Turkey Illustrates The Real Risk Of Emerging Markets

The current political turmoil in Turkey illustrates with startling clarity the real risk in the so-called Emerging Markets.  Commonly used economic indicators such as GDP growth, debt, deficits, corporate profits, etc. tell only part – the superficial part -- of the story.

            Much more important for anyone seduced by the theoretical growth potential of these markets are issues like the underlying political stability, existence of ‘crony’ capitalism, competence of government institutions, level of systemic corruption, and -- most important of all – respect for the rule of law.

            A brilliant young Turkish financial analyst, who needs to remain anonymous given the poisonous climate in Turkey, emphasized this contradiction in a recent email about Turkey and cautioned against a headlong rush into emerging markets in general.

“The key issue is to understand that a growing population, rich natural resources, or a large manufacturing (assembly) base do not in themselves make a good long term story. In fact, three common denominators of emerging markets are lack of the ‘rule of law’, an economic system of ‘crony capitalism’, and a poor education system. These, in turn, create a system of constant corruption and regular boom/bust cycles. In emerging markets corruption is the grease that turns the wheels of the economic system – where politicians, bureaucrats and businessmen benefit at the expense of productivity and innovation. This system is usually supported by a political system that plays on social/political divisions along different ethnic, religious or political lines.”

            Turkey, thanks mainly to the work of former economic minister Ali Babacan, doesn’t score too badly on the raw numbers. Unfortunately, the country scores at or near the bottom of any league table on the second set of issues – the ones that can really make or break any investment. President Tayyip Erdoğan has gone out of his way to show that he recognizes no constitution and no law except the law of sheer power.

            The dramatic events yesterday that saw the dismissal of the prime minister only confirm this trend. It is well known that Erdoğan does not tolerate any dissent from his narrow, parochial world view – particularly his ambition to transform the office of president into an untouchable, unaccountable power center. Prime Minister Ahmet Davutoglu was seen as the softer, more reasonable side of Turkey’s unequal power balance. Despite his frequent avowals of undying loyalty, he apparently infuriated the president with his lack of enthusiasm for several issues key to Erdoğan’s megalomania: 1) the change to an unchecked presidential system, 2) his reluctance to throw people in jail before a trial, and 3) his willingness to use professionals like Babacan as economic advisers rather than rely on the sycophants who surround Erdoğan.

            In some ways Davutoğlu was the architect of his own downfall. His deeply flawed foreign policy only succeeded in completely isolating Turkey. Arab countries don’t really trust Turkey, Russia openly loathes and mocks Erdoğan, and the Europeans would really like to keep Turkey in some sort of ante-room to be seen and not heard. The Americans look on in despair at the rapid polarisation in Turkey and the deterioration of the country’s political discourse. But then they grit their teeth and think of Turkey’s geopolitical importance. Perhaps Davutoğlu’s main foreign policy problem as far as Erdoğan is concerned was to be perceived as mildly pro-Western. Erdoğan despises the West. He reacts furiously when Western politicians, journalists, NGOs, etc. scold him for his miserable record on human rights, press freedom, or judicial independence. His only response is loud bravado that ‘Turkey was great once and will be great again’.

            The name of the non-entity who takes over as prime minister is completely irrelevant because his only job will be to enact whatever Erdoğan wants. Cabinet meetings will have the same vibrant discussion, bright ideas, and independent thought as Stalin’s politburo meetings.

The only sliver of good news is that Erdoğan’s Turkey has absolutely no ability to project power beyond its own borders. Erdoğan would love to act like Putin throwing his weight around. But he can’t. He is hemmed in on all sides – if not militarily then politically. The Turkish army is large, but so far has shown no interest at all in moving one meter beyond its borders. From time to time the Air Force chases Kurdish guerrillas into northern Iraq and makes the boulders bounce with a few bombs, but that’s about it.

In the long run Erdoğan will fail because he is making the same major mistake as his arch-enemy the old Kemalist regime that ruled the Republic with an iron hand for more than 70 years. By alienating a large part of the population the Kemalist regime created fertile recruiting ground for Erdoğan. Erdoğan, too, is alienating a large part of the population. He is trying to force all Turks into his narrow mold of what he thinks a Turk should be. The trouble is, Turks don’t do ‘should’. The country is too diverse, too heterogeneous to fit into anyone’s mold. Erdoğan’s mold, like that of the Kemalist regime’s, will one day break. The only question is ‘How long is the long run?’

