It is likely that the Turkish economy will suffer from serious structural defects in the coming years. The reforms are over and no one expects massive influx of foreign funds as before.
Since the famous Gezi Park uprising in May 2013, politics has been over and above everything in Turkey. In December, prosecutors launched bribery and corruption investigations against four ministers in the cabinet. The government responded by replacing top officials in the judiciary and law enforcement forces, strongholds of an Islamic movement which undermined Prime Minister Recep Tayyip Erdogan’s power. Municipal elections in March and the victory of Erdogan’s Justice and Development Party (AKP), which has been in power since 2002, in the presidential elections in August 10, 2014, essentially ended political instability, at least on the surface.
While all this was happening, significant flaws in economy went unnoticed and forgotten. Since politics settled down after the presidential election in August and the new government is formed by AKP under the new party chief and Prime Minister Ahmet Davutoglu, it is now time to discuss economic weaknesses that the political instability masked so far.
An important mainstay of AKP’s election campaigns this year was economic reforms and achievements of the past 12 years. “Reform fatigue” seems to be an impediment now. Embarking on Kemal Derviş’s economic reforms under the auspices of the IMF, which started in 2001, AKP successfully carried out reforms whose main pillars were fiscal discipline, central bank independence, better banking regulation, and inflation targeting. They all proved successful.
During 2011 general election campaign— which he won—Erdogan announced an ambitious set of economic targets for 2023, which will be a centenary of the country. These include rising to the list of 10 largest economies and having export revenues of $500 billion. It appears that these targets can be achieved only with a remarkable growth performance of about 10% a year in the next 10 years, with exports as its propeller. These are, by no means, downto- earth targets today. A quick look at recent growth performance gives us a clue. The strong growth during 2003–2007 (6.9%) stopped during the global financial crisis (minus 4.8% in 2009). However, the economy bounced back with strong recovery (9% during 2010–2011). Unfortunately, growth slowed again recording 3% during 2012– 2013. In World Economic Outlook (WEO), IMF projects growth rate between 2.2% and 3.5% for 2014–2019. Good old days of rapid growth are over and low economic growth rates may persist.
Vision 2023 targets $500 billion of export revenues by 2023. WEO estimate of export growth for 2014–2019 is between 6–7%. But the required rate for 2014–2023 to reach Vision 2023 target is much more than that: a full 13%. Two workable options to achieve such high growth rates for exports are expanding the export markets or making structural changes in the composition of exports.
As to expanding export markets, about half of Turkish exports were destined historically to the European Union. But this has been declining since 2007. The shares of EU and Middle East in Turkish exports in 2004 were 12.5% and 58%, respectively. In 2013, the share of EU declined to 41.5% and that of Middle East rose to 23.4%. Middle East emerged as the second most important trade partner. The slow-down in the EU will persist for some more time in the near future and the EU’s share may decline further. However, diversification does not seem easy due to political turmoil in the Middle East. On the other hand, there are also reasons to be optimistic. Trade relations with Iraq may develop further if politics calms down there, particularly in the northern part of the country. The geopolitical position of Turkey and international politics will assuredly affect international trade.
In the case of exported goods, Turkey still specializes in mid-stream manufactures. There is a need to increase the level of technological sophistication of exports. However, this seems difficult in the near future considering high import dependency and lack of a clearly defined industrial policy. Therefore, as WEO data also suggest, foreign trade will hardly serve as an engine of growth in the short-run.
Structural Problems in the Economy
Rapid economic growth, large-scale economic reforms aiming to strengthen the market economy, and extension of health services to large masses, among many other factors, have contributed significantly to the rise of AKP and Erdogan since 2002. Notwithstanding, certain structural flaws in the economy carried a potential to reverse the economic gains. Some of those important flaws are: excessive dependence on consumption financed by foreign capital, low savings rates, diversion of resources to unproductive areas, and rising indebtedness of the private sector. So far, the weaknesses of the economy did not stand in the way. But this does not mean they will not do so in the future, because global economic conditions are going to go through serious changes.
Many believe that one of the AKP governments’ biggest achievements is ensuring massive and continuous inflows of foreign capital under an open-door policy which financed an expanding domestic consumption. National savings rate (approximately 14% of GDP) is much lower than investment rate (21% of GDP). Government officials admit that household savings rate is fairly low and there is a need to increase it. The key point here is that the Turkish economy is consumption-driven and consumption spree is financed by bank loans. It was more difficult for consumers to borrow from banks in the 1990s. During Erdogan’s term, the conditions for obtaining bank loans were eased and credit card usage became widespread. Given the rise of middle class and enormous availability of loanable funds at a global scale, this is typical. What Erdogan succeeded at, however, is making it easier. The size of household credits as percentage of credits hit 39% of GDP in the first half of 2014. For comparison, the relevant figure was only 2% in 1998, and 11% in 2007. Increasing liabilities of households and private firms raise concerns about the possibility of financial collapse.
