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Tuesday, 24 October 2017

Turkey 2007: Year of two elections

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After five years of its most stable government in decades, Turkey faces the challenge of presidential and parliamentary elections this year, and a possible return to coalition government. Political concerns mean that it will be difficult to make tough economics decisions, but if the achievements of the outgoing government are going to be built upon, Turkey still has a lot to do. Paul Farrow reports.

This year Turkey sees two elections of very different sorts. First, in May, the Parliament will choose a new president to serve a seven-year term. Then, at the latest by early November, Parliamentary elections are due.

In the presidential election there was only ever one question: would Prime Minister Recep Tayyip Erdogan propose himself for the post. Given that his party, the AKP, has an overall majority in Parliament, the presidential election itself is a formality.

Among observers, the main concern had been that an Erdogan presidency would prove divisive if he pushed an Islamic agenda in areas under his discretion that to outside eyes may appear purely technical, such as the selection of university rectors. But Tolga Ediz, analyst at Lehman Brothers, was concerned about the affect on the AK Party if Erdogan decided he wanted the role.

"We are not so worried about noise surrounding the possible ascension of Prime Minister Tayyip Erdogan to the presidency. But we are worried that the ruling AKP may be weakened without Mr Erdogan at the helm," he said.

Standard Bank country analyst Mina Toksoz had argued that in the end Erdogan would decide not to opt for the presidency given the likely effect of such a move on his own party, with the potential for splits to open up after his elevation.

Erdogan’s decision, announced on April 24, not to put himself forward for election to the presidentcy therefore removed a major concern from the market. His party’s nominee is Foreign Minister Abdullah Gul, a choice that reduces secularists’ concerns and allows Erdogan to lead his party into the November parliamentary elections .

The AK Party won 35% of the votes in the last parliamentary elections, in 2002, but garnered fully 64% of the seats. Like the UK system, Turkey’s electoral system can turn minority opinion into majority government, but no-one doubts the benefits in terms of strong government. The contrast between the last five years and the 1990–2000 period could not be more striking, given that the earlier period saw more than a dozen governments.

A lot depends on the Turkish rule that parties must pass a 10% hurdle to get any seats, so a couple of percentage points one way or the other could double the number of parties in parliament and vastly increase the chances of a coalition.

Based on current polls, up to four parties could achieve parliamentary representation this time. In the event of a coalition, assuming that the AKP remains the largest party, the most likely coalition partner is the centre-right DYP, under Mehmet Agar. Currently the only other party represented in Parliament is the centre-left CHP. The right-wing MHP is the other party that could obtain seats.

Cem Akyurek, head of strategy at local broker Global Securities, makes the key point that after nearly five years of majority government, politics is becoming unstable again in Turkey this year. “There is a real lack of transparency in the parties currently outside parliament that may get back in next time,” he said.

EU negotiations stall

With the focus on domestic politics, broader themes are taking a back seat. After the initial excitement as negotiations for EU membership got started, sentiment has shifted, not least within Turkey. Ali Babacan, who heads the Turkish delegation in the EU talks, has been suggesting that perhaps Turkey does not need the EU so much, and opinion polls suggest that the previous strong public support for EU membership has waned.

In the EU negotiations, discussion has been closed on only one topic – science and research – and talks are yet to begin on the other 35 chapters. But the impasse over relations with Cyprus – already an EU member – is a major problem that will have to be tackled if there is to be any progress.

As well as an ultimate destination, the prospect of membership of the EU even 15 years from now is seen as a useful anchor in the meantime in terms of securing economic and political reform.

“The EU is still an anchor for Turkey, economically and politically,” said Global Securities’ Akyurek. “It almost certainly continues to have a positive effect on the level of FDI.” Certainly FDI in the last two years since the prospect of EU negotiations became a reality has dwarfed that in previous years.

Another issue that could potential force its attention on domestic events is the situation in neighbouring Iraq. In Northern Iraq, there is the status of Kirkuk, which has a considerable Turkish-speaking population and oil reserves over which Turkey has historic claims. Those reserves represent 40% of Iraq's oil, according to Moody's. Meanwhile the Kurdish statelet that has developed provides cover for Kurdish militants active in Turkey. Analysts do not discount the possibility that Turkey might invade Iraq, with a naturally negative impact on capital markets.

Economic vulnerabilities

During the years of AKP government, the economic situation of the country has rapidly improved. Standard Bank’s Toksoz lists the economic positives: the risks of former government fiscal mismanagement have receded; the foreign debt service to exports ratio is now only 20% of GDP; both the government and banks are better able to deal with a floating exchange rate; FDI is likely to continue to be boosted by M&A interest in the banking sector; and the AKP cannot afford an economic crisis in an election year.

But there are reasons for concern. “The country is still vulnerable to external shocks, as shown by the May 2006 volatility,” said Serhat Gurleyen, director of research at local broker Is Investment.

That makes fiscal conservatism a keystone in the Turkey story. Certainly the government's commitment to a high primary budgetary surplus and FDI inflows prevented an economic crisis in 2006 which might have been expected given the rising inflation rate (c.10%) and a current account deficit over 8% of GDP.

On the budgetary side, there was a primary surplus of 6% in 2006 (IMF definition) compared with the IMF target of 5%. The government has been committed since 2001 to achieving an overall public sector primary surplus of 6.5% of GDP, and has achieved that in three of the five years. Government revenues have been bolstered by higher collection rates for tax and social security arrears.

However, the first two months of 2007 showed a poor performance in terms of the primary surplus. Tax receipts are 70% indirect, which makes revenues very susceptible to demand. In addition, it seems that there was some window-dressing of the 2006 numbers so 2007 is not as bad as it appears.

