Turkey approaches day of reckoning on economic reform

By bne IntelliNews November 11, 2015

Kivanc Dundar in Istanbul -


The unexpected success of President Recep Tayyip Erdogan’s Justice and Development Party (AKP) in this month’s general election should bring much-desired political stability and economic policy coherence, which could create a better business climate. However, many questions remain as to whether the new AKP government would be willing or able to deliver the long-delayed and much-needed economic reforms that will restore the kind of investor confidence that is key to put the $800bn economy on a more sustainable growth path.

Turkey needs a new success story to lure foreign capital and to restore investor confidence. And this “new story” should be a reform-minded government spending much of its time and energy on reinvigorating economic growth by improving the business climate. 

Analysts argue reforms must aim at increasing domestic savings through better private pension schemes in order to reduce the country’s current account deficit and restructure the economy in a way that GDP growth no longer causes large external imbalances, say analyists. Domestic production must reduce its dependence on imported intermediate and capital goods, and exporters must produce more higher value-added products. The latter requires government-sponsored R&D, innovation activities and more skilled workers, i.e better education.

The reforms that investors are expecting from the new government must address serious problems: the country’s dependence on foreign capital to fund its large current account deficit, currently at around 5% of GDP; inflation that is running above 7%; domestic savings that are less than 15% of GDP; much needed legal and educational reforms; and unemployment that is nudging double digits.

Growth model failing

Turkey’s economy was slowing even before this year’s election cycle. GDP growth fell to 2.1% in 2012, recovered to 4.2% in the following year, but eased to 2.9% last year. In November, leading economic institutions released their expectations for the Turkish economy. The European Commission joined the IMF in cutting the 2015 forecast for the Turkish growth; both now expect 3% growth, from 3.2% and 3.1% respectively.

The European Bank for Reconstruction and Development  (EBRD) maintained its growth estimateat 3%, but lowered the GDP growth forecast for 2016 to 2.8% from 3%. The OECD expects Turkey to grow 3.1% this year, unchanged from the previous forecast, but slashed its estimate for 2016 to 3.4% from 3.9%.  All institutions unanimously warn that volatile capital market conditions require cautious macroeconomic policies and urge reforms.

The growth model that Turkey has pursued under the consecutive AKP governments since 2002 has reached its limits, Emre Deliveli, an economist, told bne Intellinews.

The AKP came to power 13 years ago when then coalition government of social democrats, nationalists and centrists collapsed after the 1999-2001 economic crisis. The weak coalition government had, with the help of the IMF, put in place a number of reforms to strengthen financial institutions, to create independent regulatory bodies, to carry out privatisations, and to introduce fiscal prudence.

The political chaos and economic turmoil of the time paved the way for the AKP to assume power at the 2002 elections. The AKP continued to implement the IMF-designed programme in an extraordinarily favourable international climate. Turkey’s GDP growth averaged 6.8% between 2002 and 2007 until the global financial crisis broke out.

The growth model was based on external financing, which feeds domestic consumption and investment through credit expansion, and it has created external vulnerabilities, says Deliveli. “This has to change now and Turkey must adopt a new export-based growth strategy. Not only domestic factors but also the global financial environment necessitate such a transformation”.

Turkey’s heavy reliance on foreign cash to finance its current account deficit makes it susceptible to changes in investor sentiment, as the prospect of higher US interest rates hangs over emerging markets. The country’s annual external financing needs are put at $200bn. This looks particularly hefty when compared to the central bank’s inadequate usable foreign exchange reserves, estimated at $37bn by Standard & Poor’s.

Turkey’s short-term debt, owed mostly by the private sector, corresponded to 16.5% of its national income as of end-Q2. The private sector’s total foreign debt – short and long-term combined – rose from 17.6% of GDP in 2005 to 37.2% in Q2/2015, while Turkey’s total foreign debt stock increased from 35.5% of GDP to 52.5% over the same period.

Reform agenda

The markets have immediately welcomed the AKP victory; the stock exchange rallied and the lira, one of the worst performing emerging markets currencies this year, gained ground against the dollar. But after this cheerful start, investors have switched to a “wait and see” mode to digest the election results and to figure out what all this would mean for the Turkish economy in the medium and longer terms.

The November election has eliminated much of the political uncertainty that followed June’s inconclusive result – there will now be no parliamentary election until 2019 – but it has not ended social tensions. If the ruling party, emboldened by its electoral success, does not change its polarising ways, and if it tries to impose its will over the other half of the nation that did not vote for the AKP, there will be troubles ahead.

