As game changing goes, Turkey’s latest move is striking. The government announced in September a three-year economic programme which aims to get a grip on public finances while steering the economy out of recession and back to growth.
But in doing so, Turkish authorities have at once thrown down the gauntlet to the IMF on the terms for a possible loan, while sending a strong signal to markets that the government believes it can manage its debt just fine.
In an interview with Emerging Markets, Ali Babacan, Turkey’s deputy prime minister in charge of the economy, is unambiguous in his message on economic reform: make no mistake about it, we’re doing it our way.
“It’s a political choice at the end of the day,” says Babacan. “This is the choice of our government; this is the way we want to go; and others should probably make their calculations according to what we have declared.”
The reforms envisaged are largely in line with IMF thinking: the plans hinge on a commitment to tighten fiscal policy, to help rein in a soaring budget deficit made worse by the economic crisis.
Turkey has lacked an external anchor for economic policy since its IMF standby agreement expired last year. When it failed to release a fiscal plan as expected in the spring, and negotiations with the IMF dragged on inconclusively, fears grew that the government didn’t have a plan to turn the fiscal woes around.
EXIT STRATEGY
But now, says Babacan, Turkey has provided the clearest evidence yet that its economy is on the road to recovery – and that an IMF loan is not vital.
“We are declaring a predictable but gradual return to fiscal discipline, but we are not doing this too fast to choke growth,” he says. “We are going to be one of the few countries which has explicitly and openly declared its exit strategy.
“Every government has to try and time its exit strategy correctly from its fiscal stimulus programme. If it’s premature, it can derail growth. If it’s too late, it can lead to fiscal or inflationary concerns. The medium-term economic programme is our exit strategy.”
The government expects the economy to contract by 6% this year, with growth “probably” beginning in the fourth quarter, and then GDP growth of 3.5% in 2010, 4% in 2011 and 5% in 2012, according to Babacan.
But things don’t always go to plan. Having initially believed the global economic crisis had “bypassed” Turkey, in the words of prime minister Recep Tayyip Erdogan, the government was forced to open up the public coffers this March – when it became clear that Turkey’s economy had been hard hit – and it spent $10 billion on infrastructure and tax cuts.
The measures were a response to the rapid contraction of the economy in the first quarter, which shrank by 13.8% year-on-year, as exports plummeted by 30% and domestic demand also fell sharply. “Turkey was one of the worst hit economies by the credit crunch in the first quarter, according to GDP figures,” says Mahmut Kaya, chief economist at Garanti Securities.
The stimulus, and the fall in tax revenues from lower economic growth, led to a 6% budget deficit – not as big as some of Turkey’s peers in central and eastern Europe, but still galling for a government that prides itself on its fiscal prudence and on the fact that in 2007 it became the first Turkish government to achieve a budget surplus in 23 years.
“It took a lot of effort to bring down the debt over the last five years from the high levels of the beginning of the decade. Now, some investors are worried we are going back to the bad old days,” says Kaya.
But Babacan says the stimulus is being withdrawn and that there are no plans to increase government spending. “We are taking back all the stimulus plans we have enacted,” he says. “There is a limit to fiscal expansion. I believe we have reached that limit.” The government says it will not increase government spending up to 2011, when it faces a general election, and will then begin reducing public debt in 2012. It also says it will reduce the budget deficit to the Maastricht criteria of 3% by 2012. “When we looked at the overall fiscal picture, we found that it is good enough to hit our targets,” says Babacan.
FISCAL RULE
Turkey will also for the first time introduce a ‘fiscal rule’ in 2011, which will define the level of available spending according to the deficit level. “It’s the first time in our history we have used such a rule, which will bring long-term predictability to our fiscal framework and reduce risk premiums,” says Babacan.
He says he will not provide explicit debt to GDP targets under a fiscal rule – “The deficit target will imply a public debt to GDP ratio for the long term.
“But the essence here is that if we are too far away from our target then the annual fiscal targets will be higher. If we are closer to the target, the adjustments will be smaller.”
Similarly, the fiscal rule will also allow higher deficits in years when growth is below the long-term average, and conversely, lower deficits when growth exceeds expectations, he says. “In good times we are planning to save for bad times – this is the essence of the fiscal rule,” Babacan says.
Market reaction to the medium-term programme has been mixed so far. Standard & Poor’s and Moody’s both raised the country’s outlook to stable, while Turkish bond and stock prices were mainly carried along by the broader emerging market rally.
“Most investors have a wait-and-see attitude to Turkey at the moment,” says Tevfik Aksoy, economist at Morgan Stanley in London. “The government has a very gradual fiscal adjustment plan, which envisages a slow recovery – 3.5% growth next year is not much at all for a country with such a fast-growing population.”
But some observers are concerned that a delay to 2011 in spending cuts is inviting trouble, as a fiscal rule won’t take effect in time to keep a lid on pre-election spending. Moreover, the government has little room to manoeuvre if growth disappoints again.
“We welcome the fiscal rule, but perhaps the government could introduce it sooner than 2011,” says Aksoy. “What worries me is there is no contingency plan if the global recovery is slower than expected.”
SPENDING CUTS
Independent Turkish economist Murat Ucer is more bearish: “The government has lost control on the expenditure side. Primary budget expenditures started to grow very fast even before the crisis – they have grown from 17% to 22% in the last two years, mainly on healthcare and municipal spending. There are no signs the government will make cuts; just more efficiencies.”
Babacan won’t be drawn on what spending cuts will be made, or when. “There are savings we can definitely make, but we have to be very careful on the savings side that we don’t do things that can influence growth in a negative way. We are looking at the sensitivities of expenditure and revenues.”
