Interview with Professor Vefa Tarhan – Structural Problems, Structural Solutions: Turkish and the European Economy after the Global Financial Crisis

Interview with Professor Vefa Tarhan
Structural Problems, Structural Solutions:

Turkish and the European Economy
after the Global Financial Crisis

As Centre for Policy and Research on Turkey (ResearchTurkey) we have conducted an interview with Professor Vefa Tarhan on Turkish economy’s past and present focusing especially on the period after the global financial crisis. The interview attempts, with the expertise of Professor Tarhan, to shed light on the developments regarding the global economy after the crisis, challenges and how these challenges were tackled by Turkish economy. Moreover we tried to provide our readers with some ideas and hints regarding the future of Turkish economy with the help of Professor Tarhan.

Professor Tarhan currently teaches at the Quinlan School of Business at Loyola University Chicago. In the past he has taught at the Kellogg Graduate School of Management at Northwestern University and the Olin School of Management at Washington University. He was advisor to Kemal Kılıçdaroğlu, the leader of the Republican People’s Party (CHP), on “Economic and Financial Issues” between June 2011 and May 2012. During the early part of his career, Professor Tarhan’s research focused on monetary policy and banking related issues. During this part of his career he was also a research consultant at the Federal Reserve Bank of Chicago. Later in his career, Professor Tarhan’s research focused on various topics in “Corporate Finance” and covered the financing decisions of firms, share repurchases, capital structure decisions and whether firms face constraints in accessing capital markets, and mergers/acquisition decisions. Many of his academic articles have received “Outstanding Paper” awards at various conferences.

Synopsis of the Interview:

‘“Rising tides lift all boats”, Turkey, benefited from the favourable global conditions, political stability, and the reforms of Kemal Derviş. Government officials thought their policies were responsible for the success factors; they were consumed with hubris, and did not execute any of the structural reforms that the country badly needed’

‘I would (prefer) slower growth. Because… there is the trade-off; the faster you grow the more external financing you need and I think Turkey is very vulnerable in terms of raising external funds’

‘Turkey has record-breaking financing needs. At the same time, we have to find this money in an environment where the appetite for risk has dried-up and investors are not willing to provide funds to high risk countries like Turkey’

‘There is a ‘moral hazard’ problem in external financing of Euro-zone as countries like Greece and Germany were rated as similar risk countries’

‘I do not think there is an optimal currency area in Europe or (anywhere) in the world’

The controversial accounting game played between Iran and Turkey (in buying oil with gold) helped current account deficit being reported lower.

‘Turkey not only does not get any slice from this (World’s FDI) cake, it does not even get a significant portion of the crumbs that are formed as you are cutting the cake.’

Some politically motivated actions of the government against private firms discourage foreign firms from making direct investments in Turkey.

Due to hedge funds coming to Turkey, Turkish Lira was overvalued between 2002 and 2010. What we have seen recently can be described as “correction”.

A country’s ability to service its debt is more important than its indebtedness ratio in investment decisions. Turkey’s figures are much lower in this sense than many countries although its debt level is lower than them, hence it would not receive positive investment decisions.

Full Text of the Interview

‘“Rising tides lift all boats”, Turkey benefited from the favourable global conditions, political stability, and the reforms of Kemal Derviş. Government officials thought their policies were responsible for the success factors; they were consumed with hubris, and did not execute any of the structural reforms that the country badly needed’

Hello Professor. First of all I would like to thank you for accepting Centre for Policy and Research on Turkey’s interview proposal. We would like to talk to you about Turkish economy and global economy’s status over the recent years, especially after the global financial crisis and on how you think the progress will be in Turkey and globally. I would like to start with a question on the performance of the Turkish economy during the recent past, in order to give our readers some perspective about the economy. I would like to start by asking you about the period that followed attempts to industrialize the country via import substitution programs. When we look at the Turkish economy in this time frame we see periodic crises in about every five to ten years. Would you think that these “chronic” crises have finally come to an end especially after 2001 crisis? This crisis was basically based on sudden outflow of funds, “hot money”? Do you think or can we say that now the economy is more stable and this kind of crises will not happen again?

It is true that during the last 11 years the economy did not experience a financial crisis, primarily due to the fact that the world has been stable. The world was a wonderful place economically prior to the mortgage crisis. In fact, I call this period “Lale Devri (Tulip Era)”: Inflation, interest rates, volatility were all very low, productivity and growth was high, and there were technological breakthroughs. Many of these benefits took place because of the positive effects of globalization. But, after the crisis, we realized that there was a negative side to globalisation as well. In the old days, if something went wrong with an individual economy, only that country was affected. For example, the 2001 crisis affected only the Turkish economy. Nowadays, due to the contagious effects of globalization, if a country catches an “economic cold”, the rest of the world is affected: some other countries also catch a cold, some countries come down with flu symptoms, and there are some which even catch pneumonia.

