Prime Minister Erdogan’s prophecy that the global crisis would “pass Turkey tangentially” was not quite accurate: Turkey suffered a 4.7 percent decline in GDP in 2009, compared to a decline of 2.4 percent in upper-middle-income developing countries. Nevertheless, the economy is expected to grow more than 6 percent this year, placing Turkey ahead of most countries. In the short term, the Euro area crisis, Turkey’s soaring current account deficit, and domestic politics pose the biggest risks. In the longer term, Turkey must address a low savings rate and weak education system if it hopes to catch up to the fastest-growing emerging markets.
The Pre-crisis Period and Short-Run Growth Prospects
When the global financial crisis came about, Turkey’s economy was in good shape: the banking system was robust and the government’s low debt-to-GDP ratio and small deficit provided ample room for fiscal stimulus. Much of this strength was due to IMF-sponsored reforms and a robust growth spell in the pre-crisis period.
Combined with the IMF strait-jacket, Turkey’s push to qualify as an EU candidate encouraged the country to undertake major reforms.
Following the slump triggered by the 2001 banking crisis—which cost Turkey about one quarter of GDP—the country substantially improved transparency in banking and public finances. Combined with the IMF strait-jacket, Turkey’s push to qualify as an EU candidate encouraged the country to undertake major reforms—not only in the economic sphere but also on the political and social front.
Fiscal discipline helped generate an annual average primary surplus (the budget balance excluding interest payments) of about 4 percent of GDP during 2003–2008. The public debt-to-GDP ratio came down from 98 percent in 2001 to below 40 percent in 2008, with a budget deficit of about 2 percent in the latter year. Fiscal discipline, together with responsible monetary policy, finally pushed inflation down to single digit.
For the first time, Turkey’s share of world FDI was representative of its economic size. Catalyzed by Turkey’s negotiations to join the EU, FDI inflows jumped from a historical annual average of about $1 billion to $10 billion in 2005 and $20 billion in 2006 (in crisis-ridden 2009, they fell to $8 billion).
However, by the time EU negotiations started in 2005, reform fatigue had set in. In addition, opposition to enlargement in the EU and populist French and German leaders discouraged Turkey’s bid. A cycle of elections, including a controversial presidential election and significant challenges to the ruling party added to the turmoil. The economy suffered. GDP growth, which had averaged 8.9 percent in 2004–2005, slowed to 5.8 percent in 2006–2007 (and 0.7 percent in 2008).
While it was a mistake not to have a deal with the IMF at the onset of the crisis, having weathered the storm without it became a plus.
Nonetheless, when the global crisis began, Turkey’s banks had a very high capital adequacy ratio (about 17 percent) and a very low non-performing loan (NPL) rate. Foreign exchange exposure had been strictly limited by the regulator and reduced public deficits decreased crowding-out, allowing a surge in credit to the private sector. The financial system and currency proved resilient through the crisis.
While exports fell considerably during the crisis, the 2009 contraction in GDP was largely due to falling domestic consumption and investment, and the current account deficit largely evaporated. Had Turkey not declined to continue its stand-by agreement with the IMF, confidence may have held up better and the recession may have been milder.
Turkey is emerging from the global financial crisis in relatively good shape. When the global recovery started, ratings agencies raised Turkey’s risk ratings two notches. The OECD forecasts more than 6 percent growth for 2010. Certainly, the low base effect is important, but both domestic and foreign confidence in the economy have also been restored. While it was a mistake not to have a deal with the IMF at the onset of the crisis, having weathered the storm without it became a plus. As for a strait-jacket this time around, Turkey prefers a “fiscal rule”—which Parliament will enact soon and envisages a 1 percent deficit in the medium term—to IMF-imposed discipline. This fiscal rule and robust growth forecast sets Turkey apart from most countries, and a strong Turkish lira and a relatively liquid market for it make Turkey attractive to investors.
