Ignore politics at your own peril

One of the occupational hazards of being a professional economist is that our forecasts are sometimes wrong. Real world situations are usually very complex, non-linear and therefore difficult to predict. In order to simplify complicated real world problems, we make assumptions. Obviously, a change in the underlying assumptions can send a whole forecast in an opposite direction. This makes it easy to understand John Maynard Keynes, a great British economist, who is reported to have said “When the facts change, I change my mind.” In early February this year, I presented Merrill Lynch’s 2007 Year Ahead Report to local investors in İstanbul. The presentation, which included an overview of key global economic trends and investments themes, was also focused on Turkey’s political outlook because both presidential and parliamentary elections were scheduled for this year. With the usual caveats about the difficulties of making point forecasts, I painted a reasonably constructive scenario for both the global economy — strong growth and plenty of liquidity — and domestic Turkish politics — plenty of noise, but a benign outcome in both the presidential and parliamentary elections. Noting that the ruling party had a significant majority in the parliament, I argued that presidential elections would be smooth. I’ve also noted that opinion polls were suggesting that the governing Justice and Development Party (AK Party) would most likely win a second term either as a single-party government or be the lead coalition member. Our base case scenario for Turkish politics was implicitly based on a working assumption that Turkey, as an EU accession candidate, had implemented political reforms, enhancing its democracy. Global backdrop has so far remained supportive of emerging markets in general and Turkey in particular. Despite the economic slowdown in the US, global growth is still strong and liquidity is ample. However, I got it wrong on domestic politics. Turkey’s presidential elections were far from being smooth. Why? Well, I simply failed to anticipate the extent of the opposition by Turkey’s secular and military establishment. Despite the compromise, the opposition parties have boycotted the presidential election, and appealed to the Constitutional Court for cancellation of the parliamentary ballot on the grounds that there was no two-third quorum. Only hours after the main opposition Republican People’s Party appealed to the Constitutional Court, the army stepped in with its own statement threatening the government with an intervention. The court ruled in favor of the opposition last week, effectively preventing the ruling AK Party from choosing Mr. Gül as the president. This was a highly controversial ruling because the Turkish constitution doesn’t have an explicit provision for a two-third quorum. In addition, such a quorum was not sought in the previous presidential elections. The latest news is that Gül has withdrawn his candidacy. While the political turmoil has unsettled investors, the market reaction has been relatively modest. Turkish equities fell 7.3 percent in dollar terms, YTL weakened 1.1 percent, while the sovereign debt spreads widened by 10 base points. Despite last week’s losses, Turkey is one of the best performing emerging markets year-to-date. The stock market is up 20.4 percent, YTL is nearly 5 percent stronger against the dollar, and the Turkish external debt has generated year-to-date total return of 3.4 percent, slightly outperforming ML IGOV index. The market’s unemotional response to political crisis doesn’t seem to be unique to Turkey. Other emerging markets such as Israel, Ukraine, and Thailand have recently weathered political turmoil reasonably well. Have investors become complacent about political risk in Turkey and around the world or are they simply demanding less compensation for holding risky assets because of improvements in the underlying macroeconomic fundamentals? We think it is a bit of both. Yes, there have been significant improvements in emerging markets macro fundamentals, making them more resilient to both internal and external shocks. For example, EM foreign currency reserves now amount to more than 70 percent of their external debt. More importantly, the global backdrop remains supportive of risk taking. The pace of global growth remains strong and inflationary pressures appear moderate. World economic growth in 2007 is expected to be around 5 percent for the third year in a row, making it the best growth cycle in three decades. Similarly, there is still ample liquidity. The year-on-year growth in the global dollar liquidity remains above 10 percent. However, past experience shows that sustained financial market upswings can also make investors complacent. Even though there have been significant interruptions in the current global bull market, the market corrections since October 2002 have been short-lived. Investors, who tend to have short memories, seem to be treating every market correction as a buying opportunity. Looking at Turkey specific factors, investors seem to think that the constitutional court decision, which paves the way for elections, will help defuse political tensions between the government and the establishment. Markets also seem to think that the ruling AK Party will do well in early elections. In short, the court ruling is a significant development. Early parliamentary elections, scheduled for July 22nd, should provide some clarity on politics. With the governing AK Party pushing for the president to be elected directly by the Turkish people, despite the wishes of the establishment, there appears to be more questions than answers about presidential elections. It is also worth noting that sometimes political shocks take time to work their way through the system. Investors should ask themselves, ‘Do these events fundamentally change the economic landscape?’ In other words, will the parliamentary elections generate a strong, stable and reformist government? * Chief Emerging EMEA Economist & Strategist, Merrill Lynch

09.05.2007

Whose success? Mr. Derviş or Mr. Unakıtan?