Another factor that was in the Turkish economy’s favour was that having a single party government, and the political stability associated with it enabled the economy to do reasonably well. There is a saying in Wall Street “rising tides lift all boats”, Turkey, benefited from the favourable global conditions, political stability, and also the reforms of the financial system by Derviş. Unfortunately, the government officials thought their policies were responsible for the success factors; they were consumed with hubris, and did not execute any of the structural reforms that the country badly needed. Before, I had predicted that the future would be unfavourable and volatile. Due to the tapering of Fed’s monetary policy, but much more importantly, the drastic loss of political stability and the increase in political risk that accompanies instability, the Turkish economy currently is in dire straits. I am afraid; this will continue to be the case in the near future. The economy has significant fragility points. I have been saying for years that the biggest vulnerability of the economy is in finding external financing sources. For a country that has chronic current account deficits, and has increasingly been financing these and its other external financing needs by short-term funds, including the so called “hot money” or “portfolio investments”, the loss in political stability and the fact that no structural reforms were executed to solve the economy’s fundamental problems, puts the economy in grave danger.

Even if the current political problems can somehow be weathered, I think in the future there is going to be a lot of turmoil, globally speaking, because of globalisation. So even if Turkey continues to have a single party system, I suspect that we will have volatility in the Turkish economy.

So, you believe that the reform progress after the 2001 crisis have worked in terms of stabilising the economy temporarily, they were not even close to be sufficient to make the economy fundamentally stable.

Well, the problem with the reforms is that in reality there have not been any substantial reforms. You know, the reform question was in 2001. First, that was before the existing government.  Second, as you know Turkey has some “chronic” problems going on for years and we now have new problems added to that. The government did not make the necessary reforms that would bring solutions to neither the chronic nor the new problems. You know, there are two things you can do when you have a headache: The desired course of action would be to solve the problem by finding the cause of the headache and cure the problem. Let’s say maybe it is sinus headache and so you either have a sinus operation or you can just take medicine which would cure the sinus condition. Another (the undesirable course of action), would, instead of finding the root cause of the condition and taking measures that would cure it, targets the symptom of the problem and taking medication that would make the headache go away without finding and treating what it is that is causing the headache. Thus, the analogy in my opinion is that the government policies have not been trying to find the root causes of problems and solving them but rather taking measures that can at most relieve the symptoms without finding cures to the root causes of the chronic, and structural economic problems.

So you believe that what were brought to the table were all temporary solutions. What would you have advised the government if you were in charge in 2001? What were the “root causes” of the economic crisis?

We can’t obviously go over every single one, but let me give a couple of examples, for example one of the problems that Turkey has is that it has very low savings rate (12% in Turkey, 52% in China). There is a demand side and the supply side to solving this problem. So, one thing I would do is making investments attractive in order to encourage savings. People in Turkey have this concept of gambling in the stock exchange (“borsada oynamak”), for example, as if it is a horse race, they do not think that buying stocks is an investment.  So they think it is speculation, they think that it is manipulated. And maybe it is, maybe laws against “insider trading” have to be stronger but if people do not have confidence in the capital markets, if they don’t have confidence in Istanbul Stock Exchange (BIST) then they are not going to invest, instead they are going to spend their money. That’s one thing I would do, strengthening the capital markets.

Another example I’m going to give is that, as you know, there is a chronic current account deficit problem in Turkey. One reason for this is that the Turkish economy has been growing at an unsustainably fast pace. The government officials and many business associations are very proud of the high growth rate. However, growth is not always beneficial because it has to be “sustainable growth” – growth that you can finance. You know, firms or economies can grow at 10% annual rate and then ask themselves where they are going to find the money to finance this growth rate. Alternatively, they can determine what growth rate is compatible with the financing they can obtain. In other words, instead of growing at some rate and solving the equation in terms of how much funds they need, the second approach determines the available financing first, and then solves the “Growth Rate Equation”. The approach in Turkey has always been: “Let’s grow as fast as we can and then we will worry about the financing of growth later”. Sustainable growth idea is when one says “This is the amount of money I can find and based on that let me figure out my growth rate whether it is 4%, 5% or 6%”. So that’s what I would have done.

‘I would (prefer) slower growth. Because… there is the trade-off; the faster you grow the more external financing you need and I think Turkey is very vulnerable in terms of raising external funds’

So you would not agree with Prime Minister Erdoğan’s low interest rate and fast growth model?