“A key indicator that will determine Turkey's risk outlook will be whether President Erdogan will renew his bid to establish an executive presidency,” says Ege Seckin, an IHS analyst, in an emailed comment.

Erdogan, who should not be expected to drop his old habits quickly, has already made his move; just three days after the election, he decided to put the idea of transition to an executive presidential system back on the country’s agenda. Rewriting the constitution must be parliament’s priority, said Erdogan on November 4.

A potentially polarising debate around the presidential system and a new constitution will divert the new government’s attention away from the economic reform agenda. This has been set out by Finance minister Mehmet Simsek, one of the well-respected figures within the AKP by international investors, along with the long-time economy tsar, former deputy premier Ali Babacan. The agenda ranges from better tax collection to measures focusing on competitiveness and reducing current account deficit and to personal savings.

Economic reforms must be carried out quickly and effectively, said Simsek on November 6, adding that reforms will include minor changes in the budget and in the government’s medium-term programme, but the macroeconomic framework will remain the same.

But the government must match its words with deeds. The first test will be the formation of the next cabinet's economy team from the competing groups within the AKP administration.

Competing teams within AKP

The markets hope that the new economic management team will include names such as Babacan and Simsek who advocate fiscal discipline, central bank independence and structural reforms.

The worst case – but less likely – scenario is that the names close to Erdogan will be in the driver’s seat, says Deliveli. Local media speculate that Erdogan’s son-in-law Berat Albayrak, presidential aide Yigit Bulut, and the economic advisor Cemil Ertem may assume key positions in the cabinet.

Bulut, who once claimed that shadowy powers were trying to kill Erdogan through telekinesis, and lashed out at the central bank for not lowering interest rates at the height of market volatility, wrote in his column for pro-government newspaper Star on November 4 that new paradigms will be defined for institutions including the central bank, and the hegemony of local oligarchs and finance over the country will come to an end.

Okan Muderrisoglu, a columnist for Sabah, also wrote that in the foreseeable future new laws could be passed to give the central bank a new mandate to focus on economic growth and job creation. The Sabah newspaper also published a report suggesting that the central bank, the banking industry watchdog BDDK and the capital markets authority SPK would be restructured in line with a new economic model focused on growth.

Earlier this year Erdogan’s criticism of the central bank for not slashing interest rates sent the lira to record lows. There were even speculations that bank governor Erdem Basci considered resigning from his post.

Currently, the central bank’s objective is price stability and it uses interest rates to fight inflation. Monetary policy needs to stay cautious as long as inflation remains high, even if this means economic slack, warned the OECD in the latest edition of its Economic Outlook.

Turkey’s central bank, moreover, would have to raise interest rates to avoid a sharp depreciation of the currency and renewed capital flight if the US Federal Reserve starts to raise rates. This would mean higher borrowing costs both for companies and consumers, which in return will affect demand and investment.

The populist consumption-driven economic growth rhetoric employed by Erdogan’s inner circle unnerves investors. The AKP pledged to raise the minimum wage by 30% to TRY1300 (€416) and make further giveaways to farmers during the election campaign. Even Simsek said that after the elections the government would definitely deliver on promises, arguing that the impact of those election promises on the economy and public finances would be less than 2% of GDP.

The market will be indifferent to a high degree of populism and even nepotism within the senior cadres of the AKP, so long as those individuals are not responsible for economic policy, says Michael Harris at Renaissance Capital, in an emailed comment on November 9.

Erdogan will act pragmatically given the challenges ahead for the Turkish economy, Mustafa Sonmez, an economist and contributor to the Hurriyet Daily News, told bne Intellinews. Turkey needs a large amount of foreign capital and the only way to keep foreign funds flowing into the country is a reliable economy team headed by names such as Babacan and Simsek, says Sonmez, pointing to $31bn of capital outflows from the country over the 12 months until the end of September.

In a country such as Turkey that is deeply integrated with the global economy, it will be difficult for Erdogan to intervene in the central bank directly, especially when the US Federal Reserve is set to hike its rates, says Sonmez, who does not expect a radical change in the economic management team. But, he warns that Erdogan will exert pressure once again on the government to boost growth if he sees that the economy is doing badly and threatening the wellbeing of AKP’s constituencies.

Investors will still wait for a couple of months to see if the government effectively delivers the reforms it has promised, Deliveli says. Investors will cheer and the markets will rally if the new cabinet sends out the right messages, and comes forward with a clear, convincing reform plan, otherwise the euphoria will quickly die down.

