Erdogan's Economics and Fragility (Part I)

Dec 15, 2023

TABLE OF CONTENTS

1/ SUMMARY

2/ ERDO?ANISM

3/ ERDOGAN'S ECONOMICS

• Current economic conditions
• Unique industry structure
• Highly open to foreign investment
• Residential consumption is robust
• The unique political maneuvering ability of the national leader

4/ APPENDIX 1: REVIEW OF ERDOGAN’S POLITICAL CAREER

SUMMARY

In 2003, Turkey entered the "Erdogan era." Erdogan became the most influential leader after the founding president Kemal Ataturk. He departed from Ataturk's emphasis on secularization and integration into European ideas, dedicating nearly 20 years in office to restoring the glory of the former Ottoman Empire. He continuously strengthened Turkey's position and influence in the Middle East and even internationally, a political ideal referred to as "Erdo?anism."

Under Erdogan's leadership, Turkey experienced rapid economic development, earning it the nickname "Little China of the Middle East." Real estate and infrastructure construction saw continuous improvement. Despite the impact of the pandemic, Turkey emerged from its unique position as the "foreign investment garden" in the global economy with remarkable economic resilience. In 2020, amidst the pandemic, the GDP grew against the trend by 1.8%, making it one of the few countries globally to avoid economic contraction during the pandemic. We believe that Erdogan's economic policies created unique advantages for Turkey to maintain developmental momentum under 20 years of high inflation:

1. Special industry structure. The Turkish economy is supported by the service sector and low-end manufacturing, attracting foreign investment primarily in real estate appreciation and allowing contracts in dollars and euros. The ability for foreign investors to settle in dollars helps insulate investments from the depreciation of the Turkish lira, effectively decoupling overseas investments from the local currency.
2. Highly open investment environment. The investment environment is highly open to foreign investors with a high degree of market freedom. Leveraging Turkey's strategic location as a bridge between Europe and Asia ensures its position as a vital channel for international trade, providing security for manufacturing exports. Turkish banks heavily rely on foreign currency financing, allowing the influx of foreign capital into real estate and infrastructure sectors, driving economic growth.
3. Clear tendency in consumer spending, driving the "income-wage" cycle to support growth. Household income and expenditures contribute around 55% of Turkey's GDP. Prolonged inflation has resulted in a relatively low savings rate, and the active consumption habits of the population support the positive cycle of "income-wage" growth for businesses.
4. The unique political mediation ability of national leaders. Erdogan, through constitutional amendments, consolidated power domestically and used Turkey's NATO membership and its strategic position as a gateway for Asian energy and grain to enter Europe to mediate effectively between major powers. This led to substantial assistance, such as large IMF loans, for Turkey.

Despite the positive economic developments during Erdogan's tenure, the distinctive economic system he created for Turkey has several vulnerabilities. We believe these vulnerabilities mainly manifest in:

1. The collapse of critical industries when the industry structure is imbalanced, leads to systemic risks. The unbalanced industrial structure exacerbates Turkey's dependence on external resources, and if the macro external environment changes, the weaknesses in its industrial structure may struggle to provide sustained endogenous impetus for economic growth.
2. The extremely open investment environment relinquishes fund security to foreign capital, making capital flight more likely in the event of risk incidents. The historical bottleneck of Turkey's industry structure determines that external openness is the only growth mode. Special events that can trigger capital flight (such as economic downturns, earthquakes, Kurdish conflicts, East Turkistan conflicts, coups, elections, etc.) can exert significant pressure on currency depreciation.
3. The a clear tendency in consumer spending, but consumer spending is prone to decelerate during interest rate hikes to combat inflation. Consumer loans account for 48% of loans in Turkey, and there is a significant risk of spending deceleration for the household sector in a high-interest environment. In November, the Turkish central bank has already raised interest rates to 40%, and if the household sector, which contributes more than half of GDP, experiences a consumption decline, Turkey may face severe stagflation.
4. National leaders' unique political mediation ability can turn individual mistakes into national risks. Under Erdogan's strong control, both fiscal and monetary policies in Turkey are expressions of his will. Additionally, the unconventional monetary policy of aggressive interest rate hikes/cuts can impact financial markets. Lastly, due to Turkey's dependence on foreign capital, Erdogan's diplomatic actions may further negatively affect economic development.

In conclusion, although Erdoganomics provides Turkey with unique advantages for development, non-traditional economic theories may be constrained by the uniqueness of its theoretical system in the long run. In the short term, the lira may experience moderate depreciation. However, in the long run, there is still a significant possibility of a substantial decline. In the short term, Turkey's economic advantages may allow for low-quality high-speed development because, under trade protectionism in the EU and Asia-Pacific regions, Turkey can still capitalize on favorable conditions and receive support from foreign investments. However, in the long term, if the government and credit system supported by Erdogan collapse, the lira may again experience a significant plunge.

