Dilemmas and Trilemmas of Turkish Policies in the QE Era
Dilemmas and Trilemmas of Turkish Policies in the QE Era
Following every round of quantitative easing (QE) by the US Federal reserve, the Brazilian finance minister Guido Mantega, has warned of trade and currency wars as Brazil’s currency and current account deficit (CAD) reached new peaks. Even in Asia, excluding China, the aggregate current account balance turned into a deficit from mid-2011. Other big emerging markets (EM) like Turkey were no exception. With its CAD at a historical high in 2011, the Turkish Central Bank (CBT) switched to unorthodox policies that aimed for a weaker lira to boost export competitiveness. In early 2013, the East Europeans joined in from Polish Economy Minister Piechocinski to Hungary’s Matolcsy arguing for weaker currencies. As the Japanese central bank initiated its quantitative easing, the Russian Central Bank governor, Ulyukayev declared that the world economy was “on the brink of currency wars”.
Even if the “currency war” theme is somewhat overstated for now, it is clear that manipulating currencies is not just something the Chinese are doing. This focus on national currencies reflects the underlying tug-of-war for export led growth in the global economy with the EM foreign balances inevitably deteriorating as the massive US CAD “corrects”. As long as international interest rates remain low, and the search for yield sends capital flows into the more dynamic EM economies and boosts their currencies, these pressures are likely to remain the defining parameters of EM policies. Capital flows data show that the volume of private capital inflows to EM have been running at over $1 trillion per year since 2010 –close to the peak in 2007. But for how long is this likely to continue? History shows that policies will have to adjust fast once these conditions change, and US interest rates begin to rise. In 1994, the sharp change of course by the Federal Reserve resulted in a shock sell-off in financial markets. This caused a massive outflow of capital from EM, and a near default in Mexico. Rising international interest rates also contributed to the Asian debt crisis that followed a few years later in 1997.
Turkey’s strong recovery out of the global crisis has had to be reined in to contain the widening CAD. In addition to high oil imports, this reflected strong credit fuelled domestic demand growth, which in turn was funded by capital inflows into the financial sector. The latter had strengthened the lira which, combined with the weak demand in the EU, had undermined export growth. To slow the economy, the government adopted an unorthodox mix of low policy rates to discourage short-term capital inflows to weaken the lira, plus macro-prudential regulations and a rise in interbank borrowing rates to slow credit growth. This and a (post-election) paring back of public spending at end-2011 braked GDP from 8.5% in 2011 to an estimated 3% last year and reduced the CAD somewhat. But, despite this dramatic reduction of growth, the CAD remains high at an estimated 6-7% of GDP, and inflation remains high which means that in real terms the decline in competitiveness continues.
Turkish policy in the next few years will have to tread a fine line between these global pressures and domestic structural impediments (low employment ratio, low domestic savings rate, high dependence on energy imports). Policy will also have to cope with the regional conflicts in the Middle East, and potential electoral pressures from the several elections scheduled in 2013-2015. But while it is possible to see Turkey achieving 3-4% growth on this policy trajectory, the current global conditions are unlikely to last. In the longer term, a new growth model and political outlook is needed to raise productivity by tackling the structural issues and ensure sustainable growth.
The East-West Dilemma
The line-up of external speakers, at the 4th extraordinary congress of AKP in September 2012 seemed to confirm Turkey’s strategic east-ward turn. EU membership accession process was hardly mentioned. That EU membership has fallen in government priorities is hardly surprising given the crisis in the EU and the stalled Turkish membership process. But, it is not as simple as that. Since Ottoman times, Turkish elite, has struggled with this strategic balancing act.  The “turn to the East” reflects regional and global trends in place for over a decade. But even this is already changing. For most of the republican era, the frozen geostrategic balances of the Cold War had constrained Turkey’s regional policies. With the collapse of the Soviet Union, Turkey’s regional economic and foreign policy orientation became multi-dimensional. The “turn to the East” began in the 1990s under various coalition governments.  The strong growth of the Middle Eastern economies since the start of the 2nd oil boom in 2003, and in Turkey, the rise of Anatolian business interests seeking to export to their natural hinterland have in turn reinforced this trend. Turkey now has a big economy that can act as a regional economic catalyst. Prior to the Arab Spring round of political instability in the region, the booming regional trade and (visa free) travel all contested to this.
