Staying the course to economic reform and a modern state
We recently returned
from Turkey, where we conducted several days of meetings with government and
business leaders in Ankara and Istanbul aimed at uncovering investment
opportunities and assessing macroeconomic and political risk.
In recent years, Turkey has made a great deal of
progress in reforming its economic, legal and political institutions and has become a more attractive environment for investment. Prime Minister Erdogan’s Justice and Development
(AKP) party and the Turkish business community are allied in their
determination to see these reforms continue, and until now have formed an
effective axis of influence. Today,
however, Turkey faces a
number of complex and interrelated economic and political issues that pose a
challenge to economic stability and progress, including reliance on foreign
capital, Iraq, Cyprus, domestic Presidential and parliamentary
elections, and waning support for EU accession both in Europe
and at home. The successful resolution
of these issues and a continuation of reform-oriented government policy are of
paramount importance to us as potential investors. Further, whether the issues are successfully
resolved has implications that go far beyond the realm of investments.
We are generally optimistic that Turkey will end up in the right
place over the long term, as pragmatic policies and commercialism supersede
political obstacles. However, we expect
that there will be moments of tension and market volatility during the upcoming
months, which could present an opportunity for the contrarian, long term investor.
To assess Turkey’s
current situation, it is important first to understand a few essentials
regarding its modern history and society.
The Republic was formed by Kemal Ataturk in 1923 following the collapse
of the Ottoman Empire, and the nation was
built on the Kemalist doctrine of nationalism,
secularism and western orientation. Turkey spans several hundred miles from Greece to Iran, and while 99% Muslim, comprises
various ethnicities, with the West more European in culture and identity, and
the East more Middle Eastern. Ataturk is
revered with a quasi-religious intensity, and to the extent that there is a
national culture, it derives from Kemalism and prizes
independence, separation of church and state and modern society. Ataturk was a military man, and the Turkish
armed forces view themselves as guardians of Kemalism. Where politics is concerned, democratic
process generally has prevailed during the Republic’s 80-year history, but
there have been episodes of military intervention in response to perceived
threats to Turkish territorial integrity and Islamist influence in government,
including several coups d’etat.
Until the current decade, Turkey’s economy has been marked by
high inflation and interest rates, tenuous economic stability, and the development
of strong national industrial groups. The
process of EU accession began formally in 1999, and in 2002 AKP leader Erdogan
was elected Prime Minister under a banner of moderate conservatism, economic
reform and a drive toward EU membership.
Under Erdogan’s leadership, Turkey’s
government has implemented institutional reforms with largely successful
results. Anchored by the requirements of
EU membership, Turkey
has passed a series of laws that provide for greater freedom of expression and
minority rights, limit the power of the military vis-àis civilian government,
and codify investment rules, largely equalizing them with EU regulations. Through a program of fiscal discipline, Turkey has
managed to reduce inflation from 70% to 10%, stabilize its currency, and
achieve a fiscal surplus of 6% of GDP, grow its economy at 7% per annum, and reduce
unemployment and government debt as a percentage of GDP. As a result, Turkey
has attracted substantial foreign direct investment (FDI) from companies in the
U.S. and Europe,
including General Electric, Citigroup, OMV, Aviva, and Banque Paribas. Further, Turkish industry has capitalized on its
geographic location and relative industrial sophistication to make successful
investments in the Middle East and former Soviet states and to position itself
as an “energy highway” for natural gas between the former Soviet states and Europe.
Following our visit, we remain convinced that Turkey can stay
the course toward economic reform and modernity. But the challenges are considerable and the
stakes high.
In the following paragraphs, we discuss the major macro and
political issues affecting the outlook for investment in Turkey and how
we consider they may be resolved.
Reliance on Foreign Capital
Notwithstanding the success of
the last five years, the Turkish economy remains fragile because it depends on
foreign capital. Turkey’s
Central Bank maintains high interest rates in order to control inflation. Large interest payments on government debt combined
with high prices on energy imports mean that Turkey, despite its fiscal surplus,
runs a current account deficit. This shortfall
in turn necessitates additional borrowings or direct investment from
abroad. Over the last five years,
foreigners have been investing. In
addition to direct investment by companies, foreign portfolio investors have
purchased 70% of the Turkish government bond market and a substantial stake in
the Turkish equity markets as well. Foreign
investment is a needed blessing. It can
also be a curse. When foreign investors
exit en masse, they produce a vicious cycle where the currency declines in
value, producing fears of inflation, which causes the government to raise interest
rates at the expense of economic growth.
This in turn has the potential to undermine domestic support for
economic reform. Foreign capital flight
last occurred in May and June 2006, when global risk aversion increased for a
brief period, and the market disruptions were severe.
In the near term, Turkey’s dependence on foreign
capital is not so much an issue to be resolved as a continuous threat to stability
which demands the favorable resolution of the issues outlined below. In our view, as long as the political
situation in Turkey
remains stable and the Turkish bureaucracy maintains its commitment to economic
reform and the EU accession process, as described below, foreign investment
should continue to flow in, attracted by growth and high interest rates. Over the long term, decreased reliance on
foreign capital will be a natural byproduct of economic stability, declining
interest rates, and growth.
