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Sunday, September 9, 2007

Turkey, The Anatolian Tiger

by Edward Hugh: Barcelona

Designer to modernize first lady's headscarf

The project of modernizing probable first lady Hayrunisa Gül's headscarf is becoming a reality, reported the Hürriyet daily. Atıl Kutoğlu, a renowned Turkish designer living in Vienna, is planning to cooperate with Hayrünisa Gül on her new headscarf style.

“I have different ideas about the new style of Mrs. Gül's headscarf in my mind. But we have not yet come together and therefore it would not be appropriate to make a conclusive statement. In the following days, we will meet with Mrs. Gül to work together on the project,” Kutoğlu said.

Turkey has, not surprisingly, been receiving a good deal of attention in the news media of late, some of it, as can be seen from the above quote from the Turkish Daily News, verging on the frivolous. We could ask ourselves, however, whether this topic really is such a trivial one as it might seem at first sight? As Manuel notes in his accompanying post, former AKP Foreign Minister Abdullah Gul was sworn in as President last week. And despite the initial knee-jerk reaction from those who equally had their own ideas about the new president's wife's style of headscarf, economic rationality and fundamentals have since reasserted themselves with the consequence, for example, Turkey's lira has now advanced for three consecutive weeks against the dollar. This is a performance which, in the current volatile environment, is much better than we are seeing from some other emerging market currencies. So someone somewhere now is more convinced by Atıl Kutoğlu's conceptual vision.

But, joking aside, it is perhaps a not a completely useless and worthless exercise to ask ourselves whether the significant losses incurred by Turkey's benchmark 2030 bond the day after Abdullah Gul was officially sworn in as President may not offer a striking reflection of how the financial markets - in this case at least - were rather more behind the curve (or better the curves, the ones in Hayrunisa Gül's hairline) than they were out in front of it.

Indeed we may well wish to ask ourselves about the extent to which such behaviour was in any way rational? After all, and at the end of the day, the wearing of a headscarf is nothing more than a rather modest expression of religious sentiment, and as Morgan Stanley Turkey specialist Serhan Sevik never loses an opportunity to point out to us the party which really represents Islamic politics in Turkey was roundly defeated in the recent elections coming in with a mere 2% of the votes. So going by the past record, and after an acute bout of institutional conservatism during the last months of the Sezer presidency (a conservatism which more often that not was what actually lay behind the negative comments which Turkey was receiving in the international press), may we perhaps not expect and look forward to a Gul era where continuing structural and institutional reform accompanied by a growing modernisation of economic and political life become the norm? I think we may, especially when we take into account that the after the electoral trouncing the CHP recently received, the Turkish military may be in no mood, even for sabre rattling.

Fortunately there are voices of reason hard at work out there trying, as best they can, to explain the obvious. Danske Bank's senior analyst Lars Christensen, for example. Chrisensen tells us that "while Turkey's secular elite sees the AKP as a threat to Turkey's secular constitution, most foreign investors see the AKP as a reformist force that will bring Turkey closer to Europe and open the economy,"

Indeed, as I intimate during my discussion of Turkey's need for pension reform (see the next part of this post), Turkey's old institutional elite may now with good reason fear that something more than the old secular constitution is in the process of being threatened.

So, as we move into a period of potential instability and growing sensitivity to risk in the emerging credit markets, this does seem like a timely moment to ask ourselves about the underlying solidity of those ever so famous economic "fundamentals" in relation to Turkey. Just how sound is the Turkish economy right now, and just how warranted are those nervous twitchings in the vicinity of the lira which we have been seeing, off and on, since the middle of August?

Manuel has already to some extent tackled the question of Turkeys stability from the political angle (I also had a crack at doing so in this post on a Fistful of Euros here). So here I will concentrate on the economic aspects of the situation (although I would just to take time out to mention at this point the interesting parallels which are to be found between what has happened in Turkey, and what may now be starting to happen in Morocco).