Over the last 12 months the markets have had the chance to judge Turkey’s performance during the mini-crisis of May 2006, when a wobble in emerging markets saw a 28% devaluation of the currency and led the Central Bank (CBT) to increase interest rates by 425bp.

The CBT now has an asymmetric policy: rate rises for negative events, but unchanged rates for positive ones. Those high rates are likely to keep inflation on downward trend, though failing to meet 4% target. Otherwise, the Treasury has a US$15bn cash reserve, public domestic debt is below 60%, and its structure is much improved.

The lira has recovered two thirds of its losses since Spring 2006, but inflation has stepped up. However, Standard Bank’s Toksoz notes that the effect on domestic demand of the rate hike was less than expected, given that credit supply was maintained and public consumption was maintained, especially at the local government level.

The CBT is not above criticism in its handling of events. “The Central Bank is now stuck between a rock and a hard place,” said Global Securities’ Akyurek. “The Bank raised rates to bolster the currency, but now has no scope to do so to control inflation.”

Like most observers he is forecasting a year-end 2007 inflation rate of more than 7%, way above the government’s – unchanged – target of 4%.

“They should have amended the 2007 target then retained 4% for 2008. The current situation is not credible,” he added. And given that the Q2 06 crisis happened just after a governor and vice-governor had gone into the Bank, some wonder if the Bank just panicked and overreacted to an emerging market wobble that was not related to internal Turkish conditions.

Deutsche analyst Tevfik Aksoy forecasts interest rates to be on hold around the current 17.5% until at the least the end of Q3 2007, easing by 100bp by the year end, while at Dundas Unlu, head of research Fazil Zobu forecasts a 100bp–125bp cut in interest rates towards the end of the year. At Is Investment, Gurleyen is more cautious, forecasting a 50bp–75bp cut in Q4.

Against that background, Global Securities is forecasting GDP growth of 4.5% in 2007, down from 6% in 2006. Local broker Dundas Unlu is forecasting 4%–4.5% GDP growth in 2007, while Is Investment forecasts 4% GDP growth for 2007.

Stubborn current account

Among economic problems, the most obvious – and one of the most intransigent – is the high current account deficit. What can be done to make Turkey more of an exporter, and more of a high-quality exporter?

Current account deficit widened to approximately US$31.1bn, 7.7% of GDP according to Moody's, from 6.2% of GDP in 2005. Energy costs played a big role; tourist receipts were hit by the World Cup and bird flu, and the import content of exports has increased.

Moody's concluded that: "Such trends suggest that Turkey's large external deficits are structural rather than cyclical, and thus will require ongoing large external financing inflows unless the microeconomic factors that lead to such a tight relationship – especially the low domestic value added – are addressed in earnest."

Deutsche’s Aksoy expects the current account deficit to stabilise just under US$30bn in 2007, a slight reduction on the 2006 figure.

Speculative inflows finance a considerable proportion of the current account deficit, thanks to high real interest rates. Privatisation revenues help, as will falling energy prices in 2007.

The appreciation of the euro and the depreciation of the US dollar have also helped Turkey, as the country exports more in euros than in dollars, but imports more in dollars than in euros. Most tourists are from the EU, so the strong euro makes Turkey cheaper for them.

A weaker currency would help to correct the current account deficit, but some question whether that deficit is as bad as it appears? Possible reasons why it might be better: trade with Russia and Northern Iraq that is not being recorded.

FDI is likely to slow in 2007. The privatisation list includes Halk Bank (US$4.5bn), Tekel tobacco, Petkim, electricity distribution (probably only after the November elections), the port of Izmir, and the National Lottery. And M&A-related inflows look set to continue, especially in banking sector – see separate article in this report.

Dundas Unlu’s Zobu notes that after a 2006 that saw huge foreign interest in banks, FDI is now going into property, insurance and energy. He forecasts US$19bn of FDI in 2007, though that figure includes payments on deals agreed already.

After years of failure under previous governments, the AKP government’s commitment to privatisation continues to impress. The sale of two plots of land in the Levent business district this March drew a lot of attention. In one, the domestic Zorlu group paid US$800m, while in the other, Dubai’s Sama group paid just over US$700m.

But Global Securities’ Akyurek warns that today’s FDI can be tomorrow’s profit repatriation. “This means that it is important for sectors benefiting from FDI to generate exports. Clearly, this is not the case with banks,” he added.

According to Vanessa Rossi of Oxford Economics, there is some hard work to be done. "The focus now should be on cutting back the external deficit, and in particular curbing Turkey's persistent problem of runaway imports, which means capping domestic demand in the short run and trying harder to encourage import substitution, as well as broader growth in services trade, if they want to break out of the constraints on growth," she said.

“Essentially the country faces the problem of looking for where it can add value in an increasingly globalised economy given that it does not fit into either the developed camp of Western Europe or that of the very low cost developing economies of India and China”

IMF winds down

Though far removed from its former importance, the IMF remains a player on the Turkish stage. The current IMF programme ends in May 2008, and Turkey's debt to the Fund stands at US$9.8bn. The final review will be in 2008, and after several years of successful economic policy, those reviews are no longer as important for market sentiment. However: “The importance of its views has declined, but the IMF still matters in Turkey,” according to Global Securities’ Akyurek.

The Fund continues to call for more market flexibility and a lower tax on employment to boost job creation, and in some areas structural reform remains essential. Pension reform has been delayed again, with the government failing to meet the stipulations of the IMF stand-by programme. The measures were passed by Parliament late last year, but suspended by the Constitutional Court. Given the parliamentary elections, it may be 2008 before this situation is resolved.

And there continues to be no move on Social Security reform, where the previous problems with pension funding have been added to thanks to government spending on healthcare. Some things don’t change.

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