Iraq The apparent U.S.
plan to create a Kurdish political entity in northern Iraq could provoke
the Turkish military to intercede in the region to protect ethnic Turks and
disrupt the formation of the new state. It
also represents a threat to the relationship between the U.S. and Turkey,
which has criticized the U.S.
for its inaction in combating the Kurdistan Workers’ Party (PKK), a terrorist
organization based in Northern Iraq, and is now
developing stronger ties with its Syrian and Iranian neighbors in response. Most Turks abhor the notion of an independent
Kurdistan in Iraq
for reasons of security, territorial integrity and resources. They fear that a Kurdish state would invite
Turkish Kurds to seek secession and unification with their brethren in the oil
rich region. Further, they expect that
an independent Kurdistan would embolden the PKK
in its insurgency efforts, which would invite Turkish military reprisals. The last time the military engaged with the
PKK, 37,000 Turkish lives were lost. Finally,
Kurdish Turkey contains the water supplies, including the sources of the Tigris
and Euphrates rivers, which serve Turkey
and the entire Middle East and need to be
protected. In an independent-minded
diplomatic gesture, Turkey’s
AKP government has indicated a willingness to reach out to the Kurdish civilian
leadership in Iraq. However, the military has made loud noises of
opposition. Any action by the military
in opposition to the Turkish government would breach the EU requirement
regarding civilian control of the military, damaging Turkey’s prospects for membership,
with collateral damage to perceived economic stability.
In all likelihood, the U.S. plan will proceed without any
intercession by the Turkish military.
While the military can stir discontent in Turkey,
and act as a spoiler relative to the AKP’s political
strength, it recognizes that contravening a U.S.
geopolitical stratagem is not in Turkey’s best interest. Further, powerful Turkish business interests
are making a great deal of money in Northern Iraq, as energy, goods and produce
move between the two countries, and these interests are applying pressure to avoid
instability in the region. Recognizing
the Turkish military’s position, the U.S.
will find a way to placate them, perhaps by assisting them in combating the
PKK, helping the government to provide economic aid to Turkish Kurds, or
helping Turkey to achieve an
acceptable solution in Cyprus.
Cyprus Cyprus has
become a sticking point in the EU accession game and is testing the tact of the
Turkish government as well as its ability to keep the military in tow. Turkey
refuses to acknowledge official (Greek) Cyprus. Since Cyprus was admitted to the EU in
2004, it has ceased direct trade with its Turkish Cypriot neighbors in the
north. In response, Turkish Cyprus has
closed its ports to the south. The EU is
using the conflict as a lever to force terms on Turkey and/or delay EU
membership. Turkey
maintains a force of 35,000 strong in Cyprus and the military has been reluctant
to reduce its presence there, because of the island’s strategic location, and so
that it can to protect the ethnic Turkish minority. The AKP government views the 2004 failure of
the Annan Plan for unification of Cyprus as a
missed opportunity and remains constructive in seeking a solution, aiming to
remove another obstacle to EU membership.
But the military purports to be less compromising, and many Turks share
the military’s viewpoint.
According to many informed Turks and Greeks, the Cyprus
issue is taking care of itself, as evidenced by the fact that the Greek
Cypriots tore down parts of the wall that separates south from north this past
week. The economic embargo becomes less
tenable as Greek and Turkish Cypriots intermingle. A compromise likely will be reached in the
next twelve months at the urging of the UN and U.S., whereby the Turks open their
ports to the Greeks and in return the economic embargo against the north is
lifted and the airport opened for air travel to and from EU countries. Eventually the Turkish territory will be
allowed some form of independent administration with continued military
presence, albeit at a reduced level.
According to sources in the AKP, the Turkish military will see this as
an acceptable solution, and further recognizes the need to unburden the Turkish
government of the $250 million/year it spends on Cyprus.
Domestic Elections In
April, Turkey
will hold Presidential elections. The
key issue is whether charismatic and reform-minded Prime Minister Erdogan will
run for President or retain the PM role, and in either case whether the pro-reform
AKP government will retain control of the Turkish political agenda. Many Turks believe that Erdogan
will find irresistible the Presidency, a highly prestigious but largely
ceremonial and non-partisan role in Turkey, and that his election would
leave a leadership vacuum in the AKP.
This in turn would lead to a coalition government at November
parliamentary elections, and without clear reform-oriented leadership, a
dilution of the government’s push toward EU accession.
We suspect that Erdogan will forgo
the Presidency, recognizing that he will have greater influence over events as
Prime Minister and that being young he will have another shot at the top job. Even if he runs and wins the Presidency, the
PM job will be filled by Defense Minister Gul, an Erdogan ally, and together
they will continue to pursue current policy.
The parliamentary elections scheduled for November should yield an AKP
majority, or an AKP-led coalition.
