Zero margin for mistakes

TURKEY IS THE world’s fastest-growing economy after China. In the first quarter of this year GDP grew by 8.1%. The central bank’s survey of business opinion and manufacturing data has indicated that the pace is continuing and that a figure close to the government target of 5% GNP growth for the full year is assured.

In addition, inflation is falling, unemployment is on the wane and exports are rising. The progress has been praised by the IMF and rewarded by Fitch Ratings, which nudged Turkey’s sovereign rating slightly upwards to B-. The Turkish parliament has passed a series of laws that brought Turkey very close to fulfiling the so-called Copenhagen criteria required to start membership negotiations with the EU. Relations with the US, which reached their nadir when Ankara refused American troops transit rights to enter northern Iraq, are improving. “All the things that should matter are moving in the right direction,” says Morgan Stanley researcher Serhan Cevik.

Is this as good as it gets or is the Turkish economy at last turning the corner?

First the good news. With the help of a strong lira and a sharp fall in food prices, inflation is continuing to plunge. For the first time in 16 years prices are falling rather than rising. In July the consumer price index fell for the second month in a row, dropping by 0.4%. The year-on-year inflation rate fell to 27.4% in July, from 29.8% in June. It appears at long last that inflation expectations and the government’s official inflation target – 20% in 2003 or almost half the 2002 rate – are converging.

“The inflation behaviour of the Turkish economy is going through a remarkable transformation,” says Cevik. “The downward trajectory in price indices is not just a temporary trend. Our investigations point to further acceleration in the disinflation process.”

In August, the executive board of the IMF expressed satisfaction with Turkey’s economic performance and released $476 million under the standby agreement. With this tranche Turkey has drawn $15 billion of the $18 billion arranged by the standby agreement in 2002 and is entering a period when repayment to the IMF will exceed funds to be received from it. To ease the burden, at Turkey’s request, the board agreed to lighten the debt repayment programme. According to this, in 2004/05 Turkey will repay the IMF $13 billion rather than $20 billion.

The IMF’s green light increased chances of receiving $5.8 billion in financial support from the US as compensation for Turkish losses sustained as a side-effect of the coalition invasion of Iraq. The government has pledged to use these funds in debt relief, which, analysts say, should ease further concerns about Turkey’s financing outlook over the next two years. However, Turkey may have to satisfy US demands that it should send troops to Iraq before it can unlock this bounty.

Reform efforts praised IMF chairman Horst Köhler says Turkey’s efforts deserve the “continu ed support” of the international community. “The government’s recent actions bode well for the success of the Fund-supported programme,” he says. “With strong output recovery and continued disinflation, the programme’s projections of 5% output growth and 20% inflation in 2003 are within reach.”

Köhler praised the government for making “strong efforts” to enact reforms and for putting in place measures “to maintain the primary surplus target of 6% of GNP”. These actions brought policies back on track to achieve the basic objectives of the IMF-supported programme, “namely, disinflation, debt reduction, and sustained economic growth,” he said.

Yet for all these favourable signs, the macroeconomic background offers a mixed picture.

The drop in inflation has been assisted by a sharply appreciating currency, which, according to some economists, was overvalued by 40% in July. This leads Lehman Brothers economist Tolga Ediz to conclude that the improvement in the economy is an “easing cycle” that is already over.

The central bank has acknowledged that there are two key risks on the inflation front for the second half of 2003. These are the possibility that the government might increase the prices of goods and services produced by the still huge public sector in order to close the fiscal gap and, second, a sharper-than-expected recovery in consumer demand. “We judge that both risks are likely to materialize,” says Ediz.

The single most important object of the economic programme – to reduce the debt to GNP ratio – has not yet been achieved. Like Brazil, Turkey’s problem is that it has a large and growing domestic debt stock that is highly sensitive to changes in interest and exchange rates. Both of these rates are susceptible to swings in market mood that are the hallmark of the Turkish economy. Despite a sharp improvement over the past year, the debt ratios remain heavy: the ratio of net debt to GNP is just under 80%.

The biggest problem on the debt front is that the markets have a deep mistrust of the government. This translates into a fat risk premium, which keeps interest rates high. In 2002 the real return on government bonds was 33%.

In November it will be a year since Tayyip Erdogan’s Justice and Development Party (AKP) won a landslide victory. Electors gave AKP 363 of the 550 seats and a clear five-year mandate. The three parties that ruled before the AKP landslide were eliminated from parliament.

Opinion polls show that support for AKP is increasing but this does not reflect performance. The government has failed to manage the economy efficiently and has certainly not shown the reformist zeal expected by the market. Authority to conduct economic policy is divided between five ministers, including the prime minister, none of whom seem to have the vision and know-how required to take Turkey out of its economic impasse.

“Erdogan has some managerial abilities but no vision, no dream for Turkey,” says an AKP member of parliament who does not want to be named.