But the Arab Spring showed the limits of Ankara’s regional reach in the Middle East with Turkey resorting to its traditional security relationship with NATO. The on-going Syria crisis and its potential to morph into a wider regional conflict possibly drawing in Iran would be hugely negative for Turkey, in the political sense (the Kurdish issue becoming even more intractable, risks of wider Sunni/Shia conflicts), and also economically, exacerbating Turkey’s foreign payments and growth constraints. This awkward balancing act, as well as sensitivity to Russian interests in the region, explains the caution with which Turkey has been approaching Syria. Despite Prime Minister Erdoğan’s strong rhetoric, Turkey has been reluctant to take unilateral action in Syria and is coordinating closely with NATO allies and the EU. However, according to the latest statements by Prime Minister Erdoğan, Turkey could look not so much to the Middle East, but even further to the Far East and become a member of the Shanghai Cooperation Council, led by China and Russia, and including Central Asian states. This option of Turkey in a Eurasian Union is also not a new idea. In one form or another, it has been debated by some sections of the Turkish elite, mostly on the far-right of the political spectrum, since the founding of the republic. Of course the ongoing resurgence of growth and power by China, a potential shift of the global axis from the Atlantic to the Pacific, could well widen the appeal of these ideas more than previously.
Electoral Calendar Adds to Uncertainties
In addition to the global economic challenges and the regional strategic dilemmas, the busy electoral calendar adds further complexity and a possible populist element to the policy outlook. 2013 to mid-2015 will see the holding of the constitutional referendum, local authority elections, presidential election – the first time president is elected by popular vote, and parliamentary elections. The Constitutional reforms are still being debated, but may include measures to increase powers of the presidency, which Prime Minister Erdoğan is expected to contest (and win, according to plan). Given the current weakness of the opposition parties, the prospect of almost ten more years of AKP rule looks possible. While international markets may applaud this for providing a measure of stability, such a long tenure in government by the same party risks increasing the already evident erosion of institutional checks and balances of Turkey’s political institutions.
Fiscal Policy Too Reactive
These complex regional strategic dynamics, the stagnant global economy, and the coming electoral schedule all set the stage for difficult economic policy dilemmas. Fiscal policy has been in a bind because along with the slowing economy came (not surprisingly!) a slowdown in tax revenue growth while expenditures continued to grow strongly. With electoral contests looming and also aiming for further sovereign rating upgrades (following the upgrade of Turkey sovereign rating by Fitch to investment grade in November 2012) the AKP economic team – led by Deputy Prime Minister Ali Babacan, opted to take corrective measures in September 2012 including a 1% rise in VAT on automotive, fuel, alcohol, and rises in natural gas prices and related increases in electricity tariffs of up to 10% (which the Energy Ministry has been asking for the past 2-years).
While this round of one-off tax hikes as well as a very successful sale of state shares in Halkbank, contained government borrowing, restricting the budget gap in 2012 to an estimated 2% of GDP,  there are deeper issues in the budget finances. The bulk of the improvement in fiscal policy indicators over the past decade came from tough reforms put in place before the current government. These were then supported by rapid growth, decline in inflation and real interest rates, and the funding boost from privatisation revenues and one-off measures, such as tax amnesties. But, studies show that Turkey’s longer term structural fiscal position has weakened since the mid-2000s based on trends in the structural primary balance – the non-interest balance adjusted for one-off measures, such as tax amnesties, and higher than usual revenues from high import taxes etc.
The AKP economic team (with the assistance of able bureaucrats in the Treasury with experience of the 2000-01 crisis) have successfully micro-managed fiscal policy and reduced public debt to around 36% of GDP in 2012. In addition, the decline in interest rates has reduced budget interest payments to historically low levels of 3.3% of GDP, from 15% a decade ago providing a fiscal windfall to fund the expansion of social services—and win elections! But the government’s ability or willingness to implement far-reaching comprehensive structural reforms is less evident. There has been no comprehensive tax reform and the tax base remains one of the lowest in the OECD (tax revenues to GDP ratio just over 20% vs 35% for the OECD). New incentives to encourage long term savings in pensions were only introduced this year after a decade of debate. Transparency of fiscal accounts needs to be improved, encompassing all quasi-fiscal institutions. Almost a decade of reactive, piecemeal reforms and pockets of low transparency in fiscal policies increase the risks of “capture” of resources by close government associates. Moreover, fiscal policy has tended to be pro-cyclical. There was a chance back in 2010 for Turkey to adopt a fiscal stability pact which was prepared, ready and credible, but which was dropped at the last minute (in the lead up to the 2010 constitutional reform referendum). Had a fiscal pact been adopted, these cyclical pressures could have been already addressed.
Monetary Policy Trilemma
Quantitative easing policies by major central banks in the past few years have been met with relief in Turkey for helping ensure continued inflow of portfolio investment to help fund the current account deficit. But this creates a major policy dilemma –called the “policy trilemma” by the OECD.