Sustained Economic Growth

In the midst of all the political debate and tension which has surrounded Turkey in recent months, one fact stands out above all the rest: the extent and duration of the economic revival which Turkey has been experiencing in recent years. The application of well-founded economic policies, which are anchored in an ongoing EU accession process and backed-up by a steady flow of International Monetary Fund reviews and arrangements, has given Turkey an increasing degree of political and economic stability which, when these are added to the extremely favorable external conditions which have until recently prevailed in the global environment, have produced impressive average annual GDP growth rates which have hovered in and around the 7.5 percent mark since 2002 now, as can be seen from the chart below.

This trajectory looks even more spectacular if we take look at the chart for changes in the dollar value of Turkey's GNP

Investment and private consumption have been the principal drivers of this growth, and for a number of years is was steadily fueled by a poweful cocktail of declining real interest rates, surging capital inflows, rapid credit expansion, and rising productivity. In addition, if we strip out the crisis-related spike of the last 12 months or so, inflation has been dropping steadily and dramatically over the past five years, as can be seen below.

Public sector debt - measured as a percentage of GDP - also came down rapidly after 2001, as can be seen in the chart:

All of this is quite striking, all the more so since, prior to 2001, Turkey had one of the most distorted economies in the OECD ambit, with volatility in real GDP growth increasing from 2.5 in the 1980s to 5.2 in the 1990s, rising to a crescendo of 8.4 during the 2001 crisis. Prior to 2001 Turkey had, in fact, been characterized by a series of boom-bust cycles which were normally accompanied by extended periods of financial fragility. However, political consolidation post 2002 and a much more favourable demographic environment have led to both growing economic rationalization and to a considerable reduction of business-cycle volatility. The volatility of real GDP growth (or any other macro variable, for that matter) have declined to historically low levels post 2001, while total factor productivity growth has surged to around 5% a year.

The combination of economic normalization and a favourable demographic headwind have functioned as a kind of technological innovation shock on the Turkish economy — accelerating both productivity growth and the level of sustainable output growth.

I will examine a number of features of Turkey's favourable demographic situation in more detail below, but for now lets take a look at one key indicator, median age.

As can be seen from the chart, after several decades of hovering in the 20 to 25 age bracket, Turkey in the late 90s punched through to the 25 to 30 range, and as we can see from the most recent data, Turkey's median age is now on a forced march upwards towards the 30 to 35 range, and should break water at 30 between 2010 and 2012. This is incredibly good news for Turkey, since it means she is set on a path towards both political and economic maturity (basically, as a kind of loose, rough and ready yardstick, we might say that the demographic dividend years are around the 27 to 32 interval. China currently has a median age of 33 and India has one of 25. China has just benekited from the dividend, and India is just about to do so).

So Turkey's progress, on any measure, has been impressive, with the dollar value of gross domestic product rising from US$154 billion in 2001 to US$403 billion in 2006 (see chart above, IMF data). Part of this dramatic rise has been a by-product of the (pre-June 2006) sustained rise in the value of the Turkish lira, but this kind of rise is just what we should expect to see repeated in developing economy after developing economy, from China (when they finally ditch the peg) to India and Brazil, and this is one of the reasons why the high compounded annual growth rates that these countries are experiencing right now will have a pronounced non-linear impact on living standards, with the gap with the developed world being closed much more quickly than most observers are currently contemplating.

On most conventional estimates, Turkey’s potential growth rate may well be, as we have been seeing, around 7.5% (or possibly even a shade higher) a rate which is more than twice the estimated average growth potential for the EU 25 countries to put things in some sort of perspective. If this growth differential were to be sustained over a significant period of time then it is perfectly plausible that Turkey's per capita income could increase from the current 30% of the EU-25 average to around 60% by 2020. But the if here is, of course, a big one. Be that as it may, and accepting the evident uncertainty which surrounds such forecasts, what is clear is that there is a clear potential for rapid growth in Turkey, and it is this impressive potential which has lead Serhan Cevic, for example, to start talking about Turkey being on the verge of becoming a trillion dollar economy.

