Economists are not remarkably good at understanding one-time structural changes. Analysing large, one-time structural changes just like the one the Turkish economy is experiencing in real time is not a simple mission. Therefore, we need to keep testing our long-term convictions against shorter-term challenges and also reassessing the effect of noise-driven fluctuations on long-term trends.
Some analysts see increasing risks in Turkey's economy and financial markets, quoting the political noise coming out of European capitals and focusing on external imbalances. Though we do not want to get into a lengthy discussion on the validity of these concerns, we should point out that fundamental variables do not point to a heightened vulnerability. Indeed, thanks to prudent policies and far-reaching institutional and structural reforms, the economy is much more resilient to exogenous' shocks, compared with the previous episodes of investor anxiety leading to a sudden liquidity crunch and a deep recession.
Contrary to the traditional argument that investors are always rational' and markets are efficient' at any given time, investors' psychological flaws may result in inefficiencies in financial markets which then trickle into macroeconomic developments. We have long highlighted such a risk of self-fulfilling catastrophic prophecy in Turkey. It is true that the availability of unprecedented global liquidity has eased the burden of adjustment in all emerging markets and that higher interest rates in the US will eventually normalise global asset allocations. However, we should not underestimate the power of macroeconomic normalisation and structural adjustment in Turkey.
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Indeed, the lira has come under sudden pressure eight times in the last four years. In our view, the country has not experienced a collapse simply because fiscal consolidation, monetary discipline and structural reforms have altogether strengthened the financial system and reduced the economy's vulnerability. For example, the financial strength index, an aggregate gauge compiled by the Central Bank of Turkey, increased from 94.3 at the end of 2000 to 110.5 in the second quarter of this year.
Of course, under the floating exchange rate regime, investors may face a greater risk of currency adjustment, but we need to bear in mind that the magnitude of a correction' in the exchange rate is a function of underlying economic variables. And we are confident that Turkey's credit quality will get better ratings and economic prospects will remain bright in the foreseeable future.
The European Council has already decided that Turkey met the requirements to start membership talks on October 3, 2005. Of course, this is still a binary event, albeit with a very low probability of negative outcome. Nevertheless, some analysts opt for following the noise' of European politicians who are obviously positioning for national elections.
Although Turkey may struggle with a variety of new challenges, compared with what previous accession candidates faced during their own negotiations, we still argue that investors would be better off by looking beyond political rhetoric. It does not get much attention these days but Europe needs a balanced, democratic and increasingly affluent Turkey, as much as Turkey needs the EU anchor'. Furthermore, losing the anchor' of membership negotiations, albeit a very significant shock to a country that has long associated it with modernisation, would not lead to a catastrophe, as long as the authorities and public at large remain committed to the underlying principles.
Turkey has been implementing a comprehensive economic stabilisation and structural adjustment programme in the past four years. Even though the building blocks are widely publicised, there are still misperceptions about how the policy framework works in practice.
Take, for example, the disinflation programme. The country's inflation rate, measured by the consumer price index, declined from an annual average of 77.5% to 7.6% last month. Especially considering the fact that oil prices keep increasing to new peaks, this is an incredible achievement for a country that was once moving towards hyperinflation.
Some believe this is just an illusion created by currency appreciation. However, the central bank does not use the exchange rate as an anchor' in its disinflation programme, and has in fact purchased US$27.6 billion in the last three years to shore up its reserves. In our view, the bottom line is that prudent policies and structural reforms have led to greater openness and competition that in turn dramatically altered the inflation process. And we see no reason for a reversal and indeed look for deflationary pressures in tradable goods.
Turkey's current account deficit has widened from 0.8% of GDP in 2002 to, on our estimates, 5.2% this year. We do not disagree that sustained external imbalances are a sign of problem. However, we should analyse the factors contributing to such a worsening' in the current account deficit.
First, given the country's industrial structure, output growth leads to higher import demand. The shift towards producing more sophisticated' manufacturing goods has strengthened this relationship between export-driven output expansion and import demand. Although the globalisation of supply chains the so-called China' factor intensifies the substitution process, foreign competition supports Turkey's evolution towards higher value-added production lines.
Second, the rise in oil and natural gas prices has led to a big increase in Turkey's import bill. Apart from developing a new energy strategy, there is very little the authorities can do on this front in the short run.
Third, the normalisation of macroeconomic landscape has increased firms' investment appetite and thereby led to a rise in capital imports. In our view, this is a healthy response to lower interest rates and improving access to the bank lending channel, and does not represent a threat to the country's international position.
Turkey's public sector has long been the leading contributor to the national savings problem because of its gigantic budget deficits a form of negative savings. However, even though the public sector still has negative savings, the budget deficit has fallen sharply in the last four years. And a lower budget deficit, coupled with the normalisation of private-sector savings behaviour after a period of increased consumption and investment spending driven by pent-up demand, will soon raise the national savings rate and thereby contribute to an improvement in external accounts.
Moreover, the wealth effect' created by the compression of interest rates will become smaller, as both the rate of change and the Treasury's marketable financing needs decline, and help to correct the widening in the current account deficit.
Turkey's privatisation revenues amounted to $8.2 billion in total, or $454 million per year, between 1986 and 2003. But, just like the rest of the policy landscape, we are now witnessing a dramatic turnaround in privatisation activity as well. Privatisation receipts, rising to $1.3 billion in 2004, will show a marked surge in 2005 and next year. A rough calculation would put the value of recent and forthcoming privatisation auctions to around $18-20 billion.
That said, getting $3 billion rent' for the Istanbul Airport or a valuation exceeding $13 billion for Turk Telekom, which will, by the way, lower the public-sector borrowing requirement, is just the part of the story. The real change is going to take place in the country's total factor productivity growth. Yes, foreign direct investment is not merely about financing the current account deficit, but, more importantly, matters for how domestic firms respond to new challenges and how the entire economy reshapes itself in a new world' of price stability and sustained growth.
By Serhan Cevik, Morgan Stanley economist, as published on the Global Economic Foru
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