The euphoria surrounding the November 2002 election quickly evaporated when it became clear that Erdogan did not have complete control over his party or cabinet. AKP is a conglomerate of many rightist factions embracing the whole spectrum from pro-west liberals to fanatical Islamist fundamentalists. This division became obvious when AKP deputies threw out a government proposal to allow US troops to use Turkish territory to open a front in northern Iraq. It showed that the dissent in AKP ranks could turn into factionalism and secession. Erdogan has to act carefully in order to prevent this. Municipal elections in April next year will be the first test of his popularity.

So far Erdogan, whose roots are in Islamic fundamentalism, has coped well with hostility from the secular establishment, which includes the powerful generals. He and the other ministers have gone to state receptions without their wives, who dress in the traditional Islamic way. Such attire in government places is unconstitutional. Erdogan announced that AKP is a centrist, not an Islamist, party.

Pushing for EU accession Erdogan seems to be dedicated to the idea of Turkey’s accession to the European Union and is doing all he can to gain a favourable report from the European Commission in October. In August parliament passed a highly controversial reform bill that curbed the authority of the generals and offered an amnesty to members of the outlawed Kurdistan Workers Party (PKK). Erdogan is hoping to convince the EU, which will have 25 members by the end of the year, that it is ready to begin negotiations on accession at the end of 2004.

The developments were welcomed by the EU but it is unlikely that Turkey will get a negotiation date from the EU leaders’ summit in December.

“Statements are one thing but what people say behind closed doors is different,” says a western diplomat. “Countries like France and Germany that are not very friendly to Turkey’s membership will need a lot of persuasion. Eventually Turkey will be taken in. But I don’t think we’ve got to that point yet.”

AKP frittered away its first months in office by trying to find ways of extricating itself from the IMF agreement signed by its predecessors in 1999. When he understood that this was not a practicable option, Erdogan bowed to the inevitable but his adherence to IMF targets has been reluctant and grudging.

Erdogan’s statement that Turkey intended to finish the current stand-by agreement with the IMF on December 2004, as scheduled, raises two questions. First, can Turkey afford to pay the IMF about $17 billion due in the next two years without a rescheduling? Second, would the government carry out any meaningful structural reforms and maintain fiscal discipline without IMF pressure? The answer is probably no in both cases.

Ali Babacan, the minister of state in charge of the treasury ministry who negotiates with the IMF, has made no secret of his desire to escape from the straitjacket. At about the same time that Köhler was praising Turkey, Babacan was telling reporters that nothing would make the AKP happier than paying off the IMF debt during its tenure in power and celebrating the occasion with the sort of festivities observed in Thailand.

Babacan (popularly known as “Babycan” because of his youthful looks) has made no secret of his plan to get rid of the IMF once the standby agreement runs out in 2004. Foreign holders of Turkish debt are uneasy at the prospect. “That day I got a hundred calls from investors,” says Botan Berker, the director of Fitch Ratings’ Istanbul office. “Everyone was worried. Yet [Babacan] went on to ask the Fund for a deferment of debt repayment, which in practice means that Turkey will remain under IMF mandate until 2007.”

This probably means that the Turkish government and the IMF will continue to work together even after the completion of the standby agreement at the end of 2004. “My best guess at this moment is that Turkey will adopt a staff-monitoring programme, which is a mild version of IMF-sponsored stabilization programmes and does not involve any new financing,” says Morgan Stanley’s Cevik.

The attitude of the market is sharply different to that of the government. Analysts say the IMF programme is necessary but insufficient and that Turkey must go beyond it if it is to overcome the crisis of confidence. But the government seems to be hardly aware that there is a confidence problem.

Its slowness in meeting IMF criteria – the last review was concluded two months behind schedule – cost the country hundreds of millions of dollars by unnecessarily keeping the government’s borrowing rates high (turning a simple headache into a migraine, is how one banker puts it).

The government’s nonchalance towards delaying IMF reviews shows that it is “naive” and “unsophisticated”, says Fitch’s Berker.

“The indicators are fine but we don’t know whether the government is really dedicated,” says Berker. “When I think of the mistakes they’ve made I find it hard to believe that they will not make fresh mistakes. They don’t seem to understand that their margin for mistakes is zero.”

Turkey’s debt situation is such that nothing short of flawless implementation of the IMF programme is feasible. Market sentiment is crucial as it adds to the debt servicing costs if it turns negative and creates rollover risk. Although yields on Treasury bills have fallen, at between 20% to 25% above the inflation target they still remain very high.

“It takes only a few days’ worth of policy mistakes, foot dragging or political instability to cause major damage. By contrast, the building of credibility takes much longer,” says Fitch Ratings’ director of sovereign ratings, Nick Eisinger.

Bear Stearns economist Tim Ash agrees that there is not much leeway for error. “Markets are either virtuous or vicious in Turkey,” he says. “Currently, we are in a virtuous cycle but this can easily change.”

It is likely to take a long time before the government is able to reduce the volatility of the domestic debt stock. Until that happens, there will always be doubts about the government’s financing plans.

“In short, expect volatility, political noise and policy mistakes,” says Eisinger.