Erdogan's Economics and Fragility (Part II)
Dec 15, 2023
TABLE OF CONTENTS
1/ SUMMARY
2/ THE FRAGILITY OF ERDOGAN’S ECONOMICS
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:
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:
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 experience a significant plunge once again.
THE FRAGILITY OF ERDOGAN’S ECONOMICS
Clear Bottlenecks in Industrial Structure
Lacking industrial support, Turkey's industrial structure faces evident bottlenecks and exhibits a high dependence on external factors. In the 1980s, when transitioning from an import substitution strategy, Turkey struggled to compete with Western technologies and couldn't match China's low-cost labor. Consequently, its development was limited to sectors like steel, cement, and automobile assembly, which offered little room for expansion, making it primarily a processing hub for European raw materials.
While earning foreign exchange, Turkey protected its underdeveloped industries by imposing trade barriers when importing advanced equipment for domestic industrial growth. However, under this protection, state-owned enterprises in Turkey lacked a sense of crisis, leading to eventual stagnation. Apart from industries related to infrastructure like steel and construction, other manufacturing sectors lagged internationally. This imbalanced industrial structure has heightened Turkey's reliance on external resources. In the face of changes in the macroeconomic environment, the weaknesses in its industrial structure might pose challenges to sustaining internal growth.
Foreign Capital Flight Poses Risks to Turkey's Economic Growth
In recent years, the weakening role of foreign capital in driving Turkey's economic growth has raised concerns as foreign capital flight poses risks. The historical bottlenecks in Turkey's industrial structure dictate that openness to the outside world is the sole means of growth. However, in recent years, foreign trade and investment have progressively lost their momentum in propelling Turkey's economic growth, making the domestic economy more reliant on consumer spending and government expenditures. High inflation and continually rising nominal wage levels have eroded the competitive advantage of Turkish businesses, particularly those in the import and export sectors. Compared to 2010, labor costs in Turkey's industry, manufacturing, and construction sectors have increased 2.3 to 2.6 times by 2016. According to the OECD, Turkey's elevated labor costs and lower technological proficiency contribute to reduced labor productivity. Additionally, structural deficiencies in Turkey's basic institutions, regulatory framework, and tax system hinder efforts to enhance domestic productivity. Moreover, Turkey faces limited opportunities for restructuring its industrial structure, with services and real estate predominantly focused on the domestic market. The low-end manufacturing sector, squeezed by competition from China and Southeast Asia, struggles to find room for improvement. The weaknesses stemming from the industrial structure are challenging to address comprehensively through reforms in the short term. If a significant foreign capital flight were to occur at this juncture, Turkey might face difficulties in sustaining long-term economic growth.
Consumer Spending Prone to Slowdown During Inflation Periods
Turkey has long grappled with high inflation, and during periods of inflation control, consumer spending is susceptible to slowdown, potentially leading to stagflation. Consumer spending in Turkey constitutes the largest share, followed by imports and exports, with fixed asset formation ranking third, and government expenditures being the smallest. If economic growth lacks momentum, it may be due to the inability of consumer spending to sustain or a significant decline in exports.
Turkey's total export volume has remained stable in the range of $20-$22 billion from 2022 to 2023, with the current depreciation of the lira favoring exports. Unless there are geopolitical risks, a substantial decrease in exports is unlikely to occur at this time. From the perspective of consumer spending, Turkey's fluctuating inflation has not directly turned the economy into ruins. Its yet-to-be-fully-realized destructive impact is mainly manifested in the difficulty for businesses to cope with the increasing cost of wages and borrowing, leading to gradual challenges in business survival and a soft job market.
Consumer loans account for 48% of the loan portfolio, and the household sector faces a significant risk of spending deceleration in a high-interest environment. In November, the Central Bank of Turkey raised interest rates to 40%. If consumer spending, which contributes over half to GDP, declines, Turkey may face a serious risk of stagflation.
Personal Errors and National Risks
The rise and fall of a nation are closely linked to political leadership, and this is particularly true in Turkey, where the presidency holds significant power. Erdogan's leadership strategy plays a pivotal role in Turkey's economic development trajectory. However, in the context of strong centralization of power, the leader's errors may bring about national risks that are hard to ignore.