EU Membership The
prospect of EU membership has provided an anchor for economic reforms and the
promise of membership’s possible benefits has helped the government sell
austerity to the Turkish public. Reforms
and stability have helped to attract needed foreign investment, perpetuating a
virtuous economic circle of stability and growth. Today Turkey’s momentum toward EU
accession has slowed, which raises further questions about economic stability
and growth. Europe has new member
integration fatigue, much of the European public is viscerally opposed to Turkey’s inclusion in the Union,
and the Continent is the midst of an election cycle, when politicians placate
rather than lead their constituencies. Turks
perceive that the membership rules are being rewritten in order to make their
accession more difficult. If the promise
of accession fades further into the future, the Turks, a very proud lot, will question
whether it still wants to be part of Europe; indeed
polls today suggest that 70% of Turks do not.
Turkey
may or may not be admitted to the EU, and as time passes its membership may become
less significant. What is critical is
that Turkey
continues to reform and develop its economic institutions. The European leadership recognizes that the EU
membership process is important in abetting Turkey’s
domestic reform efforts, and they are encouraged by European corporations have
invested billions of Euros in Turkey
during the last few years. I suspect
that once election season is over, Europe will reengage with Turkey’s EU
membership process. Over time, as Turkey
continues to strengthen its economic fundamentals and reduce its reliance on
foreign capital, actual EU membership will matter less. In fact, there is an argument that the
Turkish economy today is benefiting from relatively low wages and its ability
to build commercial ties with its neighbors, both of which might be compromised
by EU membership.
Why we should care about the outcome in Turkey? As Daniel Fried, U.S. Assistant Secretary for
European and Eurasian Affairs, said last month: “Turkey, a majority Muslim state,
with a tradition of secular governance, a deepening democracy and a thriving
free market is of strategic importance…
Its legacy of modernization can inspire people throughout the broader Middle East.” Turkey borders Syria,
Iraq and Iran. It is an important partner in the fight
against terrorism. The trans-Caspian gas
pipeline from Kazakhstan to Turkey may provide Europe
with an essential alternative to Gazprom for its supply of natural gas. There is the importance of protecting
existing U.S. and EU investments
in Turkey. And with the 17th largest economy
in the world, and a population of over 70 million, Turkey represents a potentially
large market for Western goods and services.
While the West assumes that Turkey
will remain secular and within its sphere of influence, it is not inconceivable
that Turkey
could follow the path of its more conservative Islamic neighbors. If the economy were to regress, this risk
would be heightened. On the one hand, Turkey is part
of NATO, an active member of the UN, WTO and European Customs Union, and faith
in Ataturk’s notion of a secular republic is deeply rooted among the older
generation. On the other, fundamentalism
is finding more disciples among younger people, and 30% of Turkey’s
population is under the age of eighteen.
The economist who escorted me through Ankara reminisces that when she was at
university there in the 1980s, she and her fellow alumna were enthused about
women’s rights, economic development, and social modernity. Today by contrast an increasing number of
the university’s young women are wearing the highly politicized traditional
Muslim head scarves, and questioning whether Turkey should stay the course
toward Western individualistic capitalism.
For reasons that are both economic and geopolitical in
nature, Turkey’s
success is of the utmost importance to the West. Despite what may appear to be cavalier attitudes
toward Turkey around the Iraq and Cyprus
issues, it is our view that the U.S.
and EU leaderships clearly recognize its importance and will behave
accordingly.
What does all of this mean for Tocqueville’s
investment strategy? We are long term
bullish. Turkey has a large young
population. Nearly every product and
service you can imagine, from cookies to hospital beds, is underpenetrated on a
GDP/capita basis, so growth potential is high.
Turkey
has a creative, entrepreneurial business culture and a stable of first rate
companies. Assuming a sound
macroeconomic environment, valuations are attractive. But Turkey remains vulnerable. In a year when so many tangled issues need to
be unwound, it is easy to imagine a moment – spawned by the comments of a
hawkish general, or a too-close-to-call election, or a general rise in global
risk aversion - when foreign investors flee Turkey and markets correct. We will therefore exercise patience and wait
for some negative event to create an opportunity to buy quality assets at
distressed prices.
James Hunt
April 2007
This article reflects
the views of the author as of the date or dates cited and may change at any
time. The information should not be construed as investment advice. No
representation is made concerning the accuracy of cited data, nor is there any
guarantee that any projection, forecast or opinion will be realized.
References to stocks,
securities or investments should not be considered recommendations to buy or
sell. Past performance is not a guide to
future performance. Securities that are referenced may be held in portfolios
managed by Tocqueville or by principals, employees and associates of
Tocqueville, and such references should not be deemed as an understanding of
any future position, buying or selling, that may be taken by Tocqueville. We
will periodically reprint or quote extensively from articles published by other
sources. When we do, we will provide appropriate source information, including
hyperlinks to websites we borrowed from. The quotes and material that we
reproduce are selected because, in our view, they provide an interesting,
provocative or enlightening perspective on current events. Their reproduction
in no way implies that we endorse any part of the material or investment
recommendations published on those sites.
New York, NY 10019