No, not at all. If I had to take sides in this “gas pedal vs. brake pedal” debate, I would take the side of Babacan and Başçı. They are advocating a slower growth rate. I mean they weren’t coming out and saying it outright, but that was essentially their argument. What Minister Çağlayan was arguing for was that we have to grow fast so the Central Bank should accommodate this, by lowering interest rates. However, first, lower interest rates would not necessarily produce faster growth rates. For example, in the developed countries, interest rates were at historically low levels, but their growth rate was very low. But suppose that they do, it may still not be desirable to grow at a fast rate, since faster the growth rate, the higher is the current account deficit, and the higher is the likelihood of inflationary pressures. In this dispute the Prime Minister took the side of Mr. Çağlayan who was arguing for fast growth rates, because he thought everyone should be proud of growing fast. On the other hand, the other side was saying maybe we should slow down the growth rate of the economy.  So, if I had to take sides on that, I would take the side of slower growth. Because, you know, there is this trade off; the faster you grow the more external financing you need I think Turkey is very vulnerable in terms of raising external funds; it is a lot harder to find external financing for Turkey than many other countries.

‘Turkey has record-breaking financing needs. At the same time, we have to find this money in an environment where the appetite for risk has dried-up and investors are not willing to provide funds to high risk countries like Turkey’ 

Well, you have been saying that external financing is one of the vulnerabilities of the economy and a major one as well. Why do you think this is the case? Is that because Turkish governments have a bad history in finding external financing?

There are two things at play. First of all there are not many investors in this environment who are willing to make long-term investments in countries like Turkey. I mean the investors out there are not even investing in their own developed economies. Rather than investing in stocks they’re buying bonds and that’s why interest rates are so low. They’re willing to accept negative real returns (looking for a “safe harbour”). So the reason why external financing will be difficult for Turkey is; one, we need huge amounts of money because we’ve been growing at a fast rate, which results in increasingly high levels of current account deficits that need to be financed. However, there is this misconception that a country’s external financing need in a given period is equal to the current account deficit of that period. In reality, external financing need exceeds the current account deficit, because during the same period, the country has to pay off its maturing debt. For example, as of October 2013, Turkey has $164.7 billion of debt that will mature in 12 months. This amount far exceeds the forecasted current account deficit of around $60 billion. Thus, during October 2013-14, Turkey’s external financing need is around $225 billion, even though the current account deficit is expected to be $60 billion. So we have record financing needs. At the same time, we have to find this money in an environment where the appetite for risk has dried-up, and investors are not willing to provide funds to high risk countries like Turkey. By the way, they are not even willing to invest in their own countries because of the high level of global uncertainties.

In the first eleven months of 2012, the current account deficit has been a little lower than previous year, are your worries still justified or  would you be less worried?

No. As the data above showed, a big chunk of external financing need is debt that will be maturing, and there is nothing that would shrink this amount. Second, as we know now, due to global uncertainties the growth rate for 2012 was very low (2.2%), and lower growth rates imply lower current account deficits. By the way, during the first 9 months of 2013, the growth rate picked-up to 4%, and as a result, the current account deficit during the first 3 quarters of 2013 is 28% higher relative to the same period in 2012.

While we are on the topic of growth, I want to mention one more aspect of it. Our economic officials and the prime minister focus on the growth number (they want it to be as high as possible), but do not realise that there is high and low quality of growth. What is important is to have high quality growth. The factors that make growth high quality are as follows: 1. Growth that creates current account surpluses (like China’s growth), rather than deficits. 2. Growth that will be triggered by investments, rather than by consumption. 3. Growth that originates in the private sector, and not the public sector. 4. Growth that is balanced (i.e., at least partially driven by foreign trade), and not dominated by internal demand. The Turkish growth experience of the last 11 years shows that the growth in question was low quality, because it almost always flunked items 1, 2, and 4. The growth of 2013, also flunked item 3. Because, the growth was ‘manufactured’ by the public sector (both investments and consumption). In fact, private sector investments declined for 7 quarters in a row, before showing a modest increase in the third quarter of 2013. One can also argue that another low-quality factor was the fact that, it was the construction boom that accounted for the lion’s share of private sector investments.

Let’s talk about the global economy as well. I shall mention the Euro-zone crisis which is very important for Turkey as well. Do you believe that the crisis can be solved in the current system without breaking the Euro-zone?

No, I really don’t see that happening, there’s no solution to the Euro-zone problems. I think it’s going to collapse and in some sense it should collapse. Because, there were 17 countries (with Latvia joining the Euro-zone and the EU about 2 weeks ago, now it is 18), as you know in the zone. These are 18 of 28 members of the European Union so not all of them. Whereas, 10 are part of EU like UK but are not part of Euro-zone. The problems are in Euro-zone countries, because by being a member of the Euro-zone you give up some macro-policy tools as a government that you could use to fight economic down turns, if you were not part of the Euro-zone. For example you don’t have the monetary policy tool. You don’t have your own central bank; instead the European Central Bank conducts monetary policy for all 18 countries. As an individual country, you lose the monetary policy tool. You also lose the tool of exchange rate policy since you don’t have your currency, and have the Euro instead. This of course means that you can’t devalue your own currency or you can’t intervene in the foreign currency markets. So you lose two of the three (fiscal policy, monetary policy, foreign exchange rate policy – major tools). You lose for sure two of them and even partly the fiscal policy. The Euro area puts restrictions on governments about how much they should spend.