The 2006 Crisis

Of course, it may seem strange to be talking about the Turkish economy in such glowing terms if we go back and think about what happened to the Turkish economy in the middle of 2006. A quick glance at the 2 year currency curve can give us perhaps the clearest possible demonstration of the extent of the crisis which, and against all prognosis, suddenly rolled in across Turkey's bows at the beginning of June last year:

Of course, volatility forms part of the normal and natural functioning of financial markets, and the if the volume of speculative positions attached to any currency starts to balloon, and as a consequence inflation and current account deficit fears also start to set in, then it is really in the normal course of events that the level of risk-averse anxiety should rise rapidly, and this increase in the anxiety register, as we are seeing right now, can provoke sudden shifts of sentiment which can wreak economic havoc, especially in the context of emerging markets.

And so it was in Turkey in the early summer of 2006, when intensifying risk nervousness, of the kind that can weaken even commodity-based currencies in the midst of a commodity bubble, caused a capital outflow hemorrhage from Turkey’s financial markets and a very sharp depreciation in the value of the lira - at one point the drop was 19.0% against the dollar and 21.3% against the euro, and all of this in a matter of just four weeks.

The impact of the outflow was such that the 5-year bond yield increased by 460bp from 13.4% to 18.0% over the same period, an up-jerk which naturally lead to a sudden contraction in the availability of domestic credit. Faced with the severity of the shock which hit the Turkish economy the central bank had little alternative but to moved aggressively, and the policy rate was raised from 13.2% to 17.25% in the space of just 20 days. As of September 2007 the overnight borrowing rate of the CBRT is still at 17.5%, ie subsequent to this "event" there has been no monetary easing, a feature of the situation which should give some pause for thought when you come to look at the fact - as we will see below - that Turkey's expansion has not only survived the shock, but has in many senses "carried on regardless". This is in stark contrast with what is happening in say Hungary, where a central bank base rate of a "mere" 7.75% is currently sending domestic demand spiraling downwards and begining to provoke what may well turn out to be quite a severe recession. So why the difference? What makes Turkey so special. This is the question we will be asking here.

With the benefit of hindsight it is now obvious that the giddy bout of global risk aversion which arrived "suddenly last summer" hit Turkey’s financial markets far more than the underlying macroeconomic fundamentals would justify, and part of the evidence I would present to justify this assessment would be the way in which the Turkish economy has subsequently weathered the storm (see below)and recovered its upward trajectory. This underlying reality did not however stop foreign investors from cutting their exposure to Turkish government securities and other lira assets by a whopping US$9 billion during May–June 2006, and in the process fuelling a sharp decline in asset prices.

Regardless of whether there was a coherent economic justification for the sudden eruption of financial volatility in the Turkish case, given the level of liquidity-driven speculative positions that were present across the globe in mid 2006, the onset of a herd-like rush to beat the rest to the door should have surprised no one, especially since, in the 16 months from January 2005, capital inflows that could have been categorised in some broad sense or other as ‘hot money’ to the value of some $18 billion had entered Turkey, and this had clearly served to push the lira’s valuation up above the "comfort zone".

On the macroeconomic side of things, subsequent to the crisis - and following adherence to the 6.5 percent GNP primary fiscal budget surplus target advocated by the IMF in combination with the strict monetary policy restraint that was applied by Turkey's independent central bank, - inflation has once more been started to come steadily down, and with this turn in inflation and in the public borrowing requirement there has been a revival in confidence, and the start of an easing-off in the level of real interest rates. In this context having a floating exchange rate has proved to be an effective shock absorber for Turkey, and it has provided significant incentives for the intelligent management of the risks associated with sharp corrections in currency values.

On the structural side of things, bank recapitalization and enhanced supervision, tax reforms, and privatization have all helped to restart private credit growth, a process which has been aided and abetted by a slow but steady rise in the levels of FDI, and given added impetus by an internal policy of increasing competitiveness. Here is a brief summary of the uptick in FDI that Turkey has seen in recent years:

However, perhaps the best measure of the underlying robustness of the present wave of Turkish growth is to be found in the recent performance of quarterly GDP, a performance which, as can be seen below, has really held up remarkably well under the circumstances:

There are, however, other measures we could use of Turkey's robustness. One of these is inflation, and it is to this topic we will now turn, since given the dramatic currency correction, the risk of a wage price spiral was clearly present. Fortunately this risk, as we will now go on to see, has not come to fruition.