Weak Independence of Monetary and Fiscal Policies
Excessive centralization has compromised the independence of the central bank's monetary policy, leading to unconventional economic measures such as aggressive interest rate hikes or cuts that impact the financial environment. Currently, Turkey's central bank governor is appointed by Erdogan, making monetary policy essentially reflective of Erdogan's intentions. Based on the analysis of his tendencies, there is a high probability that he is not inclined to return to orthodox monetary theories, as some might expect.
At this stage, Erdogan is less concerned about whether the benchmark interest rate is too high or too low. His primary focus is on retaining foreign investments and maintaining government credit, which he deems effective for Turkey. On August 25, 2023, the Turkish central bank raised interest rates by 750 basis points, from 17.5% to 25%, three times higher than market expectations, causing significant impact on the financial environment.
The monetary and fiscal policies of Turkey are direct expressions of Erdogan's will. In July 2018, Erdogan announced a decree granting the president the power to appoint the Governor and Deputy Governors of the Central Bank of Turkey, as well as members of the Monetary Policy Committee. Prior to this, Erdogan appointed his son-in-law as the Minister of Finance. In March 2021, just two days after the Central Bank of Turkey raised interest rates to curb inflation, Erdogan dismissed the then Central Bank Governor Naci Agbal (who had taken office in November 2020). Erdogan appointed Sahap Kavcioglu, who criticized the hawkish policy, as the new governor, immediately ending the interest rate hiking cycle and starting a rate-cutting phase from September 2021. This move coincided with the eve of the first interest rate hike by the U.S. Federal Reserve in March 2022.
These bold actions illustrate the extent to which Turkey's monetary policy is used as a political tool. Future fluctuations in monetary and fiscal policies may continue to serve Erdogan's policy agenda rather than being driven by prudent economic considerations.
Divergence in Monetary Credit
Abandoning monetary credit to achieve economic growth without emphasizing quality. Erdogan's economic approach carries a distinctive Turkish flavor, centered around exploring self-oriented policies. In his perspective, high inflation necessitates interest rate hikes, as rising prices reflect an excess of circulating currency relative to insufficient goods. However, this view treats the country as an independent closed economic entity. In the context of the modern international trade system, where the world is seen as a global village, Erdogan needs to transcend his unique brand of Turkish exceptionalism. Even without an international currency minting privilege like the U.S., he maintains the nation's creditworthiness and the attractiveness of domestic assets in a unique way. From an economic standpoint, he abandons Turkey's monetary credit, relying on the endorsement of U.S. dollar credit to drive rapid but potentially low-quality growth. Politically, it showcases to the international community that internal and external challenges cannot shake Turkey's government stability and economic vitality, with internal challenges referring to military coups and external challenges involving diplomatic mediation among major Eurasian powers.
Historically, after Erdogan came to power, a million old lira was exchanged for one new lira, distancing itself from the reputation of his Zimbabwean counterparts. Through extreme foreign capital openness, Erdogan transformed Turkey into an international tax haven and a money laundering hub. Turkey also acquired a large number of underperforming state-owned enterprises to enrich the national treasury. With massive inflows of foreign capital each year (about 2% of GDP), Erdogan opened the doors for foreign investment. As mentioned earlier, real estate is a major industry for housing foreign capital, especially after the 2008 financial crisis and the recent global monetary easing amid the COVID-19 pandemic. In 2022, Turkey's property prices surged again, ranking first globally. Inflation has ravaged the wealth of ordinary citizens, particularly the working class and the poor. As discussed earlier, these segments of the population are among the few "losers" in the inflationary scenario. However, Turkey's stock market and assets priced in foreign currency have shown stable growth. Only the middle class and above have the means to convert currency and allocate assets in foreign currencies. In summary, Turkey's domestic credit currency system and its industrial sectors supporting economic growth have deviated to some extent. Core industries with foreign currency backing show robust growth, but the cost is the managed flow of wealth towards the affluent class capable of holding foreign currencies. This development leads to quantity-oriented growth with poor quality, significant wealth disparity (with many devout Islamic followers experiencing poverty), and a massive brain drain towards Europe and the United States.