Turkey has implemented over 19 International Monetary Fund (IMF)-based major and minor stabilization programs to-date. As is well known, a standard IMF program aims to improve the balance of payment accounts, improve efficiency in public sector debt management and reform the whole system towards a functioning market economy, including major privatization, and liberalization of the trade and financial accounts. In order to achieve these general goals, the IMF provides long-term credits with appropriate rates as compared to the domestic situation of the borrower country. Since 2003 the latest IMF program has been implemented by a new and single-party government. Current data to hand in terms of major macroeconomic indicators such as growth performance, per capita GDP, trends in CPI, budget deficit and public debt make obvious the success of the current government. There are some arguments, however, insinuating that any successes of the program go back to Mr. Kemal Derviş, as he finalized the architecture of the IMF program during his ministerial term, and arguing that this government simply implemented the program. I interpret this argument as a caricature of reality for many reasons. First of all it can not be argued that current program is a “home made” one in which national priorities were imposed during Mr. Derviş’s term This is one of the well known aspects of IMF programs, harshly criticized by many famous anti-IMF economists, Nobel Prize winner Joseph Stiglitz being the most recent. The IMF programs are standard packages, including well known conventional “belt tightening” measures, tough medicine for the society. In other words the programs are one-sided and simply imposed. It is up to you as a borrower country to succeed under the “given” conditionality. Therefore at least a significant part of the success must be explained by the quality of implementation. In that regard success of the current program definitely belongs to the current government. As a matter of fact, legitimacy of the stabilization programs is a critical yardstick for the success of the program. This legitimacy has been achieved and even maximized by the current government. What is obvious is that in order to substitute the legitimacy of the program, whose creators became political castoffs in the last election of 2002, the strong support of society must be harvested by party programs. Now we are passing through a year of double elections. Normally we should not expect any government to preserve fiscal discipline during election distress. However the Justice and Development Party (AK Party) government continues keeping budget discipline without electoral concerns. Finance Minister Kemal Unakıtan released the breakdown of Turkey’s budget for the first five months of the year. Taking the figures for the whole of the first five months, Unakıtan said the budget deficit had declined to YTL 3.34 billion. On the other hand the primary surplus from January through the end of May stood at YTL 20.32 billion. As it is known, the primary surplus excludes interest payments on debt load and is a good indicator of state finances. Budgetary performance is just one example of how and why this government should be seen as the champion of the last IMF-based stabilization program.

14.06.2007

Truths and lies about Turkey’s economy

Never mind those wearing the blinkers of ideology, I am stunned to see valued academics, whose words I respect, commenting on Turkey’s economy in an unfair fashion, distorting its basic figures.
A few days ago I listened to Professor Gülten Kazgan, a renowned name from the left of the political spectrum, give a speech at a meeting. Although a veteran commentator her mind remains extremely vigorous, and she still follows the daily developments of the economy.

She drew such a pessimistic picture of the economy that, listening to her, some might say, “It is a must that we land in Samsun again (the starting point of the Independence War) and reorganize the National Forces.” But my occupation is also economics and I will state here the question that I asked to her as one economist to another.

It is 2002 and you are the prime minister. Let’s assume that you were asked to lower the budget deficit to 1 percent of gross national product (GNP), reduce the inflation rate to single-digit levels and drop the net debt stock to 45 percent of GNP. While doing all this, you will attain an annual growth rate of 7 percent. Furthermore the unemployment rate will decline from 12 percent to 9.8 percent. At the same time you will contain the current account deficit to around 2 percent of GNP and real interest rates to between 4 and 5 percent. You will also curb the inflow of hot money. How would you do that? I have asked this very same question to many “huge” academics on various occasions. And there is no answer of course. Is this a “we only criticize without offering constructive suggestions” approach?

