Economic Realities Begin To Hit Home

Forget the usual loud-mouthed bleating from Turkish President Tayyip Erdoğan about Turkey’s exclusion from the coalition fighting to retake the Iraqi city of Mosul from the sadistic Islamic State. Even if he is right, almost everyone outside Turkey has become sick and tired of his bombast about Iraq and several other topics. Simply put, other leaders and diplomats are no longer willing to separate the message from the messenger.

But the real news out of Turkey has nothing to with Erdoğan’s bruised amour-propre, coups and counter-coups. No, the real news as discussed recently by two well-known journalists is the widening fault line in Turkey’s economy.

Ahu Özyurt, notes in a recent column that the proverbial man-in-the-street is suffering.

“In the most historic shopping mall of all, namely the Grand Bazaar in Istanbul, 600 shops have been closed because of an ‘unspoken’ economic crisis. Four decades ago such news toppled a shah in Iran.”

Hundreds of shops in the Grand Bazaar have closed

She notes that others from hairdressers, to landlords, to posh restaurants on the hills overlooking the Bosphorus are also suffering from a lack of customers.

A respected jeweller with shops in the Grand Bazaar and an up-market shopping center complained that “There are no Western tourists coming, no Western businessmen, no Japanese either. We are off the cruise calendar until 2018. The only shoppers here are Arabs that stay in the hotel and use the gift cards given by the hotel to buy clothing. There is no light at the end of the tunnel.”

In another column she quotes the founder of a menswear clothing line as saying that shopping-mall driven consumption has plunged drastically. In an attempt to ease the high consumer debt burden the government said debt could be restructured into 70 installments – albeit at high interest rates. But a young banker notes that such steps are not enough. “So many people have applied for debt restructuring because they know they will never be able to pay it even if it was 140 months,” a young banker said.

One tell-tale cause of this consumer distress is that the unemployment rate has reached double digits, and Özyurt notes that the unemployment rate among university-educated youth has risen to 13%.

Economist Güven Sak writes that at a time when the Turkish government is countering a myriad of real or perceived enemies it is making itself even more vulnerable to outside influence.

“Turkey’s domestic savings rate was around 14% for the latest year on record. It’s around 50% in China, 30% in Russia, 20 % in Poland and South Africa. So 14% is a low number, even for a developing country, and it is declining. We all know that living on other people’s money makes Turkey more vulnerable, yet we plan to go ahead with it.”

Sak continues by noting that Turkey’s growth rate has slowed and its current account deficit has increased. “The global financial crisis has made Turkey a more vulnerable country.”

“So is there any wonder why the Turkish Lira has been depreciating rapidly again this week? Forget about President Erdoğan’s Mosul remarks or the Moody’s downgrade for a minute. . . . Look at the high risk strategy of low growth and less savings. It is bad driving that is pulling the lira down.”

Sadly, none of this economic reality has so far penetrated Erdoğan’s virtual world dominated by foreign (read American, Israeli and European) conspiracies aimed at thwarting Turkey’s growth, grandiose regional dreams, and his long-standing desire to create a ‘Turkish style’ executive presidency – in other words one without any of the checks and balances that define a modern democracy. Finance Minister Mehmet Şimşek, a rare voice of economic rationality in the government, appears to have lost whatever small degree of influence he may have once had. His challenge now seems to be keeping a straight face when telling sceptical Western bankers that black is white.

Erdoğan and the ruling Justice and Development Party (AKP) have no serious domestic political opposition, and are pretty much free to make whatever changes they want in the country’s political structure regardless of any external pressure or criticism. The economy is a different matter. Ignoring financial realities and global volatility sooner rather than later will lead directly and quickly to economic pain for ordinary citizens.

The Prime Minister Just Doesn't Get It

You almost have to feel sorry for the Turkish Central Bank. After weeks of watching passively as the Turkish currency sank to new lows the bank finally found the courage to fire its big weapon – a massive hike in interest rates – in an effort to halt the slide and restore the economy’s international credibility.

