Turkey’s economic potential is obvious. Sitting at the crossroads of Europe and Asia, this secular, predominantly Muslim democracy could hardly be more strategically located. With its blend of Western and Eastern cultures and fast-growing 74m-strong population, many of them young and well-educated, Turkey should be among the world’s most attractive emerging markets.
And so it has seemed. The Turkish economy has tripled in size since the early 2000s, riding an almighty wave of consumption and construction. Foreign direct investment has poured in. This ancient country, with its ubiquitous monuments and minarets, now has a multitude of skyscrapers, shopping malls and infrastructure mega-projects. These include the $11bn Istanbul-Izmir motorway, a high-speed Ankara-Istanbul rail-link and a plausible bid to build the world’s largest airport, handling 150m passengers a year.
More recently, though, economic storm clouds have gathered. Turkey’s audacity and ambition have begun to look like hubris. Debt levels are soaring and the Turkish lira looks precarious. Trade remains heavily dependent on a still sluggish Eurozone. Unrest in Syria and Iraq, just across the southern border, has also discouraged investment. Long-held suspicions the Turkish economy is a bubble have lately come to the fore.
Political risk also looms large. In May 2013, demonstrations against the closure of central Istanbul’s iconic Gezi Park provoked a notoriously heavy-handed police crackdown. That unleashed a slew of public unrest, as millions of protesters across the country expressed outrage about civil rights, inequality and corruption.
Gezi Park and its aftermath convulsed Turkey, further polarizing society. And earlier this summer, as demonstrators marked the one-year anniversary of the initial protests, tens of thousands of police were scrambled and tear gas once again deployed in downtown Istanbul.
Against this background, economic growth is important not just in terms of national prosperity but as the best way of containing social unrest. Having expanded by 9% a year during the post-Lehman bounce-back, Turkish GDP grew by just 2.2% in 2012 and 4.3% the year after. The International Monetary Fund estimates a 2.3% rise in 2014, followed by 3.1% next year. Buoyant by Western standards, such numbers don’t pass muster in an increasingly populous emerging market at a time of barely-contained political violence.
Low growth is being compounded by stubbornly high inflation – 7.4% in 2013 and an estimated 8% this year. Turkey meanwhile ran a current account deficit equal to no less than 7.9% of GDP in 2013. While expected to narrow slightly this year, the large and on-going excess of imports over exports piles downward pressure on the currency, stoking inflation even more.
Turkey’s GDP per head is $11,000, just behind Poland and about the same as Argentina and Brazil. The country boasts an array of modern firms producing goods and services for a growing middle class – at the heart of the investment case. The domestic pharmaceutical market, for instance, has grown from $3bn to $13bn during the decade to 2012. That’s led to a wave of sticky investment from leading global pharmaceutical companies from Switzerland, Germany, Japan and the US. Befitting its location, Turkey also attracts considerable attracts investment from Russia and the Gulf.
What really overshadows the Turkish economy at the moment, though, is what overshadows the prospects of many other middle-income countries – the next move of the large Western central banks, particularly the Federal Reserve. A torrent of “hot money” has poured into emerging markets in recent years, caused by ultra-low Western interest rates and “quantitative easing”. This has generated dangerous credit bubbles in high-yielding destinations like Turkey.
When American QE began in November 2008, it was billed as a $600bn program. Since then, the Fed’s virtual printing presses have generated almost $4,000bn of “funny money”, quadrupling the US central bank’s balance sheet. The Bank of England has similarly increased its balance sheet four-fold. The Bank of Japan is catching up fast, as it the European Central Bank, despite keeping Euro-QE covert, burying expansionary monetary operations under a mound of technicalities to placate the German public.
Over the last five years, much of this cheap Western money has found its way into emerging markets such as Turkey, as Western institutional investors, stymied by paltry returns on domestic bonds, have conducted a desperate “search for yield”. This investment influx has pumped up asset prices in “alternative” investment destinations while pressing-down on local borrowing costs, sparking a credit explosion. While many emerging markets have gorged themselves, Turkey has indulged more than most.
In the spring of 2013, global markets took serious umbrage at the Fed’s initial attempts to slow down QE. Several emerging markets – particularly those with large trade deficits, high inflation, slowing growth and dependence on foreign inflows – were vulnerable, their equity and bond markets tumbling. A handful were singled-out by Western analysts for their combination of weakness and relatively large size, pointing to possible systemic importance. Those “fragile five” were India, Indonesia, Brazil, South Africa and Turkey.
The emerging markets bond bubble was expressed in Turkey first and foremost in a corporate borrowing spree. Loans to Turkey’s private sector have more than quadrupled since QE began, with corporates owing some $41bn in short-term and $157bn in long-term debt by March 2014. As much as 90% of these liabilities – amounting to 22% of GDP – are denominated in foreign currency, according to Moody’s, leaving debtors at the mercy of the Turkish currency market. Add in government debts held overseas and foreign-denominated liabilities total an eye-watering 45% of national income.
After the “taper tantrum”, the lira suffered badly. It fell 25% against the dollar between the spring of 2013 and January 2014 and 27% against the euro – a plunge arrested only by a sharp interest rate hike. Since then, the currency has partially recovered but remains down 18% and 19% against the dollar and euro respectively.
Turkey’s central bank – notionally independent since 2001 – has come under enormous pressure to return interest rates to their pre-January levels. Extremely vocal in his criticism, Prime Minister Recep Erdoğan has insisted on rate cuts despite high inflation, alarming global investors. After a decade in power, the authoritarian Erdoğan’s is popular with some voters but highly divisive.
Despite heavy criticism at home and abroad, his ruling Justice and Development Party (AKP) comfortably won local elections at the end of March – in part due to a weak and divided opposition. No one was surprised when, in early July, Erdoğan declared himself a candidate in Turkey’s first direct Presidential election, to be held in August.
While credited with overseeing a transformation of the Turkish economy, many financial analysts worry aloud that Erdoğan, by pressuring the central bank to slash rates amid obvious inflationary dangers, is attempting to defy the laws of economics. In mid-July, the central bank lowered its one-week repo rate half a percentage point to 8.25%. While this is the third consecutive reduction since May, the rate remains well above its 4.5% pre-January level.
Erdoğan looks likely to win on August 10, with the AKP prevailing in the 2015 general election. As such, much will depend on the composition of government. Many international investors hope for the continued influence of Deputy Prime Minister Ali Babacan and Finance Minister Mehmet Simsek, who have defended the central bank and reassured financial markets the government will pursue stable policies. Their presence in the next cabinet will be seen as a guarantor of what remains of the credibility of Turkey’s monetary policy.
I suspect that Erdoğan will ultimately keep Babacan and Simsek in government. To ditch them, or watch them walk away, would undermine his goal of Turkey becoming one of the world’s top ten economies by 2023, with GDP of £2,000bn, up from $820bn now.
This is a laudable aim and, no doubt, there is scope for substantial investment gains for those willing to stay the course. The total capitalization of the Turkish stock market is less than 50% of GDP, and with a much smaller free-float, compared to 100% or more in most developed countries. The potential upside is huge.
Yet Turkey faces considerable financial volatility as the Fed withdraws more QE over the coming months, not least as some 70% of Turkish equities are held by foreign investors. Many of them, when the going gets tough, will be quick to head for the exit, whatever the long-term investment case.
Liam Halligan is Editor-at-Large of Business New Europe.