Now I am addressing another question to my readers. Look at Table-1. If you were presented with these data in 2001 and asked whether you would accept and make good a country with such glorious figures by 2006, would you say, “No thanks, not for me”? We wouldn’t even believe such a transformation was possible outside of our dreams.

Now here is the issue: Turkey followed the best option presented to it after the 2001 financial crisis. You have to choose from what you have to hand that is applicable and in compliance with the existing conditions you are in and the realities you face, not your dreams or wishes. In my opinion, including the path that Kemal Derviş chose, Turkey had no other rational option. Besides, with respect to the quality of application, the model adopted since 2002 has given extraordinarily good results.

Table-1 is very important since all the current debates are going on over these data, which were officially released by the authorized institutions of the state, like the Turkish Statistics Institute (Turkstat), the Treasury, the Central Bank of Turkey, etc. But those who reject these figures have no healthier data collection and analysis institutions.

Three major crises struck between 1994 and 2001, all of which hit the economy with more than 7 percent declines, and they caused the country to “lose” the 1990s. But now it has been growing uninterruptedly since the first quarter of 2002. This growth depends neither on the “fields” of state enterprises, nor on “consumptions explosions,” nor on public deficits. This growth, on the contrary, stems from exports, private sector investments and increases in productivity. What was the total factor productivity (TFP) between 1990 and 2000 — the lost decade — and where has it climbed to now? The TFP is the most important productivity and long-term prosperity indicator. The average TFP during the lost decade was 3.3 percent. What does this mean? Only 3.3 of everything produced was the result of productivity (that is, the amount of output created per unit input used). Some 23.5 percent was the result of labor and 73.2 percent resulted from capital increases. The TFP, on the other hand, has risen to 42 percent now and it is heading toward a position between 70 and 80 percent.

It is true that the apparent growth of Turkey’s real GNP is greater than its real grown as a consequence of the currency effect, that is to say, due to the depreciated dollar against the YTL. But did the Turks have the chance to say in 2001, “We are not playing any more. If the dollar hadn’t risen so high, things would be better” as the country entered into a desperate darkness as the dollar hit a peak? We are now at ease in paying our external debts thanks to the decline in the dollar’s price, just as we suffered when the dollar was “overvalued.” Even rental contracts were being arranged in dollars or euros. We got tired of encountering foreign currency, rather than our own money, everywhere. It was not unusual to see landlords and tenants quarrelling over this issue. About 70 percent of the deposits in banking were in foreign currencies and only 30 percent were in Turkish lira. Now the figures are exactly the reverse. We have witnessed days in which our own money is in circulation. What is so bad about it?

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Debt stock shrinks to 45% of national income

Let’s talk a little about debts. The increase of public debts in dollars has been taken under control, as seen in Table-3 and Table-4. Debts in YTL are still increasing, but at a significantly diminishing rate. The trend definitely indicates that the increase will eventually become a concrete decline. But some deliberately evaluate debt figures incorrectly. If you have a company, or at least a family budget, do you only look at the money you borrowed or do you evaluate what you did with that money and the changes in the costs of your borrowing? When you ask what has been done with borrowed money, then we come face top face with the GNP. The GNP means the sum of all produced goods and services in the country within a year. So we have to look at the balance of debt stock to GNP. Indicators other than this are wrong. It is obvious in Table-1 that this figure declined to 45 percent from 97 percent. This is well below even international standards. The budget deficit has also fallen further below international standards, in a very short time and under hard circumstances.

While this is the case in public debts, the most-debated issue is external debts. Turkey’s external debts have remained constant for years — they were stable at around $65 billion in terms of the dollar. Incidentally, debt to the International Monetary Fund (IMF), which was $24 billion just five years ago, has also been paid and reduced to $8 to $9 billion. Gentlemen, you can only get rid of the IMF by paying your debts, not by running up huge flags on every rock you find. The real nationalism means steering the country well and rescuing it from its debts.

While the public external debts do not increase, the private sector’s debts are growing. Private sector external debts are around $122 billion, $40 billion with short-term maturity. Banks and companies share this debt fifty-fifty up and down. This is a risk factor. However, in a market economy, companies cover their risks. There is nothing to do. The important point is they are not secured by the government. So this is the matter of borrower and lender companies. But the existence of stability and confidence is very important for both sides.