                Unfortunately, the weapon was a dud. The currency initially strengthened and then resumed its downward spiral. On top of that, the country remains firmly anchored in the so-called ‘Fragile Five’ economies – Brazil, India, Turkey, South Africa and Indonesia. According to some unknown analyst at the investment bank Morgan Stanley this is a list of countries whose economies depend too much on very nervous and unreliable foreign investment flows.

            Now, the bank faces the worst of all possible outcomes. The currency continues to weaken and the higher interest rates could begin to stifle domestic economic activity. What is worse is that the bank enjoys very little, if any, political support. Prime Minister Tayyip Erdoğan only grudgingly allowed the rate increase, and said the blame for any adverse outcome rested squarely with the bank. Thanks, Prime Minister. The governor of the Central Bank must be checking his parachute.

Erdoğan simply doesn't get the basic reality that interest rates are only part of the economic picture. Interest rates by themselves cannot change underlying realities. A short list of non-interest rate problems include:

           

1.      Corruption:  Yes, corruption is major factor in many countries. But in Turkey it became so blatant that even the normally corruption-tolerant public began to complain. The financial news service Bloomberg carried a long story that only someone as talented as the late Elmore Leonard could make up. It involves an Iranian who was given Turkish citizenship, a government minister who received – among other things – a $350,000 watch, highly suspect gold shipments into and out of Turkey, private jets, lavish parties, police escorts for the Iranian-Turkish middle man who called the Interior Minister to complain about being caught in traffic, and much, much more.

2.      Vendettas:  The prime minister seems to have made it his personal business to create serious problems for some of Turkey’s leading economic players. The Koç Group, in particular, has been singled out. The group owns Turkey’s largest refiner Tüpraş that has been singled out for massive tax penalties. Public auctions won by the group have been mysteriously cancelled. Other companies outside the prime minister’s narrow circle have received similar treatment. Bank Asya, an Islamic finance bank known for its close ties to Fetullah Gulen, has come in for heavy handed audits since the corruption scandal broke in December. People and organisations with close ties to the prime minister have been urged to withdraw deposits. The prime minister has also blasted the head of Turkey's major business group as a 'national traitor' for daring to suggest that the country has severe underlying problems that must be addressed before the economy can reach its full potential.

3.      Arbitrary Regulations: One of the biggest complaints of would-be foreign investors is the arbitrary nature of regulations. Auctions and rules are changed without any explanation. Investors complain about the inconsistent application of laws.Any serious investor would like some assurance that the law today will be the same as the law tomorrow.

4.      Political Uncertainty: Erdoğan used to brag about the stability that his ruling Justice and Development Party (AKP) had brought to Turkey. Indeed, the first few years of his reign seemed like a welcome change to revolving governments that had plagued the 1990s. By following the IMF-dictated program the economy recovered strongly from the 2001/2002 meltdown that nearly wiped out the financial system. On the back of this stability and economic improvement the AKP won subsequent elections by ever-increasing margins. Since that last election in 2011, the wheels have started to come off the Erdoğan bandwagon and he has reacted like any autocrat. His brutal suppression of the Gezi Park protests last spring, wholesale purge of the judiciary and police, and increasingly bitter struggle with his one-time ally Fetullah Gülen are merely the latest symptoms of his intolerance for any and all dissent. Very few people now will take the prime minister's rosy economic forecasts at face value. Indeed, with revelations about shady gold trading, some are beginning to wonder of the previous strong numbers were not inflated or based on very weak foundations.

It’s too early to conclude what the immediate impact of the Central Bank’s rate decision will be. The construction boom that has turned much of Turkey into a huge building site could slow down sharply. Some of the prime minister’s massive infrastructure projects could be slowed or stopped entirely. Development of the new airport, for example, was thrown into some disarray when the contractors that won the bid were caught up in the ever-widening corruption scandals. 

