Sunday, February 18, 2007

Comments on Turkish Economy

in response to Pratik's posts on Turkey:
India, Turkey and Arrow's Impossibility Theorem
Turkey's Silver Lining - An Outsider's Account of the 2001 Financial Crisis

Hey Pratik!
Thanks for your interest in my country :) It seems to me that you got the facts right, but the dots need a little more connecting. I will paint a slightly gloomier picture of the Turkish political economy today (and hence Dervis' influence.) Feel free to correct my economics wherever I go wrong!

Among all the emerging markets, Turkey still remains one of the most susceptible to global and domestic shocks, because it still finances its large current account deficit with short-term capital inflows. First a little history to explain the roots of the problem.

In the 1980's, Turgut Özal liberalized the Turkish economy by replacing import substitution with export promotion, opening the capital account and encouraging foreign investment in the country. The problem was that the social safety nets for losers from the reform were not in place on time. Instead, to avoid losing their votes, weak coalition governments kept making discretionary payments to losers, while subsidizing the exporters heavily, and this in turn led to high public debt and high interest rates. Banks preferred lending to the government instead of the private sector, and this reduced the competitiveness of the economy as a whole.

In the run-up to the crisis in 2000-2001, the Lira was overvalued: Its rate of depreciation was not able to match the inflation rate. This led to a large current account deficit financed by short-term capital inflows. There was a currency-board that pegged lira to the dollar. The sterilization of the inflows resulted in a bigger monetary base and lower real interest rates, and the banks which held treasury bills became extremely vulnerable. Sensing a crisis was looming, investors took out a large chunk of their short-term investments in 2000, but IMF came to the rescue. After the argument between the President and the PM in 2001, however, a second flight rendered the floating of the Lira and a large devaluation unavoidable.

Now the Turkish lira is again perceived to be overvalued, and the large current account deficit is again financed by hot money. The difference from 2001 is that the banking system is more robust (thanks to Kemal Dervis who established the independence of the Banking Regulatory Authority) and the Lira is floating. However, this does not mean that the economy is not vulnerable. The most recent fluctuation, which also hit Hungary, came last May, and the Central Bank had to raise the interest rates considerably to prevent a capital flight.

The deep-rooted political tensions between the nationalist-secularist establishment and the more liberal-minded (including EU proponents) are likely to stay (For more on this see The current government was not able to act decisively, but there is no real alternative. The social security system continues to run large deficits, and a recent reform proposal was reversed by the Constitutional Court. 2007 is feared to be a "lost year:" General elections will follow the controversial presidential elections. A crisis would especially hurt those who borrowed in foreign currency.

Meanwhile, another important criticism is that while FDI has increased, rather than starting businesses and creating new employment, foreigners prefer to acquire existing Turkish firms and banks.

I wanted to play the devil's advocate and paint a gloomy picture, but I know first-hand that all this does not prevent local entrepreneurs from making investments and creating employment. I hope the efforts of the private sector will improve our competitiveness despite the decades of bad public administration.

Thanks for the Sunday morning brain stimulation, but now gotta head over to the Chinese New Year parade!

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