He says that tax revenues will be the main source for shrinking the budget deficit: “When we return to positive growth next year, automatically our tax revenues will start to increase.”
There are signs the government’s tax policy is already paying dividends. One of the reasons the economic crisis has not been worse in Turkey, despite the high level of foreign debt of the private sector and the declining risk appetite of foreign lenders, is the $18 billion in unaccounted foreign capital that has entered the country since the start of the year.
Morgan Stanley’s Aksoy says: “No one is sure where this money came from, but our view is it’s Turkish corporates’ offshore funds, which they brought back into the country following the government’s announcement at the beginning of the year of a tax amnesty for offshore funds. If it hadn’t been for those inflows, the crisis would have been a lot worse.”
While the credit crunch clearly had a sizeable impact on Turkey, there is cause for cheer. For a start, the economic slowdown has helped bring down the inflation rate to around 7.5% – its lowest level in 40 years – compared to 45% when the AKP party came to power in 2002.
Kaya of Garanti Securities says: “It’s a phenomenal achievement. The decline in inflation is one of the few bright spots in an otherwise gloomy picture. Perhaps Turkey needed a crisis to bring down inflation from the low teens to single digits.”
TARGETING INFLATION
The disinflation caused by the economic slowdown has allowed the central bank to cut rates aggressively – governor Durmus Yilmaz has eased policy by a total of 9.5% since November 2008. The central bank cut rates again, to a record low of 7.25%, in September, saying the easing bias would continue “for some time”.
Yilmaz maintains the central bank’s first priority is still targeting inflation: “There are some people saying that we have put the growth concerns before inflation; it is not so. Economic activity is important, but our first and main concern is price stability,” he tells Emerging Markets in an interview. “Our domestic economy is recovering, but because of the international environment and its impact on exports, economic activity is not as good as we expect.”
Yilmaz says the unemployment rate is increasing to around 13% and will probably edge up further before the end of the year. “This is impacting domestic demand conditions,” he says.
To offset this, the central bank is cutting rates and has increased credit market activities to ease consumer access to credit. “The credit markets have somewhat softened – but not by as much as we would like,” he says.
If Turkey is hoping for a domestic-led recovery, one bright spot is the continued resilience of its banking system, which was radically overhauled after the 2001 banking crisis, and is now well capitalized and well placed to increase corporate and retail lending.
No Turkish bank has so far been downgraded since the crisis began, according to rating agency Fitch. And banks’ net income has been boosted by the declining rate environment.
Babacan says: “Our most important strength is our banking system. We’re one of the few countries in the OECD, if not the only country, that didn’t have to provide any state support to the bank sector, not even deposit insurance. In this sense, the prime minister was right to say the crisis has bypassed Turkey.”
STRONG TURKISH BANKS
Mehmet Sami, executive board member of Ata Invest, one of Turkey’s largest brokerages, says: “Turkish banks have a capital adequacy ratio of around 17%, and a non-performing loan ratio of around 5%. They are making huge profits on their Treasury bill portfolios. We expect banks’ earnings growth to be 40% this year.”
But what’s good for the banking sector is not necessarily good for the economy. The banks are making such strong profits in T-bills that they have no forceful incentive to expand their lending to the private sector.
“We need to reduce the budget deficit so that the Treasury does not dominate the debt markets,” says Babacan. “The rollover of Treasury bills on the domestic markets is more than 100%. Resources are scarce, and the private sector needs funding. It is no longer appropriate for the Treasury to crowd out the markets. As we withdraw, there will gradually be more and more capacity for private companies.”
But the key word may be ‘gradually’. If the Turkish government agreed on a loan with the IMF, then it would reduce its need to borrow either domestically and internationally, immediately creating more breathing space for private companies.
According to a recent research note by Barclays Capital: “With external demand providing limited support, Turkey’s potential strength would be a domestic growth-led recovery helped by its comparatively unleveraged consumers, relatively healthy banks and historically low interest rates.”
But the bank points out that, without an IMF programme, the government will be forced to continue to roll over debt at greater than 100% rates, leaving less room for private-sector lending and possibly raising the risk premium on Turkish assets. “This leaves the domestic demand channel less effective than it otherwise could be,” the bank says.
Babacan counters: “With the measures we have taken and the fiscal targets we have declared, the rollover rates will come down gradually.
“When we consider that the total assets of our banking system are continuously growing, and with a decreasing public-sector borrowing requirement, there will be less and less pressure of public-sector borrowing on the banks. That is how our medium-term programme is designed.”
NO IMF DEAL
Nevertheless, prospects for an IMF deal appear to be receding by the day. Prime minister Erdogan seems set against opening another IMF programme, partly to assert Turkey’s new financial maturity, and partly to protect government spending from cuts before the 2011 elections.
The IMF’s Turkey mission chief Rachel van Elkan has welcomed the medium-term programme. But while applauding its aims – in particular the planned adoption of a fiscal rule – she has also mentioned a need for “supporting measures and structural reforms, including policies to address key spending pressures.”
IMF chief Dominique Strauss-Kahn was quoted more recently as saying that he sees “no need for now” for Turkey to agree on a loan deal with the international lender.
Babacan says that if ongoing “discussions are successful then we would prefer to have a standby agreement with the Fund... but this is, of course, conditional on whether we can actually agree. “If we can’t agree, I don’t think this is going to be the end of the world.”Yet as both Babacan and his boss know, the AKP government faces a bumpy ride in the coming years – one in which IMF support cannot be ruled out.
Gazi Ercel, the former central bank governor, says: “By 2011, per capita income will be down by 20%; GDP will not be higher than it was in 2008; unemployment is going to hit record levels; and even inflation of 5% means public-sector salaries will go down. “The government was lucky from 2002 to 2007. It needs its luck to come back.”