Confessions of Turkey's 'Infamous' Interest Rate Lobby

In searching for people to blame for Turkey’s recent economic problems Prime Minister Tayyip Erdoğan has lashed out at the so-called ‘interest rate’ lobby which, according to him and his cronies, is nothing more than a shadowy group of domestic and international financiers who want to derail the Turkish economy. The following contribution to Levantine Musings is from a charter member of this group of financiers – one of the many brilliant young Turkish analysts and fund managers who work for major international financial institutions around the world. I know many of them, and these are the very people that Turkish officials should be proud of instead of mindlessly demonizing. Although the prime minister will never admit it, Turkey desperately needs this ‘interest rate’ lobby to finance the country’s yawning deficits. As this note implies the Turkey has benefitted a great deal over the last decade from the huge amount of global liquidity. As this condition ends the Turkish government is at risk of confusing good luck with good policies.

**********

Even though no one knows what Turkish Prime Minister Erdoğan meant when he talked about the “interest rate lobby” during the protests surrounding Gezi Park in Istanbul, this ‘evil’ group of people has become the number one enemy in Turkey, ahead of the International Monetary Fund, Bashar Assad and General Al-Sissi in Egypt.  Deputy Prime Minister Ali Babacan, in charge of the Treasury, added to this mystery when he said “those in the interest rate lobby know who they are”.  After a lot of rakı (the Turkish national alcoholic drink before the prime minister declared otherwise a few months ago) and serious thought, I realized that I am actually part of this evil group, as I have been making a living by investing in interest bearing instruments over the last two decades, and the owner of this blog would call us “the basis point people".  Most probably, by being a “comprador bourgeoisie”,  I must be the lowest of all, as I sold out my great Turkish nation to this malicious group, in return for an (ever diminishing) annual bonus and paying more than half of it to Her Majesty’s Revenue & Customs. 

First of all, let me try to explain how we operate.  We are part of a group called Emerging Markets Fixed Income investors.  On average, we meet with ten government and central bank officials, company CEOs/CFOs weekly from a universe of about 50 countries and well over 600 companies, all of which want to lure us to get financing at cheaper rates, so that they can provide better services for their populations and better returns for their shareholders.  Our motto is very simple “give money to those who can pay you back”.  We are a very sensitive to interest rates, and our unit is “basis point” which is 0.01%.  Even if we have one basis points (0.01%) higher return than our competitors, it would have a big impact on the size of AUM (assets under management).  Our investors are a greedy bunch as well; they range from the sovereign wealth funds to retired teachers from Japan to dentists in Brazil, who want to have higher returns for their savings so that their quality of life is better.  Anyone, who has ever dealt with the Sovereign Wealth Funds of interest free economies of the Saudis and Kuwaitis would tell you how sensitive they are to “basis point”, as they understandably want their nations’ savings to have higher returns.

Now, about our relations with Turkey.  Ever since the first the road show that  Abdüllah Gül (now president of Turkey) and Babacan did before the November 2002 elections, we meet with Turkish government ministers, Central Bank governors and Treasury officials on a regular basis.  (It is interesting to note that that first road show was organized by Mehmet Şimşek who was an analyst at Merrill Lynch back then. He has since moved up in the world and is now Turkey’s Minister of Finance.) Only last year alone, we had the opportunity to meet with three different ministers and at least five high level government officials.  The reason for Turkish officials’ interest in us is very simple: every single day Turkey has to find/borrow US$500 million to cover the short fall in its foreign currency earnings - the infamous Current Account Deficit and refinancing existing debt.  Turkey desperately needs foreign cash, the cost of which depends on how well the government sells the Turkish story enabling Turkey to earn dollars in the future. 

Until very recently the ruling Justice and Development Party (AKP)  government had done a good job.  From the very first day that AKP was leading the opinion polls and Mr. Gül told us the story of “Conservative Democracy” in 2002, we invested in Turkey and we made good returns, even though interest rates fell from 100% to 6%. (Yes, actually, interest rate lobby makes money from falling interest rates).  The day Turkey was upgraded to Investment Grade by Moody’s earlier this year, we heard from Minister Şimşek about Turkey’s ambitions of being better in technology than Germany, better in fashion than Italy.  And we bought it. Before the start of the Gezi protests, we had couple of billion US dollars invested in a Turkish government bonds and corporate bonds - - which are unfortunately worth much less than that amount at the moment. 

But now, for the first time since 2002, we see a really bleak outlook for Turkey. So far the Turkish government has been extremely lucky with the global economic situation. With global interest rates at historic lows, it was not very difficult to attract cash into Turkey. However, the rules of the game have changed profoundly.  And,for me, the biggest sign of trouble is not the current account deficit, the unorthodox Central Bank policy or even the political mess Erdoğan put himself into after his extreme reaction to the Gezi Park protests, but the fact that the government officials are becoming extremely dependent on conspiracy theories and imaginary enemies. When such thing happen you know it is the beginning of the end. The only hope for Turkey now is smooth transition of leadership within the AKP, with the hope of common sense prevailing, eventually.