The real tragedy is that Turkey could be a major economic power. It has a talented work force, large domestic market, decent financial system, entrepreneurs, strong industrial infrastructure, and an advantageous location close to major markets. But until the serious underlying problems of the political/economic administration are addressed this potential will remain just that – potential instead of reality.

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.

Back To The Barracks

There has been much breathless reporting about the sudden resignations of some of Turkey’s top military officers on the eve of the annual meeting where senior promotions are made. The reports would have us believe that these resignations signal the military’s deep discontent with the ruling Justice and Development Party (AKP).

The fact that much of the officer corps does not like AKP is not exactly hot news. What really annoys the officers is that there is very little they can do about it. Their once dominant role in Turkish politics has been steadily eroded over the last few years. The military used to regard itself as the only true defender of Ataturk’s Turkey. As such they could decide what was good or bad for the country. Politicians and the democratic process in general were viewed with deep suspicion, and both were dispensable if the need arose.

This was before the advent of AKP and its dominant leader, Tayyip Erdogan. Bolstered by his unprecedented popularity and stunning success at the polls, Erdogan has turned the tables on the military. He is now the one who dictates policy and determines what is good or bad for the country. The military has forced into a subordinated role similar to the military role in most real democracies.

Erdogan maintains this is all done in the name of democracy. True, but there is an undeniable element of revenge. It was the military, after all, that suppressed the forerunners of AKP and supported the jailing of Erdogan himself on charges of inciting tensions in the country. AKP justice officials have returned the favor by jailing several high-ranking military officers on charges (as yet unproven) of plotting to overthrow the civilian government.

In a broader context what has happened to the military merely reflects the larger changes in Turkish society since AKP came to power in 2002. The traditional aggressively secular economic/social/bureaucratic elite that had basically run the country for the last 70 years has been pushed aside by a new elite based in small towns around Anatolia instead of the power centers of Istanbul, Izmir and Ankara. This new elite is socially conservative and angry at the second-class treatment they had to endure for the first 80 years of the Republic. I remember clearly a meeting with one of these Anatolian elite in 2004 when he said the traditional power structure had “abused Ataturk’s legacy for their own ends. It is our turn to rule now.”

A good friend of ours is a charter member of the old elite. He and his wife have busy professional lives and their children go to the one of the best universities in America. He recognizes the changes and says they are not all bad.

“There is a reason that Erdogan gets 50% of the vote. His people work extremely hard. There is no question that the living standards of the lower-middle classes have improved dramatically. For the first time they feel that someone is actually working for them.”

“Just look at Istanbul. The city is much cleaner and public services have improved dramatically. I voted for the opposition party because I think we need a strong opposition, not because I thought they would do a better job running the country. They wouldn’t. Let’s face it. AKP represents the real face of Turkey. We’re not France or Switzerland. We’re Turkey. The so-called Islamic trend is way overdone. The worst thing you can say about many AKP supporters is that they are very conservative country bumpkins. That hardly makes them Islamic fundamentalists.”

“They may have as many corrupt officials as any other Turkish political party, but,” he adds with a wry smile, “at least their corruption appears to be productive.”

Whether Erdogan is becoming a typical autocrat supremely confident in his own opinions and deaf to all criticism is another matter altogether. But for the moment there is no denying that he is the most dominant force in Turkish politics for several decades.

One threat to AKP’s dominance is the economy. They came to power on the back of Turkey’s worst economic crisis, and gained increasing popularity as the country climbed out of that hole and grew rapidly. Erdogan continues to insist that the economy is fine and that Turkey will avoid the problems affecting many other countries. He does not acknowledge, in public at least, the gaping current account deficit, or increasing inflation. Turkey’s continued economic growth depends largely on continued external funding, and there are signs that could become more difficult. Interest rates on two year government bonds are about  8.5 – 9%  and inflation is at least 7%. How long are these very slim real rates of return going to entice investors? One leading economist believes rates will have to increase soon, and this could put some people like real estate developers in a tight spot. Turkey’s growth has been fueled by rapid credit expansion driven by demand for homes and cars. What happens to those borrowers when their interest payments shoot up? Who will they blame? For the moment Erdogan does not want to hear these doubts, but sooner or later inconvenient, very hard economic truths will begin to intrude on his version of reality.

