Turkey’s Economy: Now for the Hard Part

By most accounts, the Turkish economy has done reasonably well during the past decade. But the current state of affairs is nevertheless unsustainable and a rethink of the country’s growth model is a must if Turkey is to break through the so-called “middle income trap.” Why is this so? What is to be done? What stands in the way?

Turkey’s macroeconomic journey over the past decade can be broken down into three broad phases. The first came right after Turkey’s own currency and banking crisis of February 2001 and lasted until the global crisis of 2007 to 2008. Most macroeconomic indicators improved during this period. The public debt-to-GDP ratio was halved from a post-crisis peak of 75 percent, while inflation likewise dropped from around 70 percent to single digits. Thanks to a major reform of the banking sector, credit started flowing back into the economy. GDP per capita rose from around $4,000 a decade ago to almost $11,000 (in current U.S. dollars) in 2013.

The second phase began with the global financial shock of 2008, which initially sent Turkey’s economy into a sharp decline: It contracted by some 5 percent that year. But recovery came remarkably quickly. Significant policy easing and an exceptionally low interest rate environment at home and abroad allowed for average growth of 9 percent over the next two years. At the same time, indebtedness grew: The credit-to-GDP ratio rose from 30 percent prior to the global crisis to 65 percent of GDP, while household debt rose from around 30 percent to some 50 percent of disposable income. The corporate sector’s currency mismatch — the gap between the sector’s foreign currency-denominated liabilities versus assets — rose sharply to $170 billion, from $70 billion in 2007, exposing it to substantial currency risk.

Now the country has entered a third phase. Trend growth is slowing visibly as the economy oscillates more or less at the mercy of global shocks such as the eurozone crisis or the reductions in quantitative easing by the United States Federal Reserve. In the meantime, public spending has quickened while private investment remains sluggish, suggesting that the private sector-led growth that Turkey’s government once liked to boast about is losing momentum.

The good news is that, despite this volatility, the economy has proven relatively resilient, with growth this year forecast at around 3-3.5 percent. The bad news is that both GDP per capita and labor productivity have virtually stagnated since 2007. Moreover, inflation and the current account deficit as a percent of GDP have both remained high, at around 8 percent and 6 percent, respectively, during the past few years.

Given the current trajectory, it will be well-nigh impossible for Turkey to achieve Erdogan’s ambitious plan to make Turkey the 10th-largest economy in the world (which includes raising dollar-based per capita income another 2.5 times, to $25,000). To do so, per capita income would have to grow by a massive 10 percent per year through 2023.

Optimists argue that Turkey has already done something similar before, so it should be possible to replicate it. But this argument overlooks the unique factors that contributed to the transformation of the past decade: the steadily increasing global interest in emerging markets; a pragmatic government that stuck to the blueprints and policy anchors of the post-crisis IMF program and the EU accession process; and efficiency gains that were relatively easy to reap, given the low starting base. Put differently, there was a lot of “low-hanging fruit” to be plucked, and successive governments (led by Erdogan’s Justice and Development Party, or AKP) did a good job building infrastructure, helping the so-called “Anatolian tigers” to flourish, providing basic access to health and education, and so on. But growth will now have to come from more sophisticated sources — such as technology and improvements in human capital — as the old ones, like construction, run out of steam. Unfortunately, Turkey’s readiness to undertake such efforts is debatable, to say the least. (In the photo above, a man looks out at a stalled construction site in Istanbul.)

An additional reason why repeating past performance is difficult is that Turkey achieved its current near-$11,000 per capita income at the expense of escalating macro imbalances, most notably in its current account deficit. Turkey got rich fast, but did so by living beyond its means. The current account deficit (the gap between spending and income) has trended steadily upwards over the past decade, reaching 8 percent of GDP at the end of last year, after averaging below 1 percent in the previous two decades.

The current account deficit problem is complex, driven by a chronic savings deficit and a host of competitiveness shortfalls, like low skill sets, poor tertiary education, rigid labor markets, and a lack of firm-level innovation and scale. (It does not help that the country’s net annual energy import bill also runs to $50 billion.) Turkish households drew down their savings too fast, owing largely to unprecedented ease of access to credit, and productivity increases, though not insignificant, failed to keep up with the rapid real appreciation of the lira, particularly during 2003 to 2007. In fact, more than half of the growth in Turkey’s dollar-based income per capita during this period was driven by the real appreciation of its currency.

So what is to be done? The answer is to start focusing on the supply side of the economy by improving productivity — and to hope for the best, because even then, Erdogan’s ambitious targets will be very difficult to achieve. Any short list of the necessary structural reforms required would include improving higher education, increasing the flexibility of labor and product markets, addressing the segmentation in the business sector, broadening the tax base, making the budget more flexible, and tackling the informal economy.

The necessity for these reforms is generally acknowledged — as in the government’s own 10th Five-Year Plan — but there are a number of obstacles in the way of making them a reality.