Challenges To Long Term Economic Success

Deputy Prime Minister Ali Babacan of Turkey never spoke truer words. Whether the words will ever be translated into action is another matter. But for the moment, the words are welcome.

Regarded as an economic technocrat in a government of zealous ideologues, Babacan is widely credited for Turkey’s recent strong economic performance. 

He has kept a tight rein on the country’s financial management since the Justice and Development Party swept to power in 2002. He has often warned his countrymen against taking on too much debt, and once famously compared running the Turkish economy to driving a truck down a steep, winding road in a thick fog.  Perhaps most importantly he has kept economically illiterate politicians from wrecking the budget with their pet projects or handouts to favoured groups.

Deputy Prime Minister Ali Babacan

In a recent meeting hosted by theFoundation for Political, Economic and Social Research he said that Turkey needs a “predictable rule of law” to improve its investment climate. “We must certainly create a more rapid and consistent judicial process,” he told the audience. “We are not at an ideal point regarding fundamental rights and freedoms. We need more judicial reforms. To become a country where there is a functioning (italics are mine) democracy and the rule of law is our sine qua non.”

Welcome words indeed to those hundreds of people incarcerated in prisons for long periods without being brought to trial. Then he got to the heart of the matter.

“Without political reforms, economic success cannot be maintained . . . development based on economic growth alone falls short of satisfying people.” Never were truer words spoken. I wonder what the Chinese would make of them.

He continued by stating the obvious about Turkey’s education system. “Our educational system is not very pleasing. The average number of years of schooling for adults is 6.5 years. With this kind of education level it is hard to achieve a target of $25,000 per capita GDP. We can achieve this goal with a better education level,” he told the group. It is a measure of Babacan’s importance to the government that he felt free to make such comments. Most other ministers with the temerity even to hint that there was any risk whatsoever to Turkey’s economic growth would quickly be transferred to supervising car parks near the Iranian border.

His comments come on the heels of the Global Competitiveness Report that showed between 2006 – 2012 Turkey’s justice system declined from 56^th place to 83^rd place. The country’s tax regime declined from 95^th to 117^th, and the education system fell from 58^th place to 74^th place. With this kind of performance Babacan’s concerns about Turkey’s economic success are well founded.

Problems in the legal and judicial system that hurt Turkey’s growth are not limited to criminal cases. Recently there was a closely contested bidding procedure for the privatisation of the country’s toll roads and bridges that attracted three bids and was won by a consortium of Turkey’s largest conglomerate Koç Group and the Malaysian UEM Group with a bid of $5.7 billion. The process followed Turkey’s complex privatisation regulations to the letter. The winning bid was far above what the other competitors were willing to pay, and was considered very rich by other market participants. Despite this, Prime Minister Tayyip Erdoğan complained that the winning bid was too low and that he would be ‘accused of treason’ if he permitted the privatisation to be completed at only  $5.7 billion. The prime minister did not reveal how he arrived at this conclusion.  Predictably, the bid was cancelled. Nothing has been said about compensating the winning bidders for the considerable investment they made merely to make the bid.

Abrupt cancellation of the bidding process when the government is unhappy about the results is, unfortunately, nothing new. A few years ago a client of mine won a small bid for a property containing deposits of a low value industrial mineral. Two weeks after the bid the client received a two sentence notification from the Ministry of Energy saying the bid had suddenly been cancelled. No explanation, no reason was given. I made several fruitless trips to the ministry seeking some sort of explanation. Various officials had the grace to be embarrassed, but said there was nothing they could do. “It’s out of our hands,” they said.

This lack of transparency has plagued Turkey for decades. With its massive electoral mandates Turkey’s ruling Justice and Development Party has had the perfect opportunity to make long overdue and fundamental reforms to the country’s governing institutions – the very ones that Babacan talked about. By focusing instead on expanding his own authority, emasculating the military, and creating vote-gathering construction projects the prime minister has missed an excellent opportunity to make these fundamental changes that would transform Turkey’s recent economic growth into lasting economic and social progress.

Hard Liquor, Loose Women . . . And Interest Rates

You really have to feel for Ali Babacan, the head of the Turkish treasury, you really do. He is very bright and understands extremely well the complexities of the global financial markets and the key role of interest rates in navigating through those markets.  Yet, unfortunately, his job is made extremely difficult by many fellow government ministers, including the prime minister, who are ideologically opposed to interest rates per se and tend to view them along with hard liquor and loose women as spawns of the devil.