Another attractive point in external debt figures is the change in the increase of external debt stock. Turkey’s external borrowing rate is significantly declining. The increase rate of external debt was 15 percent in 2002 and has now declined to 5 percent. As the necessity to borrow declines, domestic resources step in, maturities lengthen and costs decrease, investors will turn to domestic markets. But it is still early for this.

Maybe the most critical point is that there is a false mentality of “borrow nothing, do nothing” in some circles. This is a “poor but happy nation” trick of leftist bureaucracy. Turkey is a relatively poor country that has a huge and young population and its citizens’ expectations are high in the globalization era. That’s why we have to grow more and invest more. Our national savings are not enough to make these investments right now, so we have to borrow from international markets and grow with debts. You can see the borrowing tendencies of Japanese, German and American companies. As you see the financial leverage rates — debts over equity ratio — of the companies are fairly high. In Japan and Germany in particular growth is totally based on debts. However they had borrowed from domestic markets not external markets. Of course you borrow from domestic markets if there are enough resources and they have lower costs. But why not borrow from abroad if it is more economical? Large companies, which fold their profits, also borrow. While these companies are proud of their profits, some miserable ideologues are mourning them, aiming to confuse people and show the government as responsible for this failure. Indeed there is no problem, but there is success. We have to thank the players that provide this environment.

The financial leverage of Turkish companies may be higher and they may borrow more. But they are prudent. Moreover the profitability of Turkish companies has tended to increase in recent years.

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Current account deficit falls as competitiveness rises

Many assert that the reason for the appreciation in the value of our currency is tied to high real interest payments. They say the current account deficit soars because our money is too valuable. Let’s take these claims one by one. They say Turkey had a current account surplus in 2001, but now it has a deficit. If there are people who would like to live in that country with its current account surplus, good luck to them. Whenever the Turkish economy enters a crisis period, this means that all production and imports will be halted. This is where the surplus stems from. However, at the same time, it is why unemployment hits all-time highs. Turkey with a current account surplus had 12 percent unemployment, and this was the official figure. It is quite shameful to see an academic expressing a longing for the year 2001.

Secondly, even the average kid on the street knows why Turkey has a current account deficit. Has Turkey been able to establish its production economy? Was the process that has been going on since 2001 a period of establishing an economy of production, or was it about saving the financial system of a state in economic trouble and decreasing an inflation rate of about 60 percent, pulling down interest rates which had hit 96 percent. Does it make sense to speak of a second phase before having established the basics? Did we have no problems in prioritizing and sorting in the economy? What is the meaning of “limited resources”?

So a valuable currency causes a current account deficit, but a depreciated currency (remember Turkey’s continuous devaluations in the past) closes the gap? No, if it did we wouldn’t have been struggling with difficulties in the balance of payment since the ‘90s; and we would not be speaking about current account, competition and added-value issues. Turkey’s dependency on imports is not a problem of today. It is a historically present problem.

The current account deficit will reduce not when the value of the Turkish currency goes down, but when Turkey finds new markets, masters competition, learns how to establish national brands and internalizes the concept of cutting costs.

Earlier I wrote about productivity increase. Everyone can see the long distance we’ve gone in finding new markets. Turkey is experiencing a boom in its foreign markets, thanks in part to a Foreign Trade Undersecretariat led by the vision of State Minister for Foreign Trade Kürşad Tüzmen together with the perseverance of Rifat Hisarcıklıoğlu, head of the Turkish Union of Chambers and Commodities Exchanges (TOBB), in encouraging leading civil society organizations such as the Turkish Exporters’ Assembly (TİM), Turkish Confederation of Businessmen and Industrialists (TUSKON) and the Independent Industrialists and Businessmen’s Association (MÜSİAD). And the result is there. The rate of increase in exports has surpassed that of imports since November of last year. And the current account deficit has clearly shown a downward tendency. Look at the figures. I wonder if other countries have intellectuals who hate the happiness of their own country.

Another misconception relates to interest rates. Look at Table-1 to see where the nominal rate once stood, and where it is now. In 2001 it stood at 96 percent and it is now 17.5 percent. You can see the real interest rate in Table-2. During the crisis Turkey paid exactly 34 percent in real interest payments. According to recent Treasury data, since 2005 this figure has been around 8 percent. As of April this year it was 7.4 percent on average. This will fall further when the figures for July are announced.