Tragedy Becoming Farce

The woeful state of Greek economic and political affairs is about to cross the thin line from tragedy to farce. So far the Greeks are way ahead of the other European Union players – after all they invented the art form. In fact, only someone like Euripides or Aristophanes could do this situation justice.


This tragic farce in Three Acts has the following dramatis personae including the off stage choruses of wailing people, foreign banks and hedge funds.

In Act One we have:

Happy Greek People
Happy Greek Banks
Happy Foreign Banks
Happy Politicians
Silent Economists
Silent Eurocrats

Act One opens with the Happy People dancing and borrowing from the Happy Banks to spend money they don’t have. Need a vacation? Call your friendly Happy Bank. Need a car or a gift for your wife or mistress? Call your friendly Happy Bank. The banks lend much more than the deposits they have and are confident in getting cheap loans from Europe to cover the difference. Don’t have a job to repay the loan? Don’t worry. Your Happy Politician will fix that. Government needs money to pay for all this joy? No problem. Borrow from the friendly Happy Foreign Banks. Why not? Thanks to this marvellous invention of the Euro the rates are so low it’s almost free money. Some junior economist in Brussels sees a tiny problem with all this happiness because somewhere, somehow, this money is supposed to be repaid. Before this junior economist named Ernst can voice his doubts too loudly his fellow Eurocrats send him on a two-year fact finding trip to Central Africa.


In Act Two we have:

Less Happy People becoming Angry People
Stiff Upper Lip Greek Banks
Nervous Foreign Banks
Nervous Politicians
Very Happy Hedge Funds
Suddenly Righteous Eurocrats
I-Told-You-So Economists
Baroness von Brandenburg
Sly Duc de Versailles
Bewildered Vikings
Stern Headmaster
Loud Choruses

Act Two opens with storm clouds over the Acropolis, offstage clashing of cymbals, angry wails from the chorus. We won’t pay! This is not our problem! Nervous Politicians discover that the cash drawer is empty. No money can be repaid. Something Must Be Done! Cuts! Austerity! And, God forbid, Taxes! Offstage chorus of whinging masses becomes louder. Delighted hedge funds set up an opposite chorus. Default! Default! You’re Broke! Admit It! The I-Told-You-So Economists are indulging in an orgy of self-congratulations at one of the few times their predictions actually came true. Self-righteous Eurocrats proclaim loudly that they are shocked, shocked that Greece is broke. How can this be? You told us you were a member in good standing of the Euro Club! We took your numbers at face value! You mean they weren’t true? Say it’s not so! The Baroness von Brandenburg proclaims that good, thrifty Northern European (German) taxpayers will not pay one more pfennig (oops, Euro) to the shiftless bums stealing money for their holiday homes on Aegean islands. The Sly Duc de Versailles, whose banks own about €30 billion of Greek paper, rushes to the baroness’ side to plead for caution. His pleas are accompanied by another loud chorus of Contagion, Contagion, Contagion. Think of Ireland, Portugal and Spain.

 -You’re absolutely right Baroness. They are shiftless bums that don’t deserve another centime. But    let’s not be hasty here. Remember all those nice Teutonic toys, those Volkswagens and Mercedes they bought with all that money we gave them? All those nice roads and airports you Germans built. Maybe we can find you a nice little island. Just a few Euros more and we’re out of the woods here. Now is not the time to be pedantic.

Then the Bewildered Vikings start complaining about all the money they’re spending on Greece. The Duc de Versailles flies into action once again as the Vikings get nervous.

- How can this be? How can a country not know how much money it has or doesn’t have? This does not happen in real countries! This should not happen!