According to the Turkish Statistics Office the August 2007 monthly change in the Consumer Price Index was 0.02%. This represents an annual rate of increase of only 2.4%. In and of itself this is a striking number, especially in the Turkish context. The figure is however a deceptive one and the general CPI was in fact up by 7.93% on a year-on-year basis, while the twelve month moving average was 9.46% . The monthly movement in the CPI over the last 12 months can be seen below.

What we can see at first glance from the graph is that despite the massive financial and currency shock of last summer, the monetary tightening process operated by the central bank has proved to be remarkably effective in holding inflation under control. The hardest component of the CPI for the central bank to contain (apart that is from energy) is the index for non processed food and this was up by 1.9% in August. In this context it would perhaps be well to remember that food represents some 28.5% of the CPI in Turkey (since of course Turkey is still a developing economy). Thus a significant part of the recalcitrance of the CPI to the anti-inflation efforts of the central bank can be directly attributed to difficulties in containing inflation in the food category. Interestingly, a somewhat similar situation can be observed in China. Here are the monthly movements in the Turkish food component over the last 12 months.

Behind the stubbornness in food prices lies in part the question of climate. Weather anomalies present a challenge to economic management since they find expression in the volatility of food prices. Surface temperatures in Turkey have been running around 4˚C above the normal seasonal pattern so far this year, and average rainfall is running about 60% below the long-term mean. Such dramatic changes in climatic conditions are not just a local Turkish phenomenon, of course, but that does not make them any the less troublesome for the Turkish authorities. Thus the year-on-year rate of change in food prices has increased from 9.2% in July to 12.4% last month, largely because of a 1.9% monthly jump in unprocessed food prices which consequently pushed the annual inflation rate for this sub-category from 8.9% in July to 16.2% in August. Thus Serhan Cevik argues that supply constraints stemming from climatic changes and higher exports to Europe (where adverse weather conditions have also lowered agricultural production) exert and will keep exerting an upward pressure on food prices inside Turkey, and thus on the CPI.

So for the present inflation seems to be trapped in a fairly tight range, around the 6 to 8 percent mark, but still this, it should not be forgotten, is quite an achievement given that Turkey comes from an average of inflation rate of 73.7% in the 1990-2001 period.

What is at issue here is not some mysterious Turkish resistance to a correction in major domestic imbalances but rather the combined impact of a number of evident supply-side shocks - higher energy prices, an untypical surge in food prices and the sharp depreciation in the lira. Despite this core measures of inflation confirm a gradual and steady downward shift in inflation dynamics, with the seasonally adjusted core CPI excluding unprocessed food posting a month-on-month drop of 0.3% last month while the year-on-year "core CPI" inflation rate has been steadily dropping to 6.2% in August from 6.6% in July and 10% in March. It should also be borne in mind that as living standards rise in Turkey, and a modern domestic consumer based economy develops there, food will cease to constitute such an important component in the CPI basket, so a structural solution to a structural problem is in fact in sight, and continuing economic growth is the key.

On another level it is clear that there has been something of a disconnect between the sharp retrenchment we have seen in consumer spending (final domestic consumption was, for example down 0.3% year-on-year in the latest Q2 2007 data released by Turkstat) and the resilience of inflation to further downward adjustment. The sudden and aggressive tightening of monetary conditions implemented by the CBRT last summer has produced an abrupt slowdown in domestic demand, and the rate of private consumption growth has fallen steadily from the 9.9% rate in the first half of 2006 to the 2.3% one in Q3 2006 to the 0.1% one in Q4, and now to the negative -0.3% in the last quarter. Current consumption growth readings are in fact the lowest since the 2001 crisis. This then is a significant slowdown, and it is also interesting to look at the subcomponents, where we find, for example, that the consumption of durable goods fell dramatically, from an annual growth rate of 14.2% in the first half of 2006 to a negative -8.3% rate in Q3 and -6.3% one in Q4 of last year.


