech Republic and Sweden, which support Turkish member- ship, take over the chairmanship of the union. Thirdly, there is reason to be optimistic about a breakthrough in the autumn of 2009 regarding some of the most sensitive issues in the negotiations. Fourthly, and perhaps most importantly, EU membership is still an important goal in Turkey. P rime Minister Recep Tayyip Erdogan and his AK Party have been clear about Turkey's ambitions to join and this position has strong popular support. Konda Research argues that EU support is actually not declining, which has been argued lately, but that it may change with time and conditions. It is, therefore, very important that the EU keeps the membership perspective real for Turkey. Privileged partnership or other forms of association lesser than full membership will not do the trick, as Turkey needs the carrot in terms of full membership, even if it takes decades to fulfil the criteria, in order for the stick in terms of pushing for political and institutional reforms to be effective.

Conclusions

The most important drivers for change always come from within a country, but during challenging times, external anchors could support reform-minded governments to speed up and implement difficult but necessary reforms. Turkey has a long and intimate relationship with the IMF and EU and there are, despite the considerable amount of negative rhetoric and sentiment, reason to be optimistic that the relations will develop in a constructive way in the near future, which should help to further modernise and stabilise the Turkish economic and political system.

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