Turkey’s Fragile Success

With equity markets in advanced economies treading water and low-risk bonds offering piddling interest, it’s not surprising that investors have rushed back to emerging markets. And where better to go than to Turkey, whose economy briskly rebounded from a nasty recession in 2009 to clock Asian-style growth exceeding 8 percent in both 2010 and 2011? 

Where, indeed. The transition economies in central Europe have not grown even half as fast as Turkey in recent years. And while a handful of economies in the Middle East and North Africa managed to get their acts together in the last decade or two, geopolitical risk in the wake of the Arab Spring has left investors in pause mode.

But with 2012 isn’t looking much like 2010 or 2011there’s good reason to believe that Turkey is losing its Midas touch. The economy grew at an annual rate 2.9 percent in the second quarter of this year. And while that figure is respectable in light of the sagging European economy — the European Union is Turkey’s largest foreign market — it was well below consensus expectations.

Those looking on the bright side point to the 20 percent rise in exports in the quarter. But it was driven by soaring gold sales to Iran, which is scrambling to acquire untraceable liquid assets in order to survive the Western economic embargo — and is therefore not sustainable. Indeed, without the gold windfall, Turkey might well have slipped into recession.

This decidedly mixed economic news is forcing analysts to take a closer look at Turkey’s economic fundamentals. And what they’re seeing are weaknesses that have long lurked behind the curtain. Turkey’s oversized current account deficit — 10 percent of GDP in the boom years — makes the economy dangerously dependent on the mood of foreign investors. Meanwhile, inflation remains stubbornly high, threatening to climb into double-digit territory again.

To better understand the Turkish growth story, go back to the banking crisis in 2001, which proved to be an effective wake-up call. With the help of a massive loan from the IMF, Economic Affairs Minister Kemal Dervis — an outsider finishing a two-decade career at the World Bank — pushed through a host of reforms ranging from commercial bank restructuring and central bank autonomy to the elimination of restrictions on foreign direct investment (FDI). And when the currently-ruling Justice and Development Party (AKP) came to power a year later, it continued along the lines laid out by Dervis and the IMF. Thus while AKP (and its leader Recep Tayyip Erdogan) would like to take credit for the economy’s success in the last decade, its real achievement was to have the sense not to rock the boat built by Dervis.

Actually, there is less credit to spread around than is generally assumed, since the Turkish economy faces some serious problems. Consider the aforementioned large and chronic current account deficit. In theory, there’s nothing wrong with a rapidly growing economy covering a big deficit in foreign trade with inflows of foreign capital. But in Turkey’s case, two facts give pause. First, Turks save far less of their incomes than their counterparts in high-growth Asian economies, making them uncomfortably dependent on foreign investment to cover the costs of the expansion of productive capacity. Second, much of the capital inflows consist of "hot money" – short-term loans that can exit as fast as they entered – putting the economy at considerable risk in the event of, say, a crisis in which Turkey is sucked into Syria’s civil war.

By the same token, Turkey has yet to put in place an education system capable of sustaining an advanced modern economy. The country ranked 32^nd out of 34 OECD countries on that organization’s 2009 International Student Assessment,  with 40 percent of 15-year-olds lacking the most basic math skills. (Numbers 33 and 34 were Mexico and Chile.)  The government has proposed extending compulsory education from eight grades to twelve. But there’s a catch: After just four years of schooling, children could be shunted into vocational or religious training.

Then there’s the question of economic justice. The post-2001 high-growth years, in which average real incomes nearly doubled, still left millions of Turks in poverty. The bottom tenth of households take home just two percent of total income, and Turkey ranks among the bottom-three members of the OECD in terms of overall income inequality. (Last place goes to — you guessed it — Mexico and Chile).

The most pressing economic problems, though, are related to macro stability rather than long-term fundamentals. With growth sluggish, unemployment at 8 percent and inflation low by Turkish standards, the government is pressing for stimulus. It is lobbying the central bank to lower interest rates and it is allowing the budget deficit to balloon past the 1.5 percent of GDP target.

The use of fiscal and monetary policy to counter swings in the business cycle is widely accepted. But there risks to stimulus, in large part because Turkey is so dependent on foreign capital. An uptick in inflation could trigger an exodus of hot money and attendant instability in the exchange rate.

More generally, in the atmosphere of uncertainty created by turmoil in the region, any sign that the government has set aside price stability as its highest economic priority could undermine investment driving modernization. Indeed, even if the government chooses to err on the side of conservative fiscal and monetary policy (my preference), Turkey’s prospects in the near term may be determined by events beyond its control — that is, by anything from the euro crisis to the civil war in neighboring Syria to the anti-western dynamic of the Arab Spring revolutions.

Turkey’s economic potential is undeniable. However, the country cannot hope to sustain its drive to join the select club of high-income countries if it fails to tackle the structural challenges elaborated above. To be sure, Prime Minister Erdogan and his party have presided over a remarkably successful run for the Turkish economy. But the real test — successfully managing the reforms needed to approach the productivity of the European Union and the advanced economies of East Asia — is still ahead.