As I stated earlier, , due to globalization, we now live in a world where if one country has a problem it just spreads to other countries. So in the future, there are going to be more global shocks, the shocks will be wider and deeper, and will last longer. In other words, there are going to be more, so to speak, “economic wars”. This means, that, if anything countries need more policy tools in this new world, and not less. But, the countries in the Euro area don’t even have three macro policy tools; they lose at least two of them. The 10 countries which are members of the EU but not in Euro-zone at least still have all three. I think, it is not a coincidence that the problems crop-up in the Euro-zone countries, and not in the 10 only EU countries.

But on the other hand regarding this loss of tools, while we see that some countries are really having massive problems, the others are not, like Germany and France. Why is this? Don’t these countries lose their tools as well?

Very good question. I think, you know, there are three – what I call- “stylised facts”. Anybody who is trying to explain the Euro problems have to address these facts. One, the Euro countries didn’t have any problems before 2007. That’s a fact, so you have to explain that; I have an explanation for that, I have a hypothesis for that.

My hypothesis is when there are design problems in a system, and this “loss of tools” is a design problem, you see the ramifications of that; you see the damage from that only in bad times and not in good times. As we discussed above, until 2007 the world was a wonderful place. Volatility was low, interest rates were low, inflation was low, growth was high, and productivity was high, partially because of globalization, partially because of the ecological innovations that took place in the 80s; so those were good old days. Because of these bubbles, the mortgage crisis, and before that internet bubble crisis, since 2007 the global economic conditions are not favourable at all. Before 2007, investors’ attitude towards risk was at one extreme. As you know, one of the first principles of finance is that there is always a trade-off between risk and return. Before 2007, in order to get just a slightly higher return, they were willing to take huge risks. However, in the post-2007 world,  in order to have the investors or firms take some little extra risk, you have to promise substantial additional  returns. In this changed world where the appetite for risk has almost dried-up is when investors began to discover the flaws inherent in a single-currency system Thus, in my opinion, this explains the stylized fact that the mistakes made in the design of the Euro-zone surfaced when the global economic conditions became unfavourable.

Another question associated with the Euro is something we just touched on, so I don’t have to get into detail.  The question is why is it that we see these problems in the Euro countries and not in pure EU member countries. Again, the reason for this is that while countries that are just members of the EU have all three macro policy tools, the countries that are members of the Euro, lose at least two policy tools.

The third one, which is the question you asked, is even within Euro, I mean Germany is in Euro, why is it that they don’t live/have the problems even though they are a Euro-zone country, but e.g., Greece experiences problems. Why not all Euro countries have problems? My explanation for that is that when Euro was formed, investors were under the wrong impression that the risk of Greece, I’m giving that as an example, is same as Germany’s risk  so when they were lending money, let’s say, if they’re charging 3% interest rate to Germany, they were charging the same 3%  to Greece as well. However, eventually investors discovered the reality that   Greece has much higher credit risk than Germany. Hence, Greece, let’s say, should have been able to borrow money at 10%. So if they borrow money at 3%, this creates a “moral hazard” problem, and they don’t behave responsibly, since their cost of borrowing turns out to be a lot cheaper than they should have been. As a result, they would have an incentive to waste money, by accepting investment projects that in reality have negative Net Present Values. Whereas Germany borrows money at the rate it should borrow and so behave accordingly and this behaviour is rational. So that’s why you have the problems in some of the Euro countries and not in the others.

Tarhan 2

‘There is a ‘moral hazard’ problem in external financing of Euro-zone, as countries like Greece and Germany were rated as similar risk countries’

So you believe that Southern European countries are now having moral hazard problems?

For sure, yes. As you know Greece had to be bailed out twice, Portugal, Ireland and those are really small compared to the countries which are in the verge of having problems, like Italy and Spain. They have huge economies, unemployment in Spain is 26-27% and then so that’s why I think Euro is going to collapse, it has to collapse. Because being a member of the Euro-zone has practically no advantages over being a member of just the EU, while it has major disadvantages in the form of losing some crucial macro policy tools.

Would you agree with the statement of Professor Roubini who said that the only solution for countries like Greece is to unilaterally get out of Euro?

Well, there is this view that you can have a new Euro system; it’s just that you have to get rid of Greece and let’s say that you can have a Euro system consisting of strong countries only. You know, there is this economist, his name is Robert Mundell, he won the Nobel Prize and he had this theory that there’s an optimal currency area. The Euro was essentially designed on the assumption that the concept of optimal currency areas exists.