Turkey's generally positive economic performance of recent years notwithstanding, one of the clear weakspots has been the topic of job creation. Despite all that growth Turkey's unemployment rate has continually remained stubbornly high (see chart below), running generally somewhere near to the 10% mark - a level which could be (by those who would be want to do so) be rather unfavourably compared with 6.5% one which was achieved in the year before the 2001 crash, but with the generally lower levels registered in many earlier years. As can be seen from the chart below, Turkey's unemployment rate has steadily trended up in recent years:

This argument is often used in order to criticize the kinds of reforms the AKP government has been introducing, but such cricisms are misplaced and short-sighted as I will try to explain in what follows. They are misplaced since they tend to ignore Turkey's underlying demographic reality.

Indeed, in the cities - where hundreds of thousands of rural workers flock each year in search of jobs - the unemployment rate is even higher than the national average, and in 2006 was still hovering around the 12.5% mark. And not only is unemployment comparatively high, the participation rate - which is normally under the 50% mark - is excessively low. So could we say that this has been a jobless recovery?

Well yes and no. The important issue to think about here is Turkey's demographics, and the natural rate of population increase. The Turkish Industrialists' and Businessmen's Association, for example, argued only last month that Turkey needs to create at least 550,000 jobs each year, just in order to mark time with rate of non-agricultural unemployment.

On the other hand we may also think about Turkey’s growing young population from another point of view, as a demographic gift which can help accelerate economic convergence with the developed economies, following the well know phenomenon of the demographic dividend whereby a steadily rising share of people in the working age population age ranges serves to increase per capita living standards in a non-linear fashion. Indeed the expression Anatolian tiger in the title of this post is a direct reference, not only to the earlier Asian tiger phenomenon, but also to the rather more recent - Celtic tiger - Irish one, with which certain direct comparisons may be made. Turkey is now faced with many years where the share of the population in the working age group will be high, and not only this, with steadily growing percentages of the working population in the key 35 to 50 age range. This is key, since this is the age range where productivity tends to be higherst.

However, for this potential to be transformed into a reality Turkey needs to improve the functioning of its labor market and to bring its employment rate more into line with the European average. To achieve this objective the number of those employed needs to increase by almost 50%, or by 12 million workers. This single issue, the massive "reserve army" of labour that Turkey has waiting in the wings ready to bring onto centre stage, is arguably the biggest single difference between Turkey and the other EU12 accession economies. Turkey is - in the foreseeable future at least - certainly not going to suffer from any looming labour scarcity problem, but equally if it doesn't manage to put all those people to work it isn't going to close the per capita incomes gap with the developed economies. It is a difficult balancing act that is involved here.

The scale of the problem can be readily seen by taking a quick glance at the graph below which shows us that, unlike the situation in many developed economies where population is now stagnant or even declining, Turkey's population is still increasing, and increasing comparatively rapidly (although, of course, less rapidly than in the past, hence the demographic dividend, which is all about population structure and not population size):

Given the significant difference between per capita GDP and per worker GDP, simply putting all Turkey's potential workers to work would mean achieving - in and of itself - a level of per capita income that would push above the 50% of the EU-25 average mark, and this would be without assuming any productivity improvements whatsoever.

This is why Turkey’s growing young population needs to be seen as a demographic gift that can help accelerate the pace of income convergence. The key problem is the inadequate level of employment, and the need to establish a powerful job creation machine. Thus while the working-age population in Turkey constitutes 71.4% of the total population (as compared to the 64% European average), total employment in Turkey only amounts to 43.3% of the working-age population (as compared with 63.8% in Europe). Put differently, the Turkish economy is utilizing less than half of its workforce, due in large part to an unusually low labor force participation rate (47.9% versus 72% in Europe).