The second flaw is about resource allocation. Starting in the 1980s, investible funds were channeled not to productive industries but to services, construction in particular, which accounts for half of total fixed investments. Investments diverting away from industry in a country where there is a need for further industrialization cannot contribute to future growth. For one thing, they do not stimulate technological progress. There is a severe mismatch between the government’s economic targets and its implementation.
Infrastructure investments accompanied construction boom. In 2011 general election campaign, the government launched “crazy projects” (as they were named), including a third international airport in Istanbul, new highways, and high-speed rail projects. These are under construction. Infrastructure investments may pay off well in the future but this is hardly true for construction. On the other hand, infrastructure investments may fail expectations as well. Given unavailability of funds domestically, the expectation of foreign capital inflow slowing down and international borrowing rates increasing from 2015; it remains a big challenge for the government to find the needed funds. These projects may even be impeded.
Financing of consumption and investments and foreign capital inflows are responsive to interest rates. In Turkey, interest rate is not only an economic issue; it is political as well. Normally, under such macroeconomic circumstances as rising inflation, depreciating currency, and an alarmingly large current account deficit, the right “textbook” policy for an independent central bank is to raise the interest rate. But Erdogan, known for his strong aversion to high interest rates, has been arguing against it strongly since last year. The Bank had complied until the beginning of 2014, at the cost of damaging its independence. When the Bank substantially raised the benchmark rate from 6.75% to 11.5% in January, Erdogan criticized this move harshly. It is understood that low interest rates are needed to sustain the consumption boom, especially in the construction sector.
Indebtedness of the Private Sector
During the course of economic growth, a new class of conservatives and entrepreneurs believing in the supremacy of the market economy was nurtured. Private firms obviously received the biggest share of profits from economic growth. However, a cost had to be paid during this process. Due to the high-interest-rate-and-lowexchange- rate policy, which was adopted until the global financial crisis to secure inflows of foreign capital, domestic borrowing had become extremely costly for private firms who turned to borrowing from international markets at more favorable rates. They accumulated and keep accumulating exceptionally high amounts of foreign debt. Things changed after the global financial crisis. Private firms turned to borrowing from domestic banks, whose capital was made stronger after the banking sector reforms earlier. Credits extended by banks to the private sector (including household credits) passed 100% for the first time in 2014. It was only 56% last year and merely 25% in 2007. Private sector is highly dependent on bank loans.
As long as there is excess liquidity in the world’s capital markets, things are easy in Turkey. But when this liquidity named “hot money” is unavailable, vulnerabilities of the economy come to the surface. Economic growth was realized by boosting private consumption financed mainly by foreign borrowing. But, much of these foreign funds are coming in the form of short-term debt. These will be paid in foreign currency. With the recent “corrective” depreciation of the lira against the dollar since mid-2013, the exchange rate risk exacerbated the situation. As a highly open economy, Turkey is vulnerable to adverse effects of the exchange rate. Due to Fed’s decision to raise the interest rates gradually, it is expected that 2015 will witness a strong dollar. Surely, this will negatively affect the large foreign debts of the private sector.
What Is Awaiting Turkey in 2015 and After?
It is likely that the Turkish economy will suffer from serious structural defects in the coming years. The government successfully carried out reforms which started twelve years ago and put the economy on high-growth track. However, the present situation is different and low growth performance seems to persist. It is time for the government to face economic challenges on the thorny road to 2023. The reforms are over, no one expects massive influx of foreign funds like before, economic growth rates will be moderate, private sector has accumulated large short-term foreign debt, and the current account deficit continues to be a major threat.
The first and foremost task for the new government which took office in the end of August is to bring in the lost dynamism to the economy. AKP government promotes free market economy. Private sector, against which it is leaning its back, is looking to the government amidst stringent political conditions not only in the country but also in the Middle East. To make things worse, there is a politically polarized environment in the country.
In the medium-to-long run, Turkey needs to revise its industrialization strategy. At the present, there is no clearly defined and communicated industrial policy. Such a strategy should have a long-run perspective so that the country can overcome high import dependency and reduce current chronic account deficit.
January 11, 2014 edition of the Economist stated that “Superficially, the country modernized rapidly, observers say, but underneath the old habits of government-by-favor, which Mr. Erdogan had once opposed, seemed to wheedle their way back.”How will it go? Time will tell. At the moment, the situation is not encouraging.
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