Business wars

As part of the reforms, the new government must improve business climate, as Erdogan’s growing authoritarianism has dented investor confidence. The Word Bank reported in October that Turkey dropped to 55th place out of 189 economies in its latest “Doing Business 2016” ranking from its 51th place in the previous survey.

 “A sustainable improvement in the investment environment in the country will also require the AKP to curtail a trend of politicisation in economic and business policy, which was most recently demonstrated in the government’s controversial takeover of Koza Ipek”, says Seckin from IHS.

In October, the authorities seized Koza-Ipek Group’s companies, including newspapers and TV channels allegedly linked to US-based cleric Fethullah Gulen, a previous ally of Erdogan now turned arch enemy. Prosecutors appointed a panel of trustees to manage the Koza companies, following an investigation into Koza-Ipek over its alleged links to the so-called “Fetullahist Terrorist Organisation”.

Shortly after the elections, the Turkish police on November 6 this time raided the offices of the Gulen-linked Turkish Association of Businessmen and Industrialists (TUSKON) and related business associations in the capital Ankara on the orders from a prosecutor as part of an investigation into the Gulenist network.

The question is whether the government crackdown would be limited to the Gulenist network, or other business groups such as Dogan, which owns media outlets critical of Erdogan could be targeted. Or, alternatively, whether the government would use its electoral success as a window of opportunity to normalise relations with the wider business community. Dogan, one of the country’s largest conglomerates, is active in the energy, media, retail, real estate marketing, and financial services sectors.

TUSIAD, the largest business association, congratulated the AKP on its election victory, but said the business community expects the incoming government to quickly enact a number of regulations in the areas of development and competitiveness. It also called on the jubilant AKP to end the heightened social polarisation. TUSIAD wants to see some signs of attempted reconciliation from the government, says Sonmez.

Erdogan has been at odds with TUSIAD, which represents the country’s leading 3,500 companies. Companies linked to TUSIAD members employ about 50% of the registered non-agricultural and non-public sector workforce in Turkey. Excluding energy imports, TUSIAD member companies account for 80% of Turkey’s total foreign trade.

Erdogan accused Muharrem Yilmaz ,the former chairman of TUSIAD, of treason in January 2014 when Yilmaz commented that foreign companies would not invest in a country where there was no respect for the rule of law. In April this year, the president slammed Cansen Basaran-Symes, the association’s current head, for her critical remarks about the state of the Turkish economy and lack of reforms.

“I expect that while fighting with the Gulen community, the AKP will not target the secular media circles as the latter would be expected to reduce the intensity of their anti-government stance,“ Yuksel Taskin, professor of political sciences at Marmara University in Istanbul, told bne Intellinews.

Day of reckoning

All these issues are coming to a head just as the expected normalisation of US monetary policy is making the competition for foreign capital fiercer among developing countries, putting more pressure on the Turkish economy, whose foreign funding needs, according to the OECD, are projected to reach 25% of GDP in 2016, including the refinancing of external debt.

The post-Fed rate-hike environment will put policymakers at Turkey’s central bank between a rock and a hard place. If the currency depreciates as a result of the central bank’s inaction or populist policies, inflation will rise and corporate balance sheets will come under pressure. If policy makers increase rates to defend the currency and prevent an exodus of capital, this will hinder economic activity, very much to Erdogan’s dismay.

If Erdogan and the new government continue the narrative of polarisation and attacks on the ‘interest rate lobby’, we expect lira shorts to pay off nicely, says Harris at Renaissance Capital. “The central bank should go ahead and normalise in November. Bringing this [rate rise] forward will send a strong signal that the central bank has been unshackled by the end of the election cycle. Any further delay only tells us the central bank is continuing to defer to political sensibilities.” Harris thinks the bank should deliver a 150bpt hike to bring the policy rate to 9%.

“If the government pursues our recommended path, we think the pendulum could begin to shift from a focus on Fed vulnerability to a focus on Turkey’s windfall from low commodities and the underlying implied lira competitiveness from double-digit export growth to the EU”, says Harris.

The day of reckoning will come for the AKP when it announces the new cabinet. And only then will investors decide whether Erdogan and his AKP’s extended dominance would be a good or a bad thing for the markets and the Turkish economy. A reform package will provide assurance but this won’t be enough, as the markets would like to see them implemented swiftly.

Thus, it will take a couple of months before the AKP regains investors’ trust and during this period it will become clear if really there is an internal power struggle within the ruling party and how this will play out.  An intensification of intervention in the independence of Turkish institutions, including the central bank, could lead to more sluggish growth, and lower ratings, warned Standard & Poor’s on November 6. 

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