Babacan is constantly forced into defensive and somewhat silly explanations of this clash between reality and ideology without seeming to contradict the prime minister who has a notorious dislike of any dissent.  “My prime minister’s will for a zero real interest rate is an ideal target. That is an ideal target which we would really like to see at one point, but that point might not be so close,” the beleaguered Treasury chief said in a recent Wall Street Journal interview. Very careful understatement, that.

The Turkish economy is going through a particularly dangerous period right now, and the prime minister’s zero interest rate goal is starting to resemble the fanciful foreign policy zero problems strategy.  The zero interest goal is morphing into high rates and multiple problems. Babacan’s efforts to resolve the ideological positions of many of his fellow cabinet members and financial reality have led to some odd contortions that strain the credibility of Turkish financial policy. Whether the prime minister likes it or not Turkey’s economic policy is closely bound to Europe, and the same forces creating so much trouble in Europe are rapidly making themselves felt in Turkey. With the currency depreciating rapidly, personal and corporate debt increasing to record levels and inflation headed back to double digits rates in Turkey are set to head north quickly.

And as interest rates head inexorably northward we can expect consumption to slow down, thousands of apartments remaining unsold, government funding becoming more difficult, massive new infrastructure projects remaining on the drawing board, and unemployment rising. Not welcome news to a government that has won the last two elections on the back of strong economic performance.

Growth At A High Price

A little background will help make this clear. For much of the last 9 years the Turkish economy has boomed on the back of a strong currency and low interest rates. Until a few years ago personal and corporate debt were extremely limited, held in check by Turkey’s chronic high inflation and interest rates. Credit card debt was just beginning and mortgages were almost non-existent.  After its own crisis in 2001 Turkey implemented  IMF-approved reforms that had the desired effect of lowering inflation and interest rates. The currency strengthened and the country began a 10-year run of high growth. Credit expanded rapidly, consumers discovered the joy of loading up their credit cards, contractors borrowed heavily to satisfy the incredible building boom all over the country. And why not? Interest rates were low and the relatively strong currency encouraged massive imports to meet demand for industrial material and the latest consumer goods from all over the world. Expensive imported cars were the order of the day.

Kool-Aid, Anyone?

A few notes of caution were raised about the escalating Current Account Deficit (roughly, imports are much more than exports), but they were drowned out in the self-congratulatory celebrations of high growth, low rates and continued currency strength. It was cheap to borrow in foreign currency and repay with a strong, stable currency. And borrow they did. Officials were in no mood to listen to warnings that this rapid ride might end in tears with an equally strong down-turn. It wasn’t just the officials. Bankers and financial market players were all drinking the same Kool-Aid, and they kept telling people that a new day had dawned and Turkey would be able to fund its deficits indefinitely. The Turkish Lira was to become the new, stable model for developing countries. Turkey’s newly assertive foreign policy was supported by this strong economic growth. Listening to the prime minister Turkey was about to assume its rightful place alongside Brazil, India, Russia and China as one of the major winners of the young 21^st Century. Or was it? Had the hype gotten ahead of reality?

The first warning bell was sounded by the current account deficit that was on track to reach nearly 10% of Gross National Product – a dangerous level in any country. The problem was how to pay for this huge deficit. As long as global financial institutions were flush with cash they were happy to lend to Turkey. Now that the Euro is close to implosion these same financial institutions have become much more careful where they put their funds. Not good news for Turkey. Then Europe, the major destination for Turkish exports, embarked on aggressive austerity programs with the obvious effect of consumers slowing down their purchases of those nice Turkish – assembled televisions or refrigerators.

Spooked in part by the exploding Current Account deficit investors began to shed the Turkish Lira. It’s 20% decline so far this year makes it one of the worst performing currencies in the world. The Istanbul Stock Exchange has also been in a free fall this year, down more than 30% in US dollar terms.

A common Central Bank response to rapid consumption growth and depreciating currency is to increase interest rates. Stuck with the government’s rigid zero interest rate philosophy the Central Bank has been unable to take this step. This is where the contortions come in. The official Central Bank interest rate remains at 5.75%. However, there are few, if any, transactions at this price. If a commercial bank needs to borrow from the Central Bank it will pay more than 12%. Commercial banks, under no philosophical constraints, have been quick to ratchet up their loan rates.

None of this is good news for an economy that needs hundreds of millions of dollars in external funding every year just as the sources of that funding are drying up. The sooner government officials acknowledge this trend, the chances the Turkish economy avoiding a major train wreck improve greatly.