True, Turkey still pays too much for interest in comparison with similar countries. However, they don’t have the same ruinous starting point as Turkey had. One would have to be blind in order not to see the amazing improvements we have made. When the interest rates fall to international standards, the inflation rate gets fixed around 4 percent, when the debt stock falls below 30 percent of GNP, the interest payments Turkey has to make will fall. If Turkey can keep up the current stability for another five years this could well prove possible.

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Turkey should value its success, not hide it

Since I have already run short of space allocated for this page, let me add a few brief words on other various issues:

1-The amount of land sold to foreigners during this government’s term is not that high. It is equal to land sold in previous government terms. Those who say the whole country is being sold off must prove this assertion with evidence. The Land Registry Administration announces figures each year, and the prime minister has said in the past that no land was sold in the Southeastern Anatolia Project (GAP), an integrated, multi-sector development initiative, or in the Harran region. Those claiming otherwise are short on evidence.

2-Companies are not being closed in large numbers. The rate of established and liquidated companies in the first half of 2007 is 3 percent. The economy is in a transforming period, and this rate is normal when sectors’ structures are taken into consideration.

3-It is said there are an increasing number of notices for unpaid bills being issued. This is normal in a growing economy. Again, we have to make ratio analyses. The rate of nonpayment in banking figures is extremely low. If this is not the case why are they trying to give out loans with enthusiasm?

In summary, Turkey is recovering from a really bad situation. We must not conceal our success; instead we should appreciate it. We have to work more, protect and support stability and come up with new ideas.

Great transformation of Turkish industry: A profitability analysis

The Turkish economy has been passing through a process of great transformation. This overwhelming challenge started after 1996 with Turkey’s membership in the European customs union and was further intensified with deep structural reforms triggered by the crisis of 2001.
Turkish firms are struggling with several factors to overcome this challenge and survive in a domestic and external economic environment where openness, integration and competition are the rules of the game. There are, of course, many factors to be adjusted in the new era. These are the drastic reduction in consumer price inflation (CPI), a quite unstable exchange rate and real interest rates. One can easily add many other factors to this list depending on the goal of the analysis. But there is certainly a single factor to decide whether we are headed in the right or wrong direction. At the end of the day we must look at the trends in profitability. As it is known, the İstanbul Chamber of Industry (İSO) has announced the figures from its traditional İSO Top 500 Industrial Enterprises survey since the early 1980s. This year the İSO explained its 2006 survey last week. Today I will analyze these results to decide whether the current transformation of the firms is healthy or not. But before attempting to do that, I will focus briefly on the trends of the 1990s. The reason is that, on the one hand, there is consensus among the people that the 1990s was a lost decade in every sense of the word. But on the other hand, it seems that there is regret over the high profits of the period amongst big businessmen.

We can easily observe this psychology in the 2006 ISO survey, as they repeatedly compare their profitability figures with the figures of the “lost decade.” Therefore, the first message is that they may still not understand the nature of the current transformation or the irrationality of the “golden days” of high profitability that dominated throughout the 1990s, as this decade was just a race to the bottom.

Let me briefly remind you of the nature of that race to the bottom. One of the factors requiring rapid adjustment today is the ongoing disinflation program itself. Turkey’s CPI was approximately 70 percent around 2001. High-level double-digit inflation persisted for more than two decades and therefore created its own culture.

The CPI was reduced to below 10 percent within just two years and has stayed in the single digits since 2004. Obviously this underlines a great success for the government and provides a fertile surrounding for companies in the longer term. However, it creates short-term adjustment problems for domestic companies as they operated under semi-closed and distorted market conditions for several years.

During the inflationary era, especially before the customs union with Europe, companies operated in a restrictive competitive environment and the quality of regulation was not market friendly in terms of transparency and accountability criteria. In this environment, companies established a special lender-borrower relationship with deficit financing and debt accumulating public sector.

As this wrong economic fundamental continued for many years, the relationships between big business, the public sector and the bureaucracy were converted into rigid “crony capitalism.” The companies seemed very happy in the “golden ages” of this patrimonial state as they were getting the bulk of their profits (sometimes more than 70 percent) from non-operation profits, meaning interest income derived from their lending to the state.