-That’s the point Olaf. You’re absolutely right. But how many times have I told you to forget the word ‘should’ when talking about the Mediterranean. It works with your reindeer and igloos, but loses a lot in translation when you head south.
- But . . .
- Sit, Olaf. Calm down. Just a few more Euros and we’ll pretend this never happened. Just raise your hand at the right time and we’re home and dry – or whatever you say up on the glaciers.

The Stern Headmaster, who knows the real condition of European banks, is petrified at the thought of default. Impossible, he thunders. At the same time he knows full well that he, or his lucky successor, is going to wind up with most of the dud Greek paper.

The Baroness and the Duc finally agree to have the sturdy, frugal, work-ethic obsessed Northerners make extra payments on the condition that the Greeks completely reform their economic life and become more like, well, Germans.

Cue puzzled looks by Nervous Greek Politicians. Reform? What are they talking about? We’ve been doing this for years. Oh, I get it. They want us to agree to their terms. Of course we will. How simple. We’ll agree to anything. Actually doing anything is another matter, but agreeing is easy. This is accompanied by much offstage banging about, shuffling of chairs, and loud cries heard by the audience. Oh, do be quiet and do what you’re told for once! Don’t you realize we have the upper hand. They have to give us the money or they go bust along with us. Just shut up and go through the motions of these so-called reforms. Then things will return to normal. Trust me.

Curtain.

Act Three opens with more wailing by the chorus of Angry People. The Sly Duc de Versailles once again takes the centre stage he loves so much.

-See, my friends. There is a magic word here. Pretend. This is what the Baroness and the Vikings don’t really understand. You don’t have to Do anything. (He shivers at the very thought of this.) But we pretend to pay the Greeks who immediately turn around and give the money back to our banks for all those nasty Greek bonds. The Greeks pretend to reform, jettison a few hapless cabinet members pour encourager les autres, and in a few years everyone has forgotten about this petite je ne sais quoi. The only people left holding the bag, as you Anglo-Saxons put it so well, are the Stern Headmaster and the people at the IMF who, tant pis, seem to be without a leader at the moment. They will perhaps understand in about five years what a great game this all was.

He gives a very Gallic What Else Can I Do shrug and slithers off the stage.

Meanwhile the Eurocrats are left with a problem. How to make sure the Greeks at least try to implement some of the reforms? The solution? Find someone to go to Athens to oversee the process. Who better than young Ernst? Honest and dependable young Ernst, and, more important, expendable young Ernst. An urgent call goes out to Central Africa to find young Ernst, if possible, and bring him home.

Young Ernst is dispatched to Athens with firm instructions to make sure the shifty Greeks stick to the Northern European plan. His zeal distresses his Greek counterparts no end, and they particularly don’t like this business of working through lunch and even on the weekends. At last they come up with a solution. They call upon shapely young Maria to do her national duty and introduce this handsome young Teuton to the ‘lighter side of Greek life.’ In time nature takes its course and the work hours begin to slip, the cigarette and ouzo breaks become more frequent, and Ernst’s reports back to Brussels and Berlin get shorter and shorter.

In the final scene we see the sun setting slowly over an Aegean island, and Young Ernst, clad only in shorts and adorned with a new tattoo, is dancing the sirtaki with Maria to the sounds of bouzouki music. Happy People have once again returned to a Happy Country.

                                                             The End

Returning To The Drachma Is Not The Answer

Writing about the Greek economy is like trying to catch a ball rolling rapidly away from you down a steep hill. The moment you write something, that ‘something’ becomes outdated by yet more very strange behaviour by Greece’s juvenile political class.


As the country stands on the brink of bankruptcy the major political parties still cannot work together on a common solution. My favourite comment comes from a former cabinet minister who loudly proclaimed he was against the structural reforms required for the country’s financial life line. “Our economic policy has failed, and we are putting the achievements of the last 25 years on the auction block,” George Lianis said today in the Financial Times. Achievements?! What achievements is he possibly talking about?