Lets look at the data a little more closely. First off, the following graph shows the steady rise in Turkey's over 15 population since the late 1980s:

Now what is most striking in the light of this significant and ongoing rise in the available labour force in Turkey is the fact that overall relatively few extra jobs (in total) have been created since the start of this century, despite the significant increase in GDP and value created:

True a slight upward trend can be identified across all that fluctuation (in fact, if we look at annual averages, there were 1,600,000 more people working in 2006 than there were in 2000, or an annual average job creation rate of 280,000 or so, but this needs to be compared with a rise of 5.5 million in the over-15 population during the same period, thus without even budging the participation rate Turkey could have comfortably created roughly half a million jobs a year), and true there is a shift in the pattern after mid 2006 (according to Turkstat, Turkey's working age population increased by 854 thousand between May 2006 and May 2007, and at the same time non-agricultural employment increased by 489 thousand, but it is too soon to decide whether there is any real trend here, since the latest data we have is in fact for May), but still, Turkey has evidently still to create the huge jobs creation machine it so obviously and so pressingly needs.

This being said, the massive rise in GDP in comparison with the much more modest rise in total employment - and assuming a fair amount of "job churn" - does imply that the quality of employment has improved considerably, and this, as we will see in the next post, is reflected in the productivity numbers.

If we come to participation rates - again according to TurkStat - the 2006 annual participation rate was 48%. This in fact is a considerable drop over the participation rate in which was prevalent in the late 1980s - which was around 57%, or nearly 10 percentage points higher. The participation rate has in fact been steadily dropping as the weight of new arrivals in the labour market made it harder to create sufficient jobs, as can be seen from this graph:

The next graph, which shows the total population in the 15 to 24 age group post 2000, and the numbers of people in that age group in employment is very revealing. In the first place it show that the numbers in this group have remained stationary during this period (ie they ceased to rise) and indeed now are starting (in this very year, 2007) to turn down, what this means effectively is that we are now in the very core or heart of the demographic dividend period, ie at a critical moment.

A comparison of male and female participation rates in this age group is also revealing:

What we can observe, of course, is something which should be relatively obvious, that the employment participation rate of males is much higher than that of females in this age group, and this shows directly why the issue of female empowerment is so important in a case like Turkey's. It is also interesting to study the unemployment rate (which is a combined, male and female, one), and while it is clear that unemployment in this age group is still high (as in so many economies) the level may well have peaked for the time being, barring a sharp recession or the like, which does not seem to be in the offing at the present time.

But why is it that Turkey, at the same time as it is experiencing the longest sustained economic expansion in its history, struggling to create jobs? Like many other issues in economics, there is no single-variable explanation to lean on here. First off, structural changes, which in fact lay the basis for employment growth in the longer run, often slow the pace of employment growth in the short run, especially if older, non-productive jobs in more traditional sectors are shed in the process. Secondly, there is an ever widening mismatch between the average level educational attainment and the needs of Turkey’s newly developing industrial complex. The Turkish educational system is in sore need of reform. And thirdly, institutional bottlenecks keep the economy’s labour absorption capacity well below the rate of increase in working-age population. Among these the tax wedge of high non-labour costs must occupy a prominent place encouraging, as it does, a high level of activity in the submerged "informal" sector.

The longer term phenomenon which has so influenced the structure of Turkey's population, initially producing the rapid rise in the number of labour market entrants, and then producing the leveling-off in the numbers of those in the younger groups is, of course, the evolution of Turkey's total fertility rate, and this, as we can see blow, has been falling steadily in recent years.

Although there is some discrepancy in the data between the numbers published by Turkstat and the assessment of informed external demographic observers (who tend to have Turkey pinpointed as being below replacement fertility since the late 1990s) there can be no doubt about the strong downward movement in Turkish fertility over the last decade or so. This will produce in Turkey, as we have already seen in, for example, Southern Europe, somewhat perverse consequences, as the proportion of working age population steadily rises, followed by the proportion of prime age workers. This is what gives the economic "catch up" process its strong momentum. There is also however, a long term downside to this process as first the proportion of prime age workers will at some point begin to decline, and then the proportion of working age population, as ongoing low fertility and increasing life expectancy have their structural impact, and Turkey starts to age rapidly.

All this of course lies well out in the future, but, strange as it may seem, this is topic a question, as we will see in the case of pensions in the next post, which Turkey needs to address now, while the going is good, and not postpone, in the way that Italy for example, has postponed, at least if Turkey wishes to avoid facing the kinds of problems which now confront Italy she would be well advised to start thinking about all of this right now, and not move forward on a "live now pay later" (also known as PAYGO) basis.