Risks to the Short-Term Outlook
Euro area troubles have not negatively affected Turkey’s currency or interest rates and, to some extent, the Istanbul Stock Exchange has been exhibiting its own dynamics. But will this last? The Euro area crisis, Turkey’s soaring current account deficit, and domestic politics pose the biggest risks to Turkey in the short run.
The economy’s sensitivity to short-term domestic political developments has decreased.
Despite some success in market diversification, particularly to Africa, Asia, and Latin America, Turkey continues to rely on Europe as the destination for 45 percent of its exports. The Euro crisis will hinder exporters (whose inputs are often priced in dollars) via both slow growth and euro depreciation. The Euro crisis has already had some effects on Turkey. The capacity utilization recovery in manufacturing and retailer confidence had a setback in May. Slower growth expectations for the Euro area will likely lead the Central Bank to delay increasing its policy rate until the fourth quarter.
As the economy is picking up, the current account deficit is already soaring. It is (optimistically) predicted to reach 2.8 percent of GDP in 2010 and 3.3 percent of GDP in 2011, according to the Treasury. Under the benign scenario, Turkey will have major external financing requirements, which will increase its vulnerability. To what extent can this be covered by non-debt generating flows?
While the slowdown in structural reforms has pulled down the pace of growth since 2005, the economy’s sensitivity to short-term domestic political developments has decreased. Though the 1990s were a decade of shaky coalitions, Turkey has been ruled by a single party government since 2002. However, upcoming political change may hamper the recovery.
Barring a Supreme Court ruling, a divisive referendum on constitutional amendments is supposed to take place in September of this year. In addition, general elections are scheduled for next year, but with the Republican Peoples Party, the main opposition party, garnering 32 percent of the general vote in recent polls, speculation about an early election is inevitable. If Kemal Kilicdaroglu, popularly known as “Gandhi Kemal,” manages to position the Republican Party on the side of the underprivileged and the unemployed, he will certainly pose a challenge to Erdogan in the coming elections. That introduces uncertainty, including the possibility of a coalition government, to the political scene. But a confident and credible challenge secures systemic stability and may open the door to consensus for a badly needed new constitution—in place of what is currently the world’s longest constitution, and which has been patched up numerous times.
Long-Term Growth Challenges
Turkey has a long-term annual growth record of around 4 percent. Though quite impressive, this places Turkey in the lower band of successful emerging markets. Besides ensuring that the democratization process continues and consolidates the country’s political stability, Turkey must address two other long term challenges in order to reach a “tiger-like” economic performance.1
One is raising the overall savings rate, which has been 15–20 percent of GDP, compared to 30–35 percent in fast-growing emerging economies. The investment rate has consistently outpaced the savings rate by up to 6 percentage points, generating equivalent current account deficits—the country’s chronic vulnerability. The changing demography, in the form of less school age children, will improve the savings rate somewhat but institutional developments enabling and promoting private savings are also needed. The financial sector in Turkey is shallow even for an emerging market, with the bank deposit-to-GDP ratio at 48 percent and the credit-to-GDP ratio at 39 percent. The mortgage market and the private pension funds are starting from scratch.
Turkey has largely reached quantitative targets in schooling. On the other hand, the average quality of education is miserably low.
The other major long term constraint on growth is education. To improve labor force participation—currently about 50 percent overall and less than 25 percent for women, compared with 71 and 63 percent, respectively, in the EU—reform of and greater investment in the education system is needed. Turkey has largely reached quantitative targets in schooling, especially among boys; girls are lagging behind but catching up. On the other hand, the average quality of education is miserably low. The Program for International Student Assessment (PISA) places Turkey second-to-last among OECD countries. Turkey spends more than most OECD countries on education in terms of GDP share (7 percent versus the 5.2 percent OECD average), but the share of education in government expenditure lags behind. In a recent study, the World Bank argues that improving pre-school education with early childhood development programs would be the most efficient investment in Turkey’s future.
Refik Erzan is a professor of economics at Boğaziçi University in Istanbul, Turkey.