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Thursday, 19 October 2017

Managing Turkey

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The moderately Islamist AKP party has divided opinions in Turkey and abroad. The party is lauded by some for succeeding where other governments have failed in implementing much needed reforms. Others criticise it for jeopardising Turkey’s secular tradition, and for not going far enough in its reforms. Solomon Teague analyses the AKP’s economic credentials.

Turkey’s Justice and Development (AKP) party is not short of admirers. And unlike in the first years of its ascension to government, many of them are inhabitants of the country’s financial community. The AKP has won admiration by upholding Central Bank independence and running a tight fiscal budget.

Under AKP guidance, Turkey has made some important strides with its economy, for which the party rightly takes credit. Public sector debt, for instance, stands at 50% GDP, which is below the Maastricht convergence criteria, and while inflation is still too high to be at European entry levels, it has at least been in single digits for three consecutive years. Considering the surge in commodity prices, that is noteworthy, said Tolga Egemen, executive vice president of financial institutions and corporate banking at Garanti in Istanbul.

Added to this are 24 consecutive quarters of economic growth. That is the longest period of uninterrupted growth in modern Turkey’s history, said Beat Siegenthaler, chief strategist for emerging markets at TD Securities in London, and represents an impressive achievement for the country.

One of the AKP’s key strengths is its pragmatism. It has made mistakes but has been quick to change course when it was clear something was wrong. Siegenthaler argues that on questions of economics the party has been receptive to advice, which to an extent has offset the economic inexperience in the party.

The AKP has also restored some level of economic trust in Turkey. The electorate deserves some of the credit, as voting in a party with a large majority gave it the freedom to take decisions that a more divided coalition could not have done. But the AKP itself deserves most of the credit, said Siegenthaler. “The government has done the simple things, but it has made a difference,” he said, adding that the seeming simplicity of some of the problems it has resolved must not conceal the fact previous governments have tried and failed to resolve them. “The next step will be more difficult,” Siegenthaler added.

Turkey is benefiting from AKP’s fiscal policies too. It has the biggest primary surplus among the emerging markets, Siegenthaler said, having resisted the temptation to increase spending, even in the run up to the last election. Interest rates were hiked when the lira was selling off, while the currency revaluation, with six zeros knocked off the denominations, allowed TD Securities to begin trading the lira.

But the AKP has been timid when it comes to the more difficult problems the country faces, said Tolga Ediz, emerging market strategist at Lehman Brothers in London. In 2007, despite the lengthy global bull market, Turkey is still shackled with real interest rates in double figures and inflation in high single digits. Although inflation has come down markedly from its previous levels, it has not come down enough, said Ediz, and remains higher than levels seen in neighbouring countries.

Similarly, government debt burden has come down from its previous highs, but remains uncomfortably high and is still concentrated in bonds with very short denominations: local government, for instance, has not been able to borrow fixed interest rates in more than five year issues.

Political turmoil

Turkey has been rocked by significant political turbulence recently, arising from its presidential and parliamentary elections, held in quick succession in 2007. The election results triggered a political crisis in the country, with parliamentary elections proving inconclusive.

There are grounds for hope that Turkey’s financial markets can shrug off these concerns. The financial markets in Turkey need not pay too much attention to politics, said Mehmet Mazi, head of HSBC’s emerging markets group for EMEA, as both the governing party and the opposition have shown themselves to be pro-market, pro-business and economically rational.

“This is evidence of a critical change in Turkey. Markets have shown they have become less vulnerable to political problems. In the past something like this could have caused a financial crisis,” said Egemen.

The markets have managed to withstand political shocks and disappointing performance in the equity and currency markets and deal-flow has continued with little or no disruption, said Caroline von Nathusius, an associate at Linklaters specialising in the Turkish market.

There is therefore general optimism that Turkey’s political problems will not overwhelm the country. The AKP party has given the country the most stable government it has had in its modern history, and having come to power with 47% of the vote, now enjoys even greater support, following its successes.

“The government is aware of the problems and is trying its best to avoid confrontation,” said von Nathusius. “It knows its popularity rests on keeping a steady hand on the economic tiller.”

The AKP has won praise for three reasons, Ediz said: "It delivered reasonable budgets until 2007; it pursued privatisations, which was a new policy in Turkey; and it has been very pragmatic."

“The first term was spectacularly successful in economic terms,” said Siegenthaler. “It has given the AKP support beyond its religious base. Many people initially supported the party for its religious positions but having more than 50% support implies there is support there for its economic policies too.”

Turkey in the news

Yet these economic successes do not alter the fact that very real political problems surround Turkey and its government. Two issues in particular divide the country’s political establishment, both of which are currently subject of legal disputes and await court rulings.