ERDO?ANISM

"Erdo?anism" refers to the political ideology of Recep Tayyip Erdo?an, the current president of Turkey. Key tenets of Erdo?anism include strong and centralized leadership, as opposed to a system of power separation and checks and balances. Critics often characterize Erdo?an's political views as authoritarian and indicative of an independent autocratic rule. This perception is evident in his domestic and foreign policy measures.

On August 10, 2014, Turkey successfully transitioned to a direct presidential election, and Recep Tayyip Erdo?an, the chairman of the Justice and Development Party (AKP), became the first democratically elected president in Turkish history. Following his election, Erdo?an expressed that the presidency under the parliamentary system was largely symbolic, and he aimed to grant greater powers to the presidency through constitutional changes, transitioning Turkey from a parliamentary system to a presidential system. After the conclusion of the 2015 Turkish parliamentary elections, where the AKP secured a majority, Erdo?an's party formed an independent government, initiating the political reforms he envisioned. In January 2017, the Turkish Grand National Assembly deliberated and approved constitutional amendments, and on April 16, the constitutional amendments were ratified through a nationwide referendum. The key points of these amendments included the transformation of Turkey's political system from a parliamentary to a presidential system, endowing the president with executive powers. The president gained the authority to directly appoint and dismiss vice presidents and government ministers, eliminating the position of the prime minister. The president would no longer be bound by party neutrality and could continue to serve as the party chairman. The president would be directly elected by voters, being accountable to them rather than the parliament, which lost much of its oversight or impeachment powers over the president. Additionally, post-amendment, a president could be re-elected for one more term, with the terms served before the amendment not counting towards the limit. Following these constitutional changes, Erdo?an, despite having served 11 years as prime minister and 5 years as president, could potentially continue in office until 2029. Furthermore, in July 2016, Turkey experienced a failed military coup. After the coup attempt, Erdo?an launched a large-scale purge targeting the military, police, judiciary, various government departments and agencies, education and academia, media, religious groups, and other sectors. Approximately 70,000 individuals were suspended or dismissed due to suspected connections, and around 18,000 people were ultimately detained or arrested.

In the field of diplomacy, Erdogan's foreign policy is independent and assertive, emphasizing a balance of autonomy and pursuing strategic autonomy and great power status. As a result, Turkey's foreign relations can be described as navigating between various powers while also making numerous adversaries. Despite being a NATO member and a candidate for the European Union, Erdogan does not align with any particular side and, at times, actively confronts others to secure Turkey's relatively independent international position and national interests. This approach has, to a certain extent, strained Turkey's relations with the United States and the European Union. Turkey has long sought to join the European Union; however, the EU has shown a cautious and negative attitude toward Turkey's accession, leading to a lack of progress in negotiations. After events such as the failed coup attempt in 2016, the EU strongly criticized Turkey on human rights and democracy issues, threatening sanctions. Erdogan, in turn, expressed disappointment and resentment towards the EU, stating that he no longer expects anything from the EU. Currently, tensions between Turkey and EU member state Greece in the Eastern Mediterranean over resource disputes and military friction have escalated into a visible direct confrontation between Turkey and the EU. Regarding NATO, Turkey is an important member, but under Erdogan's leadership, Turkey frequently experiences disagreements and conflicting interests on various issues. For instance, Turkey's request for the extradition of individuals believed to be behind the 2016 coup attempt was rejected by the United States. Turkey considers Kurdish armed groups as terrorist organizations, while the U.S. views them as crucial forces against ISIS, leading to differing perspectives and weapon support. Erdogan, despite NATO's opposition, purchased the Russian-made S-400 air defense missile system, considered a betrayal and threat to NATO. This resulted in the U.S. imposing sanctions on Turkey and halting plans to provide advanced weapons, such as F-35 fighter jets. However, Erdogan's assertive and adventurous foreign policy has not brought him any benefits; instead, it has imposed significant economic costs on Turkey. Due to Erdogan's provocations, Turkey faced sanctions and isolation from Western countries, which are major pillars of the Turkish economy, contributing significantly to trade, investment, aid, tourism, and other income sources. As these revenues decrease, Turkey's economy will suffer a severe blow. In this context, Erdogan agreed to Sweden's NATO membership to ease tensions with the West, hoping to reinvigorate confidence in the domestic market. Therefore, in the long run, regardless of how intense Erdogan's verbal battles with the U.S. and the EU may be, Turkey still needs to maintain or improve its relations with the West to balance its eastward diplomacy with Russia. The relationship between Turkey and its apparent allies will not remain stable in the long term. Erdogan's ultimate goal is to secure Turkey's independent position, and conflicts, opposition, or cooperation with one or several parties are temporary compromises.

