In search of the next big event

In search of the next big event

Never mind the soap opera aspects and quite unpredictable developments that characterized the past two months, what has been happening in Turkey lately is not too difficult to understand, but of course as it is always the case, only with the benefit of hindsight.

Around spring this year, we were all becoming convinced that Turkey’s latest IMF program could work at last. There were worries about the growth outlook internally and Iraq externally, but political stability, relatively speaking, was there to stay, or so we thought. The PM’s weak health was a risk, but it was old stuff and we had gotten so used to it that it had largely dropped from our “immediate risks to the outlook” list.

The political equation, at least from an economist’s perspective was quite simple: These guys would have to stay in the game, as an early election would be a political suicide, given their meager standing in the polls and the dubious growth prospects. Waiting and hoping to reap the benefits of recovery and the IMF program in general would appear to be their best bet, under the circumstances. Admittedly, this was a fragile equilibrium, but Turkey is a fragile country, and this was after all a coalition that managed to build a track record of legislating over 20 key reforms against all odds. In sum, despite the risks, the outlook was pretty OK back in April.

Alas, it never gets that easy in Turkey, the volatility king of all emerging markets! From early May onward, the PM’s weak health combined with some ill-conceived debate on EU accession started to demolish hopes that we could finally see a government in Turkey finishing its full term. Markets were patient for a while, hoping the transition within the PM’s party (DSP) or defining a post-Ecevit world could be relatively smooth, but after seeing the senior coalition partner MHP determined to spoil Turkey’s EU bid and the PM showing no intention to leave, despite a visible deterioration in his health, it did not take too long before they started to roil: rates rose by over 20 percentage points in a matter of weeks, while the Lira depreciated by over 20%.

The trouble is that, this business of markets and confidence is a bit like the toothpaste and the package, once out, it is almost impossible to get it back in. And it is no wonder we are up again for a really rough ride. To understand what is going on, it is useful to think of Turkey’s experience in the past few years as jumping between a “good” equilibrium with low interest rates and a “bad” one with high/unsustainable rates, while struggling to manage a heavy public debt burden. True, economic and political fundamentals change over time, and in fact, there has been a secular improvement over the past year, but these are often dwarfed by sharp swings in sentiment.

As you will recall, back in late 1999, an IMF disinflation program with an exchange rate anchor altered the sentiment dramatically and stabilized an otherwise unsustainable debt dynamic. In less than a year, through a combination of bad design, bad policy, and bad luck, the program collapsed, tipping the system off to a bad equilibrium. The strengthened IMF program, administered by Minister Dervis, a new and credible face, calmed the waters somewhat, but interest rates never declined to sustainable levels while a clash around Turkish Telecom in July, which almost sent Dervis back to DC, aggravated things even further.

As the country was heading toward the wall, ironically in spite of broadly sticking to the IMF recipe, it took a massive shift in the geopolitical landscape in the aftermath of September 11 to change its fortunes once again. Geopolitics combined with a decent IMF report card prompted the IMF and the US Treasury to throw another $10 billion to Turkey’s rescue. It worked for a while, until the events took over yet again.

As I was sending this note out, the markets had relatively calmed down, thanks to rekindled hopes on EU and an embryonic new political formulation with Dervis as a key player, as well as reflecting the fact that rates are already up by 20 percentage points compared to their pre-crisis levels. Nevertheless, with rates still over 70% against 12-month ahead inflation expectations of 30%, it is quite clear that Turkey’s debt equation does not add up.

The main trouble on the debt front is that for a country whose currency is very weak, whose capital markets are shallow, and that has no real “anchor” (such as that of joining a powerful economic block some day) Turkey’s debt is way too high. In net terms, public debt stood at over 90% of GNP at end-2001, about two thirds of which was domestic. Not all of this domestic debt is to the “market”. That is, a good chunk of it is buried in the public sector’s own balance sheet in one form or another, but about 40% is nevertheless held in private portfolios (largely by public at large and private banks) and is of short maturity.

What has Turkey’s strategy been about this? In fact, it has been a pretty ambitious and orthodox one in nature. It counts on a strong fiscal adjustment characterized by non-interest surpluses backed by structural reforms, resumption of growth, a diversification of the investor base (read “deeper capital markets”), and most importantly, lower real interest rates, presumably resulting from a dogged implementation of the IMF program and its heavy structural conditionality. This sounds analytically appealing but the problem is often the timing. The authorities sort of try, but then some shock, often big enough, always derails this cozy scenario before we see the light.

Analytically, there are two immediate challenges as regards the debt dynamics. One is that it has to come down as a percent of national income, and the other is that the market should be willing to absorb more and more of it at reasonable interest rates. Very roughly speaking in economist jargon, the first one is called debt sustainability (or solvency problem of the government), and the latter, the rollover/liquidity risk. The problem is that they both get into difficulty very easily as soon as confidence flips, and leave little room for policy to influence the final outcome.

These days, the top officials, including Minister Dervis and the IMF guys like to emphasize that we are less vulnerable because Turkey is stronger institutionally, thanks to, among others, a floating exchange rate, central bank independence and the new public debt management law. Perhaps, but this is a bit like hoping that a fire won’t start because the town has a huge water supply to put it out anyway. The trouble is that the link between the two is not there, i.e. markets (fire) do not see a tangible impact of these reforms (water) as yet. The bottom line for them is that there is no guarantee that the current policy stance will be kept, which is a fair concern, but the government keeps asking them to hold a larger amount of debt, at rates that recall Ponzi-schemes.

What to do then? There is really no easy answer. We need to hope for the next “big event”, and that is either a political resolution to the current chaos or the IMF/US throwing in more money, in one form or another. An accession negotiations date offered by EU in Copenhagen in December could be another one, but that is even less likely.

I heard some analysts suggesting sort of a “third way”: Turkey should pull a Russia on investors and solve this debt problem once and for all. Why pay all this debt, they argue, just look at Russia how it flourished only a few years later? This sounds sort of appealing at first glance, but is plain non-sense at all other levels. We have no intention nor space to go into a detailed Russia versus Turkey comparison, but whoever argues that default is one way out of Turkey’s quagmire, should at a minimum, control for the respective roles of the “Putin factor” and the windfall from oil prices in crafting Russia’s post-default recovery.

More arguments can be developed: when Russia defaulted there were many foreign investors that were effectively taxed whereas in Turkey, it will be directly the depositors who would suffer. The consequence of defaulting on one’s own citizens is more than just a bad “reputation effect”, it is years and years of distrust and economic anarchy. And last, but not least, one-off “stock” adjustments mean nothing unless the economic and political modus operandi (“flows”) is fundamentally altered.

The only practical way out, which is sort of in our control, is a stable government. With an early election call already made, that depends on the nature of the coalition that will emerge. The good news is that we can afford to wait a few more months, as the risk of an imminent debt blow up is not too large as long as hope prevails. Markets are liquid, rollover requirement is not that huge, and interest rates are high but not yet high enough to offset fully the gains from the beginning of the year. The bad news is, we better see elections produce a stable government fairly quickly, that is sufficiently well equipped to operate in a fairly challenging international environment. Basically, this is a race against time, and time is ticking!

Murat Ucer is an economist and a EuroSource advisor to Turkey

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