Now let me return to the 2006 survey. The İSO Top 500 Industrial Enterprises survey is known as the equivalent of the Fortune 500 for Turkey and it shows generally that the economy is headed in the right direction. In fact, the results show that Turkey’s companies have reached unprecedented levels in almost all areas, from exports to employment and from production-based sales to profits. For instance,

the sales profitability of the 500 companies in total was 5.9 percent in 2006 while it was 4.6 percent in 2005. Although the profitability rate in 2006 was higher than in the previous year, it was still below 8.5 percent, the level 10 years ago. However, you all know the meaning of that high profitability of the 1990s, after my explanations above.

the asset profitability of the 500 top industrial firms increased to 7.3 percent last year from 5.4 percent.

and finally, equity profitability increased to 13.8 percent from 10.3 percent — its level in 2005.

Also, export performance should be seen as a good indication of a transformation under global competitive pressures. The automotive industry gets the highest share in the exports of the top 500 companies with a 28.1-percent stake. The metals industry ranked second with a 19.6 percent stake. The export of metal goods and machinery spares took third place with a 17.5 percent stake.

As a matter of fact, the same trends can also be observed from the Central Bank of Turkey’s Financial Stability Report (2007-I) released just before İSO 500 survey. The central bank’s data is quite reliable as it derived from balance sheet reports of the companies that appear on the Istanbul Stock Exchange Market (İMBK-100). As is seen in the table below, both equity and asset profitability of the companies for all firms, including manufacturing firms, have risen significantly since 2004. As we put all these figures together, it seems that big companies started doing quite well in the global environment and therefore at the moment there is no rationale for complaining about foreign exchange rates or the domestic interest rate. However, the situation should be drastically different for small firms.

An economic crisis unlikely in Turkey

The world is being subjected to another period of economic turbulence obviously triggered by the malaise of the US economy. As a matter of fact, nobody can predict the extent or magnitude of anxieties existing in markets around the world. It seems as though loan problems in the US mortgage market are proving responsible for the recent issues. This is actually the simplest and perhaps most visible sign of unregulated global capitalism — financial markets are blind and short-sighted. Similar to what happened in East Asia in 1997, the same story is being repeated for the US, supposedly the most transparent and accountable working market in the world. The American economy has several structural imbalances such as current account, budget and saving deficits. In order to preserve the system, the economy continuously accumulates record levels of public debt. However, as the competitive strength and macro-economic bases of the American economy deteriorate, the value of the dollar has declined more than 50 percent against the basket of major currencies, including the yen, sterling, euro and yuan, in the last five years. Nobody knows how this economy’s soft landing could be possible without seriously damaging the world economic system.

Still America seems to be capable of exporting its problems around the rest of the world, thereby maintaining its underachieving economic system. The rest of the world is well aware of the fact that even if the US economy continuously creates global problems, it must be kept alive at any cost. In order to maintain the current growth momentum, major global actors ranging from states to big companies are ready to pay the cost, supporting the US economy through several different channels.

Coming back to Turkey’s position on the latest crisis, we can argue that its impact on the Turkish economy could be much deeper when compared to other emerging market economies. Still I do not expect a deep economic crisis comparable to the situation in 2001. The following factors I will mention briefly would prevent any major crisis in Turkey. First, it seems that economic actors, including the public sector, have learned to live together amid global turbulence. In that regard, they invested in risk management techniques and increased their risk-taking capacity.

Second, financial indicators of the banking sector are quite robust. We owe this success to the recent structural reforms in the financial system after the economic crisis in 2001. Third, major macro-economic factors are quite satisfactory in comparison to the situation prior to 2001. We can observe all these factors with the table and figures provided.

As can be seen, Turkey’s capacity to make payment on short-term obligations is quite healthy. I agree that strong and long-lasting overshooting in foreign exchange rates would critically harm the financial situation of many companies as they have large amounts of short-term, foreign exchange-dominated debt. Despite that, it seems that they either have already hedged these debts or their debt-equity ratio is not dramatically high.

Finally, Turkey is a rising star for global capitalism. Opening our eyes 15 years into the future, we can envisage an economy exceeding a YTL 1.5 trillion gross domestic product (GDP). There is a huge potential for profit as growth and stability continue

03.08.2007