Erdogan's authoritarianism is also evident in his interference in the economic sector. In 2021, Turkey experienced a continuous rise in inflation, reaching historic highs. However, the Turkish central bank continued to implement interest rate cuts, closely linked to Erdogan's policy of "low-interest rates." Faced with high inflation, Erdogan believes that the correct approach is to lower interest rates significantly, seeing it as a stimulus for the economy. This seemingly contradictory logic stems from Islamic doctrine, indicating that he has departed from conventional Western economic knowledge and is guiding the economy with religious ideological thinking. In response to these measures that contradict economic principles, initially, the central bank resisted implementing them. However, after constitutional changes, Erdogan gained the authority to appoint and dismiss senior officials, including the central bank governor and finance minister, without parliamentary approval. Consequently, Erdogan replaced three central bank governors within a little over two years, severely compromising the independence of the central bank.

ERDOGAN'S ECONOMICS

Current economic conditions

As of Q3 2023, the current economic situation in Turkey is characterized by an annualized GDP growth of 5.9%, an inflation rate of 61.98%, a central bank benchmark interest rate of 40%, an unemployment rate of 8.5%, and a minimum wage that increased by 55% and 34% at the end of 2022 and mid-2023, respectively. The government debt stands at 31.7% of GDP, and the current account has shown a slight surplus since September. The central bank's interest rate hikes have had a dampening effect on borrowing and retail, while the economic slowdown in Europe has reduced Turkey's export quantity. However, the economy is transitioning from an overheated state to normal development. For Erdo?an, the ultimate goal of these interest rate hikes is a soft landing, as economic growth is the foundation of his Justice and Development Party's (Adalet ve Kalk?nma Partisi) rule. Beyond the data, a more emotional description of Turkey's economic environment is the visible rise in the cost of living every few months, with people quickly spending their wages on consumption rather than saving. The general outlook for the economy is pessimistic, but there are no signs of a recession in economic activity.

Looking at Turkey's 20-year economic development journey, it is a country that has developed amid inflation. Inflation remained consistently around 8% between 2004 and 2017, long exceeding the 2% target of most economies. We believe that Turkey's ability to maintain economic vitality in the face of high inflation is due to its open investment environment, unique industry structure, robust consumer spending, and leadership adept at leveraging diplomacy for economic gains.

Unique industry structure

The service sector dominates Turkey's GDP, with tourism being a crucial industry for foreign exchange income (see Figure 1). According to data from the Turkish Statistical Institute, the total number of foreign tourists in 2022 reached 44.564 million, generating tourism revenue of $46.28 billion, representing a 19% increase compared to 2019. The thriving tourism industry not only brings substantial foreign exchange income but also contributes to increased employment opportunities and GDP growth in Turkey.

To continuously attract foreign investment and retain it locally, Erdogan has implemented a series of incentive policies, significantly contributing to the growth of the real estate and infrastructure sectors in the Turkish economy. Erdogan has granted amnesty for illegal constructions in the real estate sector, allowing locals to freely build without approval before obtaining a property deed after the building is granted amnesty. During Erdogan's 20-year tenure, he issued four special building decrees, allowing regularization of illegal constructions by paying a nominal fee per square meter. In 2018, a one-time amnesty legalized 7.5 million buildings. The amnesty policy in the real estate industry enabled Erdogan to achieve a triple objective: attract substantial foreign investment, boost domestic construction investment contributing to the national treasury, maintain high public satisfaction, and utilize the earned foreign exchange to import inexpensive goods to lower inflation. Simultaneously, Erdogan has initiated significant infrastructure projects in Turkey, including constructing a bridge over the Bosporus Strait, expanding ports, building nuclear power plants, establishing a nationwide high-speed railway network, and creating a national energy network to position Turkey as a hub for energy between Asia and Europe. Erdogan has employed various special policies to retain foreign investment, maintaining an extremely open foreign capital access in the financing system, allowing funds, gold, securities, and other capital to enter and exit Turkey legally without taxation. Contracts are also permitted to be denominated in US dollars or euros.