- The Central Bank of Turkey (CBT) has kept policy rates lower than they should be given the current cycle of the economy to prevent the appreciation of the lira by discouraging short term capital flows. This has been successful, but the CBT has been missing its inflation targets, struggling with strong domestic demand, the effects of a depreciating currency, and rising energy prices. The opportunity to squeeze inflation, when it had fallen to under 5% in the depth of the global financial crisis in 2009, was missed. CPI inflation peaked at 11% in April 2012, and at 7.3% in January 2013, remains one of the highest in EM. There has been too much focus on the nominal exchange rate, while ignoring the persistent real appreciation of the lira because of higher inflation relative to Turkey’s trading partners.
- With credit growth almost halved from its peaks in 2011, CAD showing some improvement, and with 3Q2012 GDP growth coming in at a lower than expected 1.6%, the CBT cut its policy rate – for the first time in 16 months in December 2012. This is expected to ease liquidity pressures in the domestic economy and somewhat revive domestic demand in 2013. But this in turn has fed expectations that the economy will pick up speed and combined with the recent tax and energy price hikes have led to upward revisions in inflation expectations!
Foreign Payments Gap to Continue to Constrain Growth
The slowdown in domestic demand since end-2011 has somewhat rebalanced growth drivers from domestic demand to exports. Export growth reflects Turkish exporters’ ability to diversify markets away from crisis struck Eurozone and the “Arab Spring” economies which continue to struggle with political instability. Current account data for Jan-November 2012 show that CAD is down from $70bn in the same period in 2011 to $45bn. Excluding energy imports, the 12-month cumulative current account balance swung into surplus. However an uptick in imports in November suggests that with a bottoming out of the economic slowdown expected in 2013, this is about all that seems possible in the short term. It is also worrying that a major factor boosting exports in 2012 was an unprecedented increase in gold exports (to the UAE). Even with GDP growth at less than half the levels of 2010-11, the current account deficit is expected to remain high at best down to 6-7% of GDP from 10% in 2011, though this could be better or worse depending on oil prices.
As in previous years, in 2012, the deficit on the current account was mostly funded by portfolio capital inflows into bonds and equities. Portfolio inflows surged in 2012 in anticipation of Turkey’s ratings upgrade, raising the Istanbul Stock Exchange index to record highs.  The other major factor in external funding has been increasing recourse to foreign debt by the private sector. Total foreign debt is around 40% of GDP, with the private sector accounting for about two-thirds. Although levels of debt in the bank and corporate sectors are not that high, given the volatility of the Turkish lira and the increase in the short term borrowing seen in recent years (mostly by banks to fund their credit growth) these levels of debt still represent a high risk. Turkey’s external financing gap to repay the debt and fund the CAD is a high 25% of GDP. In this context, the CBT foreign exchange reserves at around $100bn ($118, including gold) remain too low.
Conclusion: Turkey Needs More Intensive Growth
In the next few years, government policy looks set to continue to struggle between the need to adopt tighter policies to reduce inflation and the foreign payments gap, while the appreciation pressures on the currency and the electoral schedule require looser policies. These constraints on policy are likely to keep Turkish GDP growth at around 3-4% in coming years—which, at more than double the OECD average, is not bad.
To some extent, the government can get away with this muddle through approach because of the low international interest rate environment but also because of the inherent dynamism of the Turkish economy. Over the past decade, a major contributor to growth has been the newly emerging Anatolian business, exporting to their natural regional hinterlands in the Middle East and Caucasus. In the coming decade, the weight could shift back to Istanbul-Izmir axis with several large infrastructural plans and Istanbul’s possibly successful bid to host the 2020 Olympics. Turkey’s place has risen 16 places to 43 in the Global Competitiveness index on the basis of its vibrant business sector, local competition, and infrastructure indicators. These improvements have resulted in making Turkey the choice for regional headquarters of many multinationals. This trend would be reinforced by further ratings agency upgrades of Turkish government bonds – which, as a ceiling, will allow upgrades to other bond issuers in the country. Turkish demographics are positive, with the dependency ratio not starting to rise for at least a decade. In addition, Turkish households are not heavily indebted and there is still some scope for domestic credit driven growth. In this sense, there is room for economic growth driven by extensive factors.
But these strengths will not be enough when global conditions change and global interest rates begin to rise. The low level of national savings means that investment and growth have become too dependent foreign capital inflows. When these decline (as they will when international interest rates rise), investment and growth will decline too, giving Turkish economic growth its stop-go pattern, in line with risk-on, risk-off (RORO) sentiment in international markets.
