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Emerging Markets

Rewriting the script

Turkey has entered the latest global economic crisis on a stronger footing than many of its counterparts. But the government remains gripped by an age-old tension between remaining popular domestically and economic prudence

For years, economic dramas in the emerging markets followed the same familiar script. Turkey, duly playing its part, would post chronic inflation, a surging public debt, a rise in unemployment and, as in 2001, a crisis in the banking sector.

This time round, the country’s exports have slumped, unemployment has risen to around 12.5% and most worrying, youth unemployment is at 25%. In the last quarter of 2008, the economy contracted 6.2%, the first shrinkage in seven years. Last month, central bank governor Durmus Yilmaz warned of a double digit contraction in gross domestic product and a “slower and more gradual recovery in 2010” than was anticipated in his January report.

Public finances have deteriorated too with the government more than quadrupling its 2009 budget deficit target to TL48.3 billion ($30.37 billion) from the previous TL10.4 billion. And the IMF, meanwhile, expects Turkey’s economy to shrink 5.1% this year, after it grew nearly 7% annually between 2001 and 2007.

Turkey’s economic rehabilitation since 2001 has relied in no small part on abundant foreign capital. But the flow of foreign capital has dried up fast, with the IMF estimating that private capital flows to emerging markets will decline from some $600 billion in 2007 to just $180 billion in 2009.

However, the slump in commodity prices and a dramatic contraction in demand has ensured that inflation remains, for now, under control and according to Yilmaz, is tipped to range between 4.8% and 7.2% in 2009, significantly undershooting the central bank’s target of 7.5%. This has left the central bank with room to manoeuvre on rates, and in an attempt to stimulate growth, it has cut seven percentage points off the benchmark rate in the last six months, the latest rate cut coming at the bank’s April 16 meeting, when it slashed rates by 75bp to a record low of 9.75%.

Promoting the package

Fairly or unfairly, IMF assistance packages have tended to play badly with the Turkish electorate. The perception that seeking outside help is an embarrassing admission of economic failure has been compounded by domestically unpopular fiscal reforms required by the IMF.

This tension between what is economically best for Turkey and what plays well with voters has left the AKP (Justice and Development Party) facing an unenviable tightrope walk between holding onto power on the one hand and implementing much needed fiscal reforms on the other.

And, as in IMF negotiations of the past, it’s these fiscal reforms that have become the sticking point in negotiations between the IMF and the Turkish government.

On both the income and expenditure side, changes are needed to bring the ratio of central government debt to GDP – expected to rise to between 7% and 8% by Gazi Ercel, president of Ercel Global Advisory – onto a declining trajectory.

Structural reforms to make the tax system less pro-cyclical are also yet to materialize. Some 70% of the country’s tax revenues are derived from indirect taxes, with only 15–20% of revenues coming from corporate and income tax, ensuring the rise in government spending has coincided with a dramatic fall in revenues. The underground economy constitutes around 50% of GDP.

The IMF is said to want the introduction of an independent revenue and taxation administration and for some indication that government spending will be controlled.

The April G20 summit in London tripled IMF resources to the IMF to tackle the economic crisis. For its part, the Fund has softened its stance by relaxing its lending terms and dropping the structuring conditionality of its stand-by agreements. The G20 also made provisions for a new flexible credit line facility conditional on a “good track record of sound macro policies”. Investors have welcomed flexible credit line facilities in Mexico, Poland and Colombia as a sort of IMF seal of approval of sound fundamentals and economic policies.

“The main aim of the IMF facility will be to support growth and bring down the debt to GDP ratio by increasing the primary surplus,” says Mehmet Mazi, head of emerging markets, EMEA (Europe, the Middle East and Africa) at HSBC. “In the past, the IMF has imposed strict limits on public spending, but this time, because the aim is to facilitate growth and to keep the credibility of the sovereign, the IMF’s caveats will be less stringent.”

While discussions regarding a new IMF arrangement remain centred on a replacement standby agreement with $25 billion–$35 billion of funding, the IMF’s gentler stance may indicate a flexible credit line for Turkey too.

According to Turker Hamzaoglu, EMEA analyst at Merrill Lynch, assuming a refinancing rate of between 75% and 80% for corporate and banks, Turkey’s external funding gap will reach some $23 billion in 2009, but could increase to $35 billion should refinancing slip to 50%.

The IMF’s bearish forecasts suggest a more generous package may be likely, and speculation is mounting that the package could be as much as $45 billion–$50 billion.

Fiscal indiscipline

But Turkish experts remain sceptical as to whether the country will be eligible for such a flexible credit line of such scale. “The IMF insists on a necessary correction in revenues and the structure of the budget because the fiscal deficit is rising and debt is concentrated on the short-term,” says Ercel.

The Fund wants to establish an independent revenue department – an independent tax administration – and wants a plan for cuts to government expenditure.

Ercel believes a standby arrangement is more likely than a flexible credit line facility, mainly because unlike the governments of Poland and Mexico, the AKP has yet failed to indicate an intention to implement fiscal reforms in the coming years.