Highly open to foreign investment

Due to constraints in industry structure and energy reserves, Turkey faces gaps in savings and foreign exchange. As a developing country, Turkey's manufacturing industry is lagging, primarily focusing on low-end products. The absence of a robust industrial base does not contribute positively to residents' savings. Additionally, despite being located in the Middle East, Turkey has avoided the most oil and gas-rich regions (except for recent natural gas discoveries in the Black Sea). This has deprived Turkey of becoming an energy-exporting country, making it challenging to acquire abundant foreign exchange. On the contrary, the lack of a strong industrial base and limited natural resources result in high dependence on imported energy, leading to a foreign exchange shortage. In the 1970s, two consecutive oil crises temporarily pushed Turkey's inflation rate to 120.11%.

The dual gaps in savings and foreign exchange force Turkey to be highly open to foreign investment, creating an industry ecosystem that is heavily reliant on foreign investors and primarily settles investments in US dollars and euros. The savings gap implies that Turkey's domestic output cannot meet domestic consumption, leading Turkey to rely on foreign investment to bridge the gap. "Foreign investment" manifests in two forms: importing products (essentially borrowing the investment outcomes of other countries to compensate for domestic output shortages) and introducing financial forms of foreign direct investment. Under Erdogan's leadership, Turkey positions itself as a European investment and tax haven. Its investment legislation complies with international standards, boasting one of the lowest corporate tax systems among OECD countries. Most industries open to domestic investment are also accessible to foreign investment, with relatively few obstacles for foreign acquisitions of Turkish companies (except for key industries such as broadcasting, aerospace, semiconductors, which have restrictions on foreign ownership percentages).

Residential consumption is robust

Residential consumption tendencies are evident, driving the "income-wage" cycle to support business growth. By observing GDP calculated through the expenditure approach, we find that residential consumption holds the largest share, followed by imports and exports, fixed asset formation, and government expenditure being the smallest (see Figure 2). Residential income and expenditure contribute around 55% to Turkey's GDP. The long-term inflation has led to a relatively low residential savings rate but a higher willingness to consume (see Figure 3). The positive consumer habits of the masses underpin the positive cycle of "income-wage" growth for businesses.

The unique political maneuvering ability of the national leader.

Unconventional monetary policies, such as significant interest rate cuts during inflationary periods, are not entirely without merit and have, to some extent, optimized Turkey's economic environment amid high inflation. This approach, often dubbed "Erdo?anomics," has short-term benefits that shed light on the reasons behind such actions. Lowering interest rates can stimulate production, immediately reduce prices, and attract foreign capital to remain in Turkey. Conversely, raising interest rates may help combat inflation but does not necessarily retain foreign capital. During the 1999 economic crisis, Turkey increased interest rates to 100%, yet a significant amount of foreign capital still exited the Turkish market. Considering the macroeconomic environment since 2022-2023 and the impact of the Federal Reserve's interest rate hikes leading to a return of the US dollar, Turkey's interest rate hikes may not be sufficient. Since 2022, Turkey has cut interest rates four times, totaling 500 bps. The average GDP growth for Q1-3 was 6.2%, with exports increasing by 14% to reach $231 billion. Turkey has sacrificed its national wealth to maintain the functioning of the country's machinery by preserving foreign investment and a vibrant market environment. Additionally, due to the depreciation of the lira, the surge in the tourism industry has brought in crowds buying luxury goods, allowing the government to earn additional foreign exchange, albeit with a heavy heart.

"Anyone who defends this (high rates) is at the beck and call of the interest-rate lobby, this is treason against this nation" --- Recep Tayyip Erdogan，2015

Erdo?an's diplomatic skill in balancing autonomy in foreign affairs indirectly contributes to the influx of foreign investment into Turkey. As mentioned in the previous section on "Erdo?anism," Erdo?an's flexibility in diplomacy has positively contributed to building trade partnerships. The European Union stands as Turkey's largest trading partner. Regarding foreign trade, Turkey has a comparative advantage in services such as aviation, telecommunications, and finance. The top three categories of Turkey's exports are automobiles, steel, and chemicals and chemical products. According to data from the Central Bank of Turkey, the country attracted a year-on-year increase of 31% in foreign direct investment in 2021, reaching $7.59 billion. Of the foreign direct investment attracted by Turkey, 60% is from Europe, 24% from Asia, and 16% from the United States.

Erdo?an's leadership has also secured substantial assistance for Turkey's economic development. Internally, Erdo?an centralized power through constitutional amendments, while externally leveraging Turkey's NATO membership and its strategic geographical position as a gateway for Asian energy and food entering Europe. These strong conditions allowed Erdo?an to mediate among major powers, resulting in substantial aid for Turkey, including significant IMF loans.

APPENDIX 1: REVIEW OF ERDOGAN’S POLITICAL CAREER

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