Bernard Kennedy in Ankara -

Turkey is preparing to reinforce its relatively comfy fiscal position by adopting legislation that promises to elevate fiscal discipline from a mere policy choice to a legal obligation. But have old habits of politically-driven public spending truly been abandoned? The run-in to next year's election will provide a stern test.

The envious glances that Turks once cast across the Aegean at the newfound wealth of EU member Greece have been replaced by knowing looks. A decade ago, it was Turkey that had to tighten its belt. Crises in Asia, Russia and the domestic banking system had put the sustainability of public debt under the spotlight, and the International Monetary Fund (IMF) dictated heavy terms in return for its life-saving intervention. But on March 10, as Greece was agreeing bailout terms with its EU partners, Turkish Prime Minister Recep Tayyip Erdogan ended a year of talks with the IMF about agreeing another stand-by loan deal by saying the government had failed to reach agreement over some of the IMF's stringent conditions and Turkey could now "stand on its own feet."

Indeed, Turkey's public debt of around 48% of GDP pales into insignificance by comparison with the three-figure debt/GDP ratios of Greece and Italy. Ironically, for the EU's least-wanted accession candidate, Ankara is holding to the 60% limit foreseen in the EU's Stability and Growth Pact long after the likes of Paris and Berlin have let go. The good news does not end there. Of the $302m gross central government debt, 75% is domestic debt and 72% is denominated in lira. In January, the government lengthened its yield curve with a $2bn, 30-year global bond issue at a modest spread of 225 basis points over US Treasuries. Fitch Ratings, Moody's Investors Service and Standard & Poor's raised their sovereign ratings to 'BB+', 'Ba2' and 'BB' in December, January and February respectively.

But not all is going Turkey's way. The debt ratio is back on a rising trend after dipping below 40% in 2007-08. A deep recession, low tax collection and continuous spending lifted the budget deficit to some 5.5% of GDP in 2009 from under 2% in the four preceding years. A further 4.9% deficit is foreseen for 2010. These levels may be modest by contemporary Greek or Anglo-Saxon standards, but domestic savings are low, and the local banks are already lending back to the government as much as they are paid in principal and interest. Meanwhile, the cost of borrowing is set to increase. Inflation returned to double figures in February, and while the central bank may hold the key policy rate at 6.5% for a few more months - in view of the still-sluggish recovery - its next move will be upward. Globally, the return of risk appetite has been interrupted by the Eurozone scare.

In these circumstances, some economists and investors are pinning their hopes on a 10-year "fiscal rule" that would make fiscal discipline a legal obligation. The rule will set the target public deficit at just 1% or 1.5% of GDP, to be reached over three to five years. It will also predetermine the amount of fiscal loosening or tightening to be implemented at times of weak or strong growth. All this is expected to win parliamentary approval by mid-May, in time to influence the budget preparation process for 2011. With the government and IMF announcing in March that they won't be agreeing a new stand-by agreement to replace the one that expired last year, Turkey's own internal systems for setting and meeting fiscal targets - and that includes the fiscal rule - become that much more important.

Too divided to rule?

Former Treasury and World Bank official Emin Dedeoglu is sceptical. He welcomes the "rhetoric" of a fiscal rule, but reels off a long list of reservations related to transparency, enforcement, timing, and unsolved structural issues such as the composition of taxes, the public personnel regime and uncontrolled spending on health and social security. "The nuts and bolts are not there," concludes Dedeoglu, who currently heads the Governance Studies unit of the Economic Policy Research Institute in Ankara. He fears that the rule will end up as a public relations exercise, creating the impression that the government is serious about fiscal discipline while buying time for a spending spree ahead of next year's general election.

Prime Minister Erdogan's reluctance to return to IMF tutelage has been attributed precisely to a desire for flexibility on the fiscal front. Part-liberal, part-Islamist, his ruling Justice and Democracy Party (AKP) must seek a third term in office by July 2011, but unemployment has soared to 14% and secularist and nationalist opposition parties are gaining ground. They accuse the AKP of seeking total control over state and society, while failing to stand up for national causes, and taking a soft line on the armed Kurdish nationalist PKK organisation.

Adding to the tensions, dozens of retired and serving military officers as well as civilians are facing trial over alleged coup plots. The armed forces undermined an Islamist-led government in 1997 and interfered in the 2007 presidential election. However, critics accuse the AKP and its supporters of trumping up the present charges to discredit their secularist opponents. PM Erdogan is also planning a referendum this summer on constitutional amendments that would revamp the High Council of Judges and Prosecutors (if not his arch-enemy, the Constitutional Court), minimize the authority of military courts and prevent any reoccurrence of the closure case lodged against the AKP for anti-constitutional Islamist activity in 2008.

Analysts in Turkey unanimously reject any possibility of a coup. An early general election, perhaps prompted by a last-ditch effort to close down the AKP under current legislation, is also seen as unlikely. But a failed referendum could signal an unpredictable and potentially unstable anti-AKP coalition as of 2011. "What's constraining the credit rating now is the perceived political instability," confirms Ayse Botan Berker, director of Fitch's Istanbul office.

Levent Durusoy of YF Securities in Istanbul believes that recent share price volatility could spread to the foreign exchange and bond markets if the lira rises above TRY1.60/USD or the yield on the most-traded government bond yield hits 10%. "The fiscal rule is not on the radar screens of investors for the time being," he declares. Nor does he see the rule as a valid alternative for an IMF accord, which would ease the pressure on domestic borrowing, shore up the lira as the current account deficit begins to widen again, and - perhaps above all - keep public finances under credible surveillance.