I don’t think there is an optimal currency area in Europe, even in the world. The closest that I can come to, in terms of countries having an integrated economy, is United States and Canada. Because there are substantial cultural differences, even in countries that on paper may appear to be similar. Of course, there’s huge difference between Germany, Scandinavian countries and southern European countries. But it is doubtful that even strong countries like let’s say Germany and Holland, Germany and Austria, Germany and Scandinavia, still have significant cultural and other differences.  In order to have an optimal currency area that would work, the citizens of these countries have to feel that they are part of the same thing; they should feel Europeans not Germans.  People say, if it works in America, and each state, let’s say California doesn’t have a central bank, California doesn’t have its own currency. They say why shouldn’t the same concept work in Europe, why shouldn’t there be a United States of Europe? What they ignore is, in United States people are Americans. So they may have come from Europe but within one generation or two they lose their original identity; they become Americans. Well whether it is Italians, or Germans will be willing to ever lose their identity, Germans will speak German, Germans have their cultural heritage which is different than Scandinavians, and they have a different way of looking at life, so they are not Europeans in spirit. I mean they are Europeans geographically speaking, but they don’t feel that they belong together. I mean Germans feel like they are Germans, Norwegians feel they are Norwegians. So this idea of an optimal currency area, I think is an elegant theoretical contribution to the literature, and he won the Nobel Prize for, it but it’s not something that can work in practice.

The controversial accounting game played between Iran and Turkey (in buying oil with gold) helped current account deficit being reported lower. 

Thank you.  If we get back to Turkey, you said that Turkey’s lower current account deficit is also due to the global uncertainties…

Yes, I mean, because it’s not Turkey saying, okay we have this current account deficit problem what can we do to lower it? Actually the government passed an incentive-package law, which they thought would bring a structural solution to the current account deficit problem. But, I have shown in my article  that this import-substation plan is not going to work. In my opinion, the structural solution for the current account deficit problem that I proposed in another article of mine, is what Turkey should put in place.

Going back to why the current account deficit came down from 75.1 billion dollars in 2011 to 48.5 billion dollars in 2012.  There are two reasons: one is that the growth rate slowed to 2.2% from 8.5%.  The other reason is this controversial accounting game that’s been played in 2012. In the old days when you bought oil from Iran, you paid with dollars, now what happens is Turkish government pays Iranians Turkish Liras and the Iranians go and buy gold with that and ship it to Iran. It is no different than if the Turkish government using Turkish Liras were to buy gold and paying for its oil imports from Iran. However, even though gold in such a transaction is a means of payment just like the dollar would be if the payment was made in dollars, the gold appears as an “export item” in the balance of payment statements. Hence, the second reason for the decline in the current account deficit is due to the “gold exports”.

‘Turkey not only does not get any slice from this (World’s FDI) cake, it does not even get a significant portion of the crumbs that are formed as you are cutting the cake.’

So back to the question about external financing, if we set aside the hot money flows, you had mentioned before that Turkey is not getting enough FDI (foreign direct investments) financing no matter how much it has increased from the levels of years 2000-2001. Before in many speeches you had also mentioned that Turkey has a great potential in terms of attracting FDI. Which industries would you see as for ones that Turkey have a potential to get more FDI?

First of all, I think it’s not just me who says Turkey should be able to attract FDI by addressing the reasons that make Turkey an unattractive destination for FDI. FDI is one of the two healthiest sources of financing because it’s long term. It represents the real sector investments by companies like General Electric coming to Turkey, and building factories etc.  As opposed to hedge funds or hot money which come and buy stocks and bonds in Turkey. The DNA of such funds is “nervous”. When economic or political conditions become unfavourable, these funds just disappear.

What I have a dispute with is our economic decision makers exaggerated claims that Turkey is creating economic miracles, the economy is being run in a perfect manner. Our ministers in charge of the economy even have the audacity to say things like “If we were in charge of the European economies, we would have solved their problems in three months”. I have a simple question for them: If all this is true, how come foreign companies are not investing in Turkey? During the 2003-2012 periods, in only one year Turkey came close to attracting 1% of the global FDI. I mean, I have this analogy that if you can think of foreign direct investments in the world as a cake, and in 2007 that cake was 2 trillion dollars (due to the effects of the crisis total global FDI in 2013 was expected to be 1.4 trillion dollars)  in magnitude which is a huge amount because, you know, the gross domestic product of USA is something like 14 trillion. The total world GDP is something like 60 trillion. This being the case, one would  think that if our economic decision makers are correct in their assessment that Turkey has a great potential, a significant portion of this money,  would come to Turkey. But, what Turkey has been able to get over 11 years is 0.6% of the total world FDI during this period. So, the analogy I use is, you know, there is this cake and you cut it in slices and distribute it to different countries as FDI goes to different countries. Turkey not only doesn’t get any slice from this cake, it doesn’t even get a significant portion of the crumbs that are formed as you are cutting the cake.