“If the Turkish government shows it is taking measures to counteract fiscal imbalances, it will be eligible for a flexible credit line,” says Ercel. “The IMF just needs some indication of an intention to control the government deficit over the next two to three years,” he adds. “But at this point in time, there has been no such signal. On the contrary, the government is offering tax rebates and an increase in spending in the municipalities.”

Murat Ucer, senior economist at Istanbul Economics agrees. “At this point, there is no option for Turkey – it’s going to have to be a standby agreement. Like everybody, Turkey has used fiscal policy in this economic crisis but now has a huge deficit – a government deficit of 6% of GDP would not be an exaggeration. The question is: how do we get back to a more reasonable level?”

And a $50 billion credit line is unlikely, Ercel says. “Turkey has a funding gap in 2009 of $15–$20 billion, and in 2010 of around $20–$25 billion,” says Ercel. “The total is more likely to be $20 billion–$30 billion.”

“The reports about a $40 billion facility are bogus,” Ucer adds. “It would take an enormous amount of fiscal adjustment for the IMF to agree to that kind of money. Sure, the IMF will be easier on Turkey – we are in a Keynesian world, but there is a limit to how far Turkey can go with fiscal stimulus.”

The limit, of course, is the ever-present risk of inflation. Ercel warns that inflation, while currently at a manageable level, could be reignited if the government fails to rein in spending. “From my reading,” he says, “the government wants to use the IMF’s funds for budgetary purposes or to extend credit lines to SMEs [small and medium-size enterprises] – that is, purposes other than the balance of payments. The IMF was very stringent on this issue but is more flexible these days, and Hungary has used its IMF funds to assist its banks with their foreign currency liabilities.”

However, Ercel warns that using the IMF’s funds to stimulate growth could reignite inflation. “With the central bank easing monetary policy, the government needs to protect fiscal policy but is doing the opposite,” says Ercel. “Inflation is an ever-present problem in Turkey, and we need to remain vigilant.”


The problems in emerging Europe are, in many respects, reminiscent of Turkey’s banking and balance-of-payments crisis of 2001. Twenty-two banks were taken over by the State Deposit and Insurance Fund, wages fell by 20%, unemployment rose by four percentage points to 10.6% and public debt skyrocketed. The result was a 6% year-on-year contraction in the Turkish economy, and the country embarked on a bank restructuring the cost of which reached 30% of GDP.

It was, perhaps, the banking sector reforms that followed the crisis which have ensured that Turkey’s banking system remains the most stable in the region. Turkey’s low domestic credit penetration has effectively insulated its banks from the crisis of non-performing loans that is plaguing their eastern European counterparts. Total credit to GDP is just 37%, and the mortgage system remains tiny. HSBC’s Mazi estimates the total volume of mortgages outstanding at $10 billion–$15 billion out of $25 billion of total home loans, which corresponds to only 4% of total GDP.

The Turkish banking sector has one of the strongest balance sheets among its regional peers – regulatory capital is around 17% and non-performing loans only 4%. And unlike their peers in the CIS, Turkish banks also have low-level exposure to international wholesale funding markets.

But fears remain that a wave of corporate defaults could be in the wings, and this has made banks reluctant to lend. This, combined with the evaporation of foreign capital flows into Turkey, has ensured that monetary policy has thus far been largely ineffective in stimulating economic growth. While the government initially hesitated, aggressive fiscal expansion has followed with higher public spending, trade credits and funding facilities for exporters and SMEs.

Holding on

The long-standing tendency in Turkey for economic crises to spill over into political ones has thus far at least been avoided. On the contrary, the country is enjoying one of the longest periods of stable government it has known. While support for the market-friendly AKP fell from 46% in the 2007 parliamentary elections to 39% at the March local poll, the government’s mandate is decent enough to ensure that few anticipate intervention by the military.

Politically, a bold cabinet reshuffle in early May saw the appointment of cabinet heavyweight Ali Babacan, Turkey’s former economy minister, as the new deputy prime minister in charge of the economy, with responsibility for the banking system and the treasury. The reshuffle also replaced the ministers of justice, finance, education, housing, industry and trade and energy.

“By combining economy minister and the deputy prime minister job, you bring decision-making and influence of the prime minister into one person,” says Christian Keller, Barclays Capital Emerging Markets strategy director. “This is definitely an improvement compared with the previous administration, but it won’t change around the economy immediately.”

Memories of the 2001 crisis remain fresh, but so too do the benefits of the economic reform programme that came in the aftermath of the crisis. In 2001, as Turkey negotiated its IMF programme, the country was facing low domestic savings, high inflation, a weak banking system and poor public finances. But sweeping reforms, tight fiscal policy (until recently), a floating exchange rate, inflation targeting and an unprecedented flow of funds from the IMF have brought about a dramatic improvement in the country’s economic fundamentals.

“We maintain that Turkey is experiencing its first mature business cycle without a full-blown crisis, which we define as a deep contraction in economic activity, sharp deterioration in macro prices and significant balance sheet impairment,” says Hamzaoglu at Merrill Lynch.

Economic growth faces strong headwinds from much weaker external and domestic demand and tighter credit. But as Hamzaoglu notes, “While this is clearly painful, as millions of people are losing their jobs, the silver lining is that this recession should still be less costly and destructive than crises of the past.”

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