Reforming Turkey’s economy will not be a piece of cake
Another sweet victory for Mr Erdogan. On June 12th, the incumbent prime minister became the third leader in the history of modern Turkey to win more than 50% of the vote in a general election. His Justice and Development party (AK) will enjoy a strong third mandate, albeit with a reduced majority (the CHP, AK’s main challenger, has more seats than in the last parliament; the nationalist MHP and the pro-Kurdish BDP have also gained).
Politically, this was a happy outcome for everyone. The strong popular support will ensure long-term stability in the political arena, whilst giving extensive legislative power to the government, a necessary tool to pass and implement structural reforms; yet the AK’s will not be powerful enough to reign alone, as the opposition’s fair representation in parliament will force the government to seek consensus on sensitive topics. But what about the economy?
AK’s landslide victory is a reward for the party’s solid economic record: a decade ago, Turkey was facing a deep financial crisis and hyperinflation (80% in 2000); since then, the successive AK cabinets have made the industry more competitive and export-oriented, restored the country’s fiscal position, doted the banks with a more solid capital base, and opened the market to foreign investment. Such a renaissance has propelled Turkey as a deserving member of the G20, and its annual income average, at $13 000, qualifies Turkey in the World Bank’s category of rich economies.
Yet matching these achievements is an equally daunting set of challenges. Unlike that of its Northernmost neighbour, Greece, Turkey’s economy is steaming ahead: figures released today show that Turkey’s growth in the first quarter, at 11%, has outpaced China’s - and beaten most forecasts, last converging towards an already red-hot 9.7%. But rather than being a cause for self-congratulation, such figures are a growing source of worry for policymakers. Today’s data confirmed that most of this growth is still fuelled by credit - either to finance the country’s impressive building boom (large-scale skyscrapers, residential blocks, corporate headquarters and commercial centres are mushrooming around the biggest cities) or to satisfy an ever-stronger domestic demand for imported goods - prompting analysts to declare that Turkey’s economy is not just overheating, but literally on fire.
The rationale behind such glowing warnings is simple. The alluring pace of Turkey’s credit-led growth results in a yawning current account deficit - according to today’s at an all-time record of $10.1bn in May - largely financed by a flow of hot, foreign money. This leaves Turkey ever more vulnerable to an external shock in the global economy, whether it be a worst-case scenario in the Eurozone, a slowdown in the US or a softening of the Chinese economy, as the country could suddenly find itself dry of financing would such risks materialize. The credit bubble would then burst, the economy would crash, and the story of Turkey’s economic resurgence would find a sorry end.
We’re not there yet - but to cool things down Turkey needs to show better firefighting skills than it has so far. As a matter of urgency, it should reassess the policy mix followed by the Central Bank. Since December Turkey’s chief regulator has relied on an unorthodox policy of low interest rates and high reserve requirements - increased four times during the period - to try and tame down credit growth, in the hope that privileging quantitative measures over interest rates would avoid boosting hot money inflows. Yet this rationale no longer holds, with capital flows to emerging markets now calming down; and the method doesn’t work anyway - as the fresh data shows the stated aim of slowing down GDP growth to around 6% remains a distant dream. The macroeconomic policy of the administration is also too lax - it runs a budget deficit of 2-3% despite strong revenues. Instead Turkey should adopt a much more aggressive fiscal and monetary tightening, using sharply higher interest rates and budget surpluses to soak up overflowing liquidity.
Such measures, however, are at best a short-term, symptom-focused treatment; in the medium term Turkey will need to do much more. Despite the improved business climate, the widening current account deficit indeed reveals that the economy still has a long way to go: it remains externally uncompetitive and dependent on external financing. The entire growth model, analysts say, has to be rethought and remodeled through structural reforms. The competitiveness bit should focus on improving the value-added potential of its industry, for the moment overly focused on intermediate goods; streamline the labour market to reduce hiring costs and youth unemployment; initiate a reform of the land registry; and modernize the judicial system. The dependence bit should work on increasing the revenue directly raised by the government through tax reforms; increasing the domestic saving rate; and addressing tax evasion through reducing the importance of the ‘hidden economy’ (evaluated at a sizable 40% of GDP).
This is a long list of difficult reforms. Yet as it enjoys the fruit of a maturing political system, Turkey should use it to bite the bullet of economic modernization.