The reason why foreign firms would not prefer Turkey can be seen in the results of a survey that TÜSİAD conducted with the Turkish firms. One of the questions in the survey was: “What are the big hurdles that you face when you are making real sector investments in Turkey?” Some of top factors that were mentioned in the responses were: ‘the legal business infrastructure is not well established’, ‘The rules were not transparent’, ‘The ground rules changed from day to day’. Now, if these things bother Turkish firms, would they not deter foreign firms from making investments in Turkey even more?

I am going to add a recent example to the above. The prime minister was angry at Koç Holding for opening their lobby to the demonstrators of Gezi Park for humanitarian reasons, who were being gassed. Koç Holding is responsible for 10% of the GDP of Turkey. The prime minister sent an army of tax-auditors to the companies that operate under the umbrella of Koç Holding. He did not stop there: he unilaterally cancelled many government contracts that Koç won in competitive biddings. Now, leave everything aside and ask the following: “Would these actions of the prime minister encourage foreign firms to make direct investments in Turkey?”

So would you say that the policy makers are happy with what we are getting and they are promoting it everywhere but they are not doing enough to get more?

No. I think they have to be aware that we are not getting much. I think they are doing this public relations campaign claiming that things are great, claiming that we are getting a lot of money. FDI in 2006-2008 were 19 billion, 20 billion, and 17 billion dollars, respectively. Since the current account deficit in those years was much lower than say in 2010 or 2011, these healthy funds represented a decent percent of the deficit. In 2010, net FDI flows dropped to 7.6 billion dollars. In 2012 it dropped 35% compared with 2011, and during the first 9 months of 2013, it was down another 8% relative to the same period in 2012.  Before we talked about the fact that Turkey’s external financing need is at least 225 billion dollars during October 2013-14. Given the trends, my forecast of FDI for the same time period will not be much more than 8 billion dollars. Now, you have 225 billion dollars of external financing need, and you can find only 8 billion of this (3.5% of 225 billion) from the most financially healthy source? It is a sad situation.

Due to hedge funds coming to Turkey, Turkish Lira was overvalued between 2002 and 2010. What we have seen recently can be described as “correction”

Regarding all of these, I wanted to ask this question of as the interest rates are higher in Turkey when compared to US and Euro-zone and we have the inflation, current account deficit etc. How do you see that the currency, exchange rates have been slightly flat for a long time until last 2 years? Do you think that the Turkish Lira is overvalued?

I think the TL was overvalued probably during the 2002-2010 period.  In my opinion the reason it was overvalued was because of hedge funds coming to Turkey, because of high interest rates. You are an American hedge fund let’s say, you are coming to Turkey you’re going to buy stocks, you are going to buy Turkish government funds. So you come with dollars, the very first thing you do is to exchange dollars with Turkish Lira. So you sell dollars, you buy Turkish Lira, well the increased demand for the TL causes the value of TL to be higher than it should be, i.e., overvalued.

But in 2011, when the government officials and the business community were celebrating the fact that “Turkey had the second highest growth rate in the world after China”, they were losing sight of the fact that high growth rate means a high current account deficit. In fact, The Economist provides weekly economic data on 57 countries. In 2011, at 10.3%, Turkey had the highest current account ratio (CAO) in the world. In fact, in spite of the huge differences in the size of their economies, Turkey had the second highest current account deficit in terms of its level after US (the CAO of US was less than 3%). Naturally, hedge funds realized what was going on. They got scared and cut back on their activities in Turkey.  As a result, in 2011, TL was the currency whose value declined the most in the world (-24%). In fact, from November 5, 2010 to the end of 2011 the loss was 36%.

So while for years, because of hedge funds, TL stayed stable and overvalued. But the game came to an end in 2011. Because the theory says that if inflation in Turkey is, say 8% and inflation in dollars or US is 2%, not every year but in the long run, Turkish currency should decline 6% a year and it didn’t for years and for years. By the way, overvalued does not necessarily mean that TL went up in value. The concept of ‘overvalued’ is that the currency is higher than it should have been, on the basis of inflation differences. For example, in 2002 the dollar was worth 1.50 TL, while the value changed from year to year, in 2010, in spite of the substantial cumulative inflation differences, the dollar was back to being worth 1.502. In 2013, TL against the dollar lost 21.6% of its value. Thus, what we have seen since 2011, in “Wall Street parlance” can be described as “correction”.

Do you think it’s going to happen again?

As I mentioned above, in 2013 TL declined 21.6%. The two year government bond rate was 4.61% in Mid-May, 2012. This was a historical low. Similarly, the 10 year rate was 6.22%. Now both rates are in double digits. In fact they reached these levels within 1.5 month of the start of Gezi. Due to the Tapering decision of the Fed, 10-year Treasury rate in US increased from around 1.75% to 2.92%. In spite of this increase, because Turkish rates increased much more, the difference between the rates of the two countries is much higher now than it was in May. Normally, this should make hedge funds to invest even more in Turkey. However, the increase in the political risk, and the premium demanded for it by foreign investors is so high that, we are experiencing dollar outflows instead of inflows.