The first is the headscarf issue that has earned a certain level of international notoriety. It is likely to be the first of the two court decisions, said Seher Fazlioglu, an economist at Global Menkul Degerler in Istanbul. The fear is if the judgement in Turkey’s Constitutional Court approves the legal amendment allowing headscarves to be worn in universities, that will open the door to further measures undoing the secular principles underpinning the Turkish state.

Something with more obvious direct consequences for the markets is the verdict regarding the constitutionality of the AKP party itself. Fazlioglu estimated there is around a 50% chance the party will be forced to close. This issue could then be dragged through the International Court for Human Rights, where the legality of such a closure could be debated, perhaps for years.

This ruling could also prove a watershed: if the court decides against banning the AKP party, Fazlioglu said, it could lead to the party becoming more aggressive and not softening its rhetoric or style. “The first court ruling will set the tone,” said Fazlioglu. “But it’s not so much about the outcome as how you handle the problem.”

There is a real prospect of Turkey being dragged through a lengthily period of uncertainty, with grave implications for the financial markets. The local elections scheduled for next year could easily end up being general elections, said Fazlioglu.

How far this will go to scaring investors away from Turkey remains to be seen. There is probably more interest surrounding the political issues in Turkey outside the country than there is inside, said Mazi. Most of the downside risk has already been priced in, he said, and the situation is unlikely to cause any more volatility in the country – at least in the long term.

Optimists stress five years of uninterrupted financial development has given investors a high level of confidence in Turkey. When the lira’s value nosedived the problem was resolved within a month, said Andreas Schroeter, head of operations in Turkey for WestLB, adding to the sense Turkey has normalised and can resolve its own problems quickly and efficiently.

Reform

The AKP may have achieved more than its predecessors, but there is a considerable amount of work still to be done. Reform has been difficult to achieve in a country that has seen its ruling elite plagued with factionalism and special interest politics.

“Single party government is new to Turkey,” said Siegenthaler – Turkey’s governments have hitherto usually consisted of coalitions of a diverse range of factions and interest groups, which is never a recipe for productive government or the implementation of difficult reform. With the AKP now in its second term it has had unprecedented time and scope to face the country’s problems head on.

The end of the global bull market and the turbulence that now grips the world economy will make further reform – of the labour market, for example – much harder, Ediz said. The question some observers are asking is how much does the AKP really care about its economic program. "Does the government have the policies, have the ideas? Most analysts are sceptical," said Ediz.

Fazil Zobu, head of research at Standard Unlu in Istanbul believes two of the biggest challenges facing Turkey are social security and tax enforcement reforms. “Turkey has a good record of managing its fiscal policy,” he said, adding that if it does a good job with these reforms it will make the inflation picture much brighter.

The government’s pragmatism was illustrated when it attempted to impose a tax on the bond market, but reversed its decision when the market response demonstrated the folly of the decision.

For Ediz, tax reform is the most pressing issue, with change urgently needed to the tax base itself as well as to the laws regarding tax evasion. "The tax-take needs to be much higher, but the government has failed to tackle it," he said. "The budget can’t improve without this, and there is no room for loosening. The broader the tax base is, the less each person needs to be taxed. Turkey needs better tax justice."

Labour market and pension reforms are also urgently needed. It is a difficult set of reforms, Toksoz said, but with the majority the government enjoys in parliament, it should be able to push them through. “The government is wasting its majority,” she said, though she conceded it also lacks economic expertise, and probably is more committed to its other, social agenda.

Turkey needs to address the problem of industry incentives, another banker said. “There are far too many in Turkey, corporates take advantage of it,” he said, arguing that the government should phase in more regional incentives, which can be used to promote growth in depressed areas, and phase out industry incentives, which distorts production.

“There are too many free trade areas – they need to be rationalised. It is so important, yet it looks to me like things are actually going in the other direction, with ideas for more to be established, for example promoting research and development,” the banker added.

IMF’s role

The IMF has been an important anchor for Turkey, providing a necessary straightjacket to ensure the government maintains its focus on sensible economic policies.

In the absence of scope for sweeping market reform in Turkey, the best the country can hope for is a new deal with the IMF, said Ediz. The next – and last – IMF instalment [of US$3.6bn] is due when the IMF completes its most recent review and could come in May. Parliament’s recent approval of social security reforms should smooth the path to release of the funds, von Nathusius said.

“It is important Turkey organises a new binding agreement with the IMF,” said Toksoz. A new standby agreement is far from a foregone conclusion; the government has indicated it will not apply for a new agreement.

There is hope for a precautionary agreement, Ediz said, which also promises financial assistance, but with added conditionalities, with money only given when it is needed. The exercise of this option could be viewed by the market as a sign of weakness and can trigger sell-offs in the financial markets, Ediz added.

"If the market gives a very stern message, for example in another currency crisis or an interest rate correction, then it may consider a full standby agreement," said Ediz, acknowledging the government's pragmatism. "But it will need a shock like that. We've already had enough of them, but it will take more."

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