Risk of Diplomatic Imbalance Failure
Internal coups cannot shake Erdogan's government, and external sanctions have yet to be imposed due to Turkey's unique geographical location. Firstly, Turkey connects the Eurasian continent, and Russia's energy and grain exports to Europe must pass through Turkey. The EU cannot afford to be without affordable energy. Secondly, countries bordering Turkey have always had a unique political status. If Turkey leans towards the West, Russia will be wary. If it leans towards Russia, Europe will be anxious. Erdogan is adept at leveraging this situation to seek funds from both the West and Russia. In July 2023, Biden verbally promised Erdogan an IMF credit line of $110-130 billion to convince Turkey, a NATO member, to agree to Sweden's NATO accession. Erdogan immediately viewed Sweden's NATO accession as a positive proposal. Turkey is also part of China's Belt and Road Initiative. Although Erdogan had offended China over the East Turkestan issue, in 2015, China and Turkey signed a memorandum of understanding for Belt and Road construction, setting aside past grievances for mutual economic development. It can be said that Turkey has a natural talent for being a "grass on both sides of the wall." It tilts towards whichever side treats it better, and severe sanctions from major powers are likely to do more harm than good. In the Middle East, Turkey has made diplomatic efforts. In 2015, when Trump imposed sanctions on Turkey, including a 50% increase in steel tariffs, causing a double blow to the Turkish stock market and exchange rates, Qatar announced a $15 billion investment in Turkey in an emergency. This came as Saudi Arabia announced the severance of diplomatic ties with and blockade of Qatar. Turkey was the first to support Qatar. The combination of internal and external political pressures has constrained and balanced Turkey. The profits of the key industries supported by foreign investment in Turkey are backed by U.S. dollar credit. Overseas investors have dispelled doubts and entered Turkey in large numbers.
Erdogan's mastery of diplomatic maneuvers and his assertive approach make us question whether the government under Erdogan's leadership still adheres to traditional country credit evaluation standards. Clearly, the international community, including major foreign investors such as Europe, deems the government credit under Erdogan's leadership as sufficient. A simple comparison reveals that political upheavals in other countries cause panic, but when Turkey faces a coup attempt, the president can call on the people to take to the streets to resist the military while he is vacationing abroad. Economically, Turkey has bypassed the conventional methods of maintaining government credit and the attractiveness of national assets through reasonable inflation rates and exchange rates (consider how the U.S. worries about inflation, and China worries about currency depreciation). In this situation, what significance does raising interest rates to conform to orthodox monetary theory have? We believe that, for Erdogan, raising interest rates is more of a compromise in response to declining foreign confidence. With the global return of the U.S. dollar, the West hopes to see higher interest rates in Turkey to curb inflation and ensure economic growth for continued investment. Erdogan will increase interest rates as much as needed to stabilize foreign confidence. Compared to other countries that proactively set inflation rate targets and prevent excessive economic fluctuations, we believe Erdogan has never treated inflation rate as a management target. He is more concerned with current growth, public support (interest payments on loans are considered exploitative and taboo in Islamic doctrine), diplomatic interests, and inflation rate is just a tool to achieve these goals. Finally, Erdogan's unique operating style, which he single-handedly constructed, is unparalleled in domestic autocracy and international mediation. When Erdogan's political career faces challenges, all the factors supporting the Turkish economy from above will fundamentally start to shake.
"Turkey has abandoned policies aimed at slowing inflation with high interest rates, shifting its focus to prioritizing increased investment, production, exports, and creating strong employment. With the help of the Almighty and the support of the people, Turkey will emerge victorious from this economic independence war." — Recep Tayyip Erdogan, 2021
In summary, while Erdoganomics has provided unique advantages for Turkey's development, non-traditional economic theories may face constraints in the long term due to the specificity of its theoretical framework. In the short term, the lira may experience moderate depreciation, but in the long term, there is still significant downside potential. We believe Erdoganomics has made remarkable contributions to Turkey's economic growth over the past 20 years, given the high inflation background. The continuous attractiveness to foreign investment, the unique industry structure, and the positive consumption habits of residents make Turkey's economic development smoother. In the short term, Turkey's economic advantages may still lead to rapid but low-quality growth, as the country can navigate through trade protectionism in the EU and Asia-Pacific regions, securing foreign support. However, non-traditional economics also exposes Turkey's development to risks. Erdogan's highly centralized political ideology has undermined the independence of the central bank in policy formulation, and aggressive interest rate cuts or hikes can cause significant volatility in the lira's value in the short term. The occurrence of potential risk events could lead to a massive outflow of foreign capital, affecting the stability of economic construction and industry development. Additionally, with high consumer loans, consumer willingness may weaken in the prolonged high inflation environment, further impacting the profitability of businesses. In the long term, if the government and credit system supported by Erdogan collapse, the lira may experience another significant plunge.
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