Before I have alluded to the quality of growth. Well, the quality also applies to financing sources as well. Over time, certainly during the last two years, the quality of financing that Turkey has been able to attract declined substantially. In financing, low quality refers to having to rely on hedge funds (‘hot money’), and other short-term financing sources such as dollar deposits and short-term credit. Turkey has been unable to attract long-term funds. During the last 2 years or so, around 80% of financing that Turkey was able to obtain were short-term, i.e.., low-quality funds. Of course what makes them low-quality is that their nature is “here today”, “gone tomorrow”. I talked about the effect of the Prime minister’s actions on FDI. How about the effect of “interest rate lobby”, “foreign conspiracies” rhetoric on the only financing we have been able to find recently: portfolio investments (hedge funds), and other sources of short-term funds. There is no interest rate lobby. There can’t be an interest rate lobby.  I recommend my article entitled “Interest Lobby or ‘Interest Lobby’Lobby? (Faiz Lobisi mi, Faiz Lobisi Fobisi mi?)” to your readers.

One of the things that made Turkey attractive to foreign investors in the past was its political stability. Now this is gone. There has been significant erosion in confidence regarding investing in Turkey.  As we all know, confidence takes a long time to establish, but can be lost in a very short time (as the experience of 2-year rates going from 4.61% to double digits in six weeks would attest).  I don’t think we have seen the worst yet. Who knows when and how the corruption investigations will be resolved? Even if it is miraculously resolved tomorrow, as I mentioned, it will take years to repair the damage inflicted by the erosion in confidence it caused.

Turkey has substantial number of vulnerabilities in its economy. Of course everyone knows about the current account deficit, huge amounts of external financing needs going forward, the low quality of both its growth, and its financing sources. But there are others. A partial list includes the following: the fact that 70 percent of the taxes are indirect, and only 30% direct, makes the tax system pro-cyclical. Debt-to-equity ratio of Turkish firms is 140% (in much less risky economies this ratio is lower. For example, it is 50% in US, and around 70% in the EU countries). The growth in credit volume has been exponential, growing at 25-30 percent per year. Consumer credit is very high for a country where the individuals have not yet developed a debt management culture. It may be the case that there is a property bubble. The savings rate is very low. The capital markets are not well-developed.

How could the central bank be considered to be “independent”, if the president of  Central Bank of Turkey (TCMB) had to spend 4 hours in July with the prime minister and the ministers in charge of the economy, to convince them that the CB had to raise the interest rate? The total reserves of the central bank are very shallow relative to other comparable countries. The Central Bank follows some very “unorthodox” policies, such as “the interest rate corridor”, which no other central bank in the world uses, and which has the effect of increasing the level of uncertainties in the economy. During May – July 2012 period 34% of the financing need was satisfied by liquidating reserves and by errors and omissions. Obviously, neither of these two sources are sustainable. Errors and omissions should be zero in the long run, and central bank has limited amount of reserves. Turkish firms have substantial amount of credit denominated in dollars and Euros. Given what has happened to the exchange rate during the last 3 months or so, some firms will clearly have difficulties in paying them off. Additionally, the public has the impression that the Turkish firms borrowed these funds from foreign banks, so the difficulty they will have in making their payments is the problem of foreign banks. This is not true; 64% of these loans are made by Turkish banks. It is hard for me to imagine, how the Turkish financial system would escape without any damage in the event of a crisis-like event when this fact is combined with over-leveraged corporate sector, over-leveraged individuals, high growth rate of credit volume, etc..

So, can we say that we are still exposed to a similar risk as before?

Absolutely. People say; it is the biggest vulnerability of Turkish economy and there are multiple vulnerabilities. I have given an incomplete list of these above. Of all the vulnerability factors that are on the above list, if you force me to say what Turkey’s most pressing and dangerous vulnerability is, I would say its financing need; external financing need.

A country’s ability to service its debt is more important than its indebtedness ratio in investment decisions. Turkey’s figures in this sense are much lower than many countries  although its debt level is lower than them hence it would not receive positive investment decisions.

I just wanted to tie this up, because you said it’s kind of cultural, as far as I understood, that the people don’t invest in stock markets, capital markets and rather they go and invest, let’s say buying houses, land, so into property markets or spending the money. Regarding this, would that be a coincidence that construction industry has been a locomotive of the growth in the recent years?