For a country to reform, society at large should feel the need for and demand it. But the Turkish business community continues to muddle through as low global interest rates continue to drive short-term money its way. The public at large also appears content, thanks to the rapid income growth of the past several years and enhanced access to basic utilities and infrastructure, a comprehensive welfare network, and the creation of (albeit mainly low-skilled) jobs. There are calls for Turkey to move up in the value-added chain, coupled with warnings about the “middle income trap,” but these do not translate into specific policy suggestions or an actionable debate on what needs to be done.

The other problem is the ever-increasing polarization of society. There is too much animosity between pro- and anti-government circles and too much self-censorship (on behalf of opinion leaders) to conduct a healthy discussion on the challenges facing the country and the ways of dealing with them. Anyone who makes even the most commonsensical arguments can expect to be accused of membership in the “interest rate lobby” (an international cabal conspiring against Turkey) or to be targeted by pro-government media.

In fact, there is an obvious solution to Turkey’s problems: the adoption of tighter macroeconomic policies in the short term to contain demand, and structural reforms in the medium term to raise potential output. But this is politically costly. In the current highly charged political context — several major pending elections, numerous regional headaches (wars in Syria, Iraq, and Gaza), and a potentially historic grand bargain on the Kurdish problem — economic reform is a distraction that could cost the government crucial votes. Growth, too, will have to be around 4-5 percent in order to hold the unemployment rate down to its already high levels of around 9 percent. Needless to say, this is the priority for Erdogan and the AKP.

So reforms are unlikely to gain momentum any time soon. We will have to watch instead where president-to-be Erdogan will take us. Unlike previous leaders, he does, at least, think big: Just consider his infrastructure mega-projects, including a third bridge and a third airport for Istanbul and digging a canal parallel to the Bosphorus.

Unfortunately, the economics of Erdogan’s vision does not quite add up. At the risk of oversimplification, it rests on two pillars: ultra-low interest rates and centralized, often capricious decision-making. The fixation with ultra-low interest rates is very risky when, as in the case of Turkey, economic growth depends on a continuous inflow of funds from abroad. Moreover, attempts to push interest rates far below inflation — based on the distinctly unorthodox argument that high interest rates are the cause of high inflation, not its result — are sure to amplify the macro imbalances, and will ultimately backfire badly.

Centralizing decision-making may sound benign, and perhaps even desirable in a country that has a long history of ineffective coalitions. But this approach, too, has huge risks. In the hands of an extremely powerful and popular leader, centralization is more likely to lead to weaker institutions and a drift away from a rules-based policy environment. Evidence for the latter has already been piling up. Even leaving aside broader questions about the future of Turkish democracy, recent developments such as the politicized use of tax inspections, verbal attacks on the Central Bank, and attempts to curtail the powers of Turkey’s Court of Audits add up to a full-blown crisis of institutions.

Despite the achievements of the last decade, the economy now seems to be on an unsustainable course. Most sober observers consider Turkey to be one of the emerging markets most vulnerable to change in the global environment. For the moment, the complacency of short-term investors is buying time. Since Erdogan and the AKP were the architects of Turkey’s success so far, investors are unlikely to jump ship just because the party seems insufficiently committed to orthodox reform or because the president’s autocratic behavior poses a potential threat to future growth. And the global environment — monetary policy in the United States, in particular — is still very accommodative, and likely to remain so in the near term. So long as that is the case, short-term investors are likely to continue indulging in “Turkey risk.”

But this won’t work forever. A new, supply-side-focused game plan is needed if investor interest in Turkey and the popularity of Erdogan and the AKP are to be sustained. To some extent Erdogan is now the victim of his own success. Under his rule, the average Turk has acquired access to credit cards, modern infrastructure, health care, and housing. With that access comes a sense of entitlement — and the expectation that these improvements will continue. Half of the Turkish population is younger than 30, and Erdogan’s popularity may gradually erode if growth does not provide the incomes and jobs this generation now takes for granted. Moreover, stalling growth and international wariness about Erdogan’s political direction mean that Turkey may have trouble finding the financing it needs. As it is, most financing is of a short-term nature, while foreign direct investment flows have slowed substantially.

Where, then, do we go from here? First, the good news: The main risk facing the Turkish economy at the moment is probably not a full-blown financial crisis. Balance sheets in the public and banking sectors are relatively strong; any excesses (in construction, for example) are relatively manageable for now. Yet there is a real danger that the economy could continue to stagnate, returning to the boom-bust cycles that plagued Turkey in the 1990s.

There is also little doubt that the next decade is shaping up to be far more difficult and volatile than the last — unless there is a return to the sound principles that served Turkey so well in the first decade of this century: building institutions, improving skills, and opening up the public sphere for debate on the way forward. These were the policies on which the AKP focused in its earlier years. Hubris should not trap its leaders into thinking they can dispense with them now.