To overcome this dependence, and to achieve sustainable growth in the long term Turkey needs to be able to achieve intensive growth driven by increases in national savings and productivity, changes in the structure of industry and energy composition, and increased efficiency in energy use. Some of these issues are being addressed but the structural reforms that are required take time and should have been introduced earlier, when the global economy was stronger. One of these reforms is the new investment incentive scheme introduced in 2012 aiming to reduce the import dependence of Turkish industry and contain the foreign payments gap. The scheme introduces a new “strategic” category eligible for incentives that includes defence, aviation, aerospace, biochemical industries among others. The government’s energy investment programme, that includes transition to nuclear energy for meeting 5% of total electricity demand by 2023, and for renewables energy to cover around 30%, will only just meet demand which growing at around 6-7% per year, will double in ten-years’ time. But, although no mean feats, for Turkey with its high levels of engineering skills, these plans are the easy ones to achieve!
Harder to achieve in making the shift to intensive growth are the well-known but politically difficult to implement policies including employment market reforms, improving access to finance by small and medium size enterprises, and encouraging the shift from the informal to formal economy, thus raising productivity. For example, the government has pledged to raise the ratio of women’s employment from its terribly low levels of around 25% to 38% by 2023 but how this will happen with low levels of child care provision and with the general cultural ethos of the AKP political leadership to emphasise the importance of the role of women as mothers and in the home remains to be seen. Similarly, a shift of economic activity from the informal to the formal sphere also requires greater political and social security, which remains lacking for many Kurds living in particularly the south eastern regions where the levels of informality are greatest. Thus the current global conditions are providing the crucial few years breathing space for Turkish economic and political structures to shift from an extensive to a more intensive growth model. This in turn requires a stronger social and political cohesion than seems to exist in Turkey and different cultural and political outlook from political leaders.
Dr. Mina Toksöz, Head of Country Risk, Standard Bank International Plc
Please cite this publication as follows:
Toksöz, Mina (February, 2013), “Dilemmas and Trilemmas of Turkish Policies in the QE Era”, Vol. I, Issue 12, pp.24-32, Centre for Policy and Research on Turkey (ResearchTurkey), London, ResearchTurkey. (http://researchturkey.org/?p=2785)
 Bloomberg News: 16 January, 2013.
 Even though at 4% of EM GDP, this amounted to half the peak year of 2007. Capital flows to Emerging Market Economies, January 22, 2013, Institute of International Finance.
 They included Egyptian president Mohamed Mursi, to the president of the Iraqi Kurdish autonomous enclave, Masoud Barzani, and Hamas leader Khaled Meshaal.
 Back in 1617-23, a series of traumatic events took place in the Ottoman Empire that resulted in the deposition and assassination of Sultan Osman II. According to Katib Celebi, an Ottoman historian of the time, contributing to Sultan Osman’s downfall was his plans to move the capital of the empire from Istanbul to a city in Anatolia, and even possibly Damascus. This “turn to Anatolia” was met with an insurrection among the Janissary corps and outrage among the Ottoman elite (G Pieterberg, “How the Ottomans Wrote their own History”, in Writing Turkey, Explorations in Turkish history, politics, and cultural identity, Ed G Maclean, 2006, Middlesex University Press, London).
 One of the few people who managed this balance well was Ismail Cem who warmed relations with the Arab states as foreign minister 1997-2002 in CHP led governments; he was also credited with taking the crucial steps that led to Turkey’s EU candidate member status.
 This has weakened BOTAŞ revenues, that in turn have reduced tax revenues from BOTAŞ into the budget. The rise in gasoline prices has put Turkey into 2nd highest in the world after Norway.
 IS Bank Economic Research Division estimates, 16 January, 2013.
 IMF, “Turkey: 2011 Article IV Consultation”, 2012.
 Only 27% of total public debt is in foreign currency, thus reducing vulnerability to currency shocks (even though this improvement is partly offset by the rise in foreign holdings of local currency debt to about 20% from 5% a decade ago).
 OECD Economic surveys, 2012. P23.
 The losses in Libya for Turkish contractors are reported to be replaced by $3.75bn of contracts in the past year in Turkmenistan. On the other hand, the “rebalancing” away from EU markets to less developed EM is not all positive as it could lock Turkish exports into lower value added products.
 While some of these flows may be from longer term investors, the bulk is likely to be short-term, leaving after another upgrade by another rating agency on the basis of that old fund manager habit: “buy on the expectation, sell on the event”.
 This can be seen clearly with Hungary carrying a high external debt repayment burden. Since 2010, the Orban government opted for unorthodox policies, deciding the country can do without IMF financial support and advice as long as portfolio capital inflows continue to cover the foreign payments gap.
 In fact, Turkey should have been upgraded to investment grade in 2010 on the back of the strong recovery from the global liquidity crisis, the resilience of the banking sector, and management of the public debt.
 National savings ratio has declined over the past decade from 25% of GDP to 15%, mostly due to the decline of household savings, partly for positive reasons as the economy grew people reduced their precautionary savings.
 EDAM, The Turkish Model for Transition to Nuclear Energy, 2013.