I think one of the basic needs of all humans, of all families is housing, right, but if you ask me about this I don’t know, because nobody knows until it happens. As I mentioned earlier, there may be a bubble in housing industry.  If you look at housing prices, it’s been going up, if you look at the index of it and I think there are a lot of these shopping centres being built and lots of those are going out of business. I think there is a lot of excess capacity. Some analysts estimate that there are about 1 million housing units that are waiting to be sold. I mean there are lots of buildings built but you know they are not being bought and the prices are going up and people have been borrowing money to buy. I mean in US a typical mortgage is for 30 years; certainly not less than 15 years. In Turkey, the maturity of a typical mortgage is about 5 years. So if there’s a crisis, if the economy is growing very slowly and it starts shrinking because of global shocks. If Turkey can’t find money overseas, which as I said it has a real danger of happening, then the businesses will not make investments, people will be unemployed and they have this huge debt; housing related and cars related, all consumption related etc. and they’ll have difficulty in making those payments. While banking industry in Turkey during the recent past has been strong because of the reforms in 2001. However, because of all the reasons I have discussed above, unlike in 2009, when the banking system was not affected in spite of the fact that the economy contracted 4.7%, it is conceivable that the banking system will be affected now.

So that issue does not stem from the household, I think firms are the main drivers of this highly indebtedness. Because I’ve got some data here that says household indebtedness ratio of around 17% which might be considered low when compared to countries like England where it’s higher than 100%.

But people in England has a culture, has an experience I should say servicing their debt, they have well-developed human capital in debt management that they have acquired over many years of experience Turks are new to borrowing, I mean individuals. So even as a country, our economic decision makers are proud of the fact that Turkish government’s debt ratio is something like 36%. Well, that’s very low, let’s say compared to Japan, 36% of GDP that is, Japan’s debt-to-GDP ratio is 230% US’s is about 100% of GDP, Germany, England 80-90% of GDP. So our ministers are saying, look at us we have such healthy fiscal discipline, we have so little debt, and our budget deficit is so small. Well that’s misleading for two reasons; one, when you look at countries like Turkey, Fiscal Monitor; a publication of the IMF has 30 developing countries like Turkey, and 30 developed countries. When you look at the average debt ratio of the developing countries, it is about the same as Turkey’s ratio.  The same holds true for the budget deficit ratio (budget deficit/GDP).  As a country, when you are comparing yourself in terms of income, you can’t use a country like Uganda, and claim Turkey is richer than Uganda, while, when the issue is debt ratios, you can’t switch the metric to developed countries just because the results will favour you.

Independent of what economic variable is used for comparisons across countries you need to be consistent, and use developed or developing countries, for all comparisons. For scientific methodological reasons, a developing country like Turkey should always use other developing country averages as its benchmark, no matter what economic variable is being discussed.

In terms of risk and debt ratios, one needs to ask how is it that Japan can borrow 10 year funds at 0.76%, with “so much debt”, and with a “very high budget deficit-to-GDP ratio” of about 10% (Turkey’s is about 2.3%), when Turkey has to pay around 10.5% for the same maturity debt, even though it has “so little debt”, and “such a small budget deficit”?

I can answer that question: In corporate finance there is this concept called, “coverage ratio”. It is a measure of to what extent you will be able to service your debt payments. If you are a bank and you are lending money to a firm, if the firm already has a significant amount of debt, it doesn’t necessarily mean as a bank you’re going to have more risk. If the firm wants to borrow one dollar more but their profit has increased 5 dollars, you have less not more risk in lending that additional dollar. Coverage ratio is defined as the firm’s profits before taxes and interest divided by interest expense. In other words, it measures how many times the money you’re making is enough to cover your interest expense. In Japan, even though they have debt of 230% of their GDP, their budget revenues i.e., the taxes they collect is enough to cover their interest expense 34 times. In the case of Turkey it’s something like 10 times. Hence the fact is that you have low debt but you have low ability to service that debt means that the credit risk assumed by the bank is higher compared to the credit risk of a firm that has substantial debt, but has such healthy cash flows that it can meet its debt obligations with no difficulty. I have developed this metric for countries. The numbers that I gave about the coverage ratios of Japan versus Turkey is calculated by me. As far as I know, the application of this coverage ratio concept in corporate finance has not been used for countries. I published my findings regarding the credit risk of developed and developing countries in Milliyet Newspaper.

Thank you very much Professor Tarhan, for your time. It has been an enlightening interview for our readers regarding the current status and future of Turkish and the global economy.

I thank you, both for your interest, and the excellent questions that you have asked.

© 2014 Research Turkey. All rights reserved. This publication cannot be printed, reproduced, or copied without referencing the original source.

Please cite this publication as follows:

Research Turkey (January, 2014), “Interview with Professor Vefa Tarhan – Structural Problems, Structural Solutions: Turkish and the European Economy after the Global Financial Crisis”, Vol. III, Issue 1, pp.48-61, Centre for Policy and Research on Turkey (ResearchTurkey), London, Research Turkey. (http://researchturkey.org/?p=4728)


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