Does he mean the bloated state payrolls with an unrealistic retirement age and pension benefits? Or possibly he is referring to the rampant corruption in many sectors of the Greek economy. Maybe he is referring to the highly efficient, competitive state run companies. Just possibly he means the very effective barriers that the state has placed in the way of anyone trying to build a business, employ people and increase productivity. Please, Mr. Lianis could you be a little more specific? Unfortunately his comments are typical of the nonsense that passes for mature political and economic debate in Athens these days.

There is, unfortunately, no easy way out of this very deep hole that Greek politicians have dug for themselves over the last several decades. Anyone who thinks the solution would be to drop out of the Euro and adopt the old national currency, drachma, should think again. Far from helping Greece such a move would make any lasting reform and recovery even more difficult. To see the folly of such a move without fundamental economic reforms people should simply look across the Aegean at the experience of Turkey during the ‘lost’ decade of the 1990s when runaway inflation and a disappearing currency were the order of the day.

I remember those days very well when annual inflation averaged 60% - 70% and it took more than 1,000,000 Turkish lira to buy one U.S. dollar. There was a daily race to see if the pace of the currency depreciation could keep up with the inflation. One time I was giving a presentation in Switzerland, where they take currency stability very seriously indeed, and was asked an embarrassing question at the end of my talk. One disbelieving Zurich banker stood, checked his notes, and asked if it was true that the currency had depreciated 5% during my talk. Alas, I had to tell him that was very possibly the case.

The disappearing currency really didn’t benefit anyone because merchants would rapidly adjust their prices or simply list the prices in a hard currency. Prices in the Grand Bazaar, for example, were almost always in U.S. dollars, and now they are in Euros. Tourism prices like hotels were always listed in hard currency. What was worse was that much of the country’s mounting sovereign debt was also denominated in hard currency, and that meant that more and more Turkish Lira had to be printed to meet the interest and principal payments.

The corrosive nature of this condition was temporarily obscured by bursts of high growth and very, very high corporate profit margins. Companies would adjust prices upward much faster than they would increase wages, pay taxes, or contribute to the social security fund that was always in large deficit. Lending by banks was much less important than their buying and trading government securities. The government needed the banks to buy this paper when not many other people would touch it, and the banks loved the high interest rates.

The music to this mad dance finally stopped in February 2001. The day that Turkey was facing one the largest bond redemptions in history the prime minister got into a hissy fit with the president and went on television to announce that he could no longer work with him. We all watched horrified as interest rates soared to near 1,000% and the currency lost more than 50% by the close of trading. The long-running financial charade quickly unravelled, and 20 banks went out of business in the aftermath of this mess.

The time for gimmicks and covering bad management by printing more money was over. As a Turkish saying puts it, “The sea ended.” This time it ended on the rocks and not a nice smooth beach. What saved Turkey and put it on the road to sustainable growth, a solid financial system, and more transparent public finances was a rigorous reform program prepared by the International Monetary Fund and administered by serious Turkish officials.

The current ruling Justice and Development Party (AKP) swept into power in the 2002 elections on a wave of voter disgust at the failures of the previous regimes and the promise of continuing economic reforms. To a large degree AKP’s electoral success ever since 2002 is due to the country’s continuing economic success story. Yes, there are weaknesses in this story, but no one can deny the vast improvement over the economic management of previous governments. The improvement was so great that the currency is no longer a national embarrassment since the government removed six zeros from the denominations a few years ago.

The recovery in Greece will be long and painful in the best case, and the current behaviour of the political class only means that it will be longer and more painful than it has to be. Turkey showed that old economic taboos like fighting privatisation can be broken and that government finances can be made more transparent. Greece could do worse than to look across the Aegean for the model of how to do this.

So Far So Good, But Can It Continue?

The Turkish economy has put up some glittering numbers in the past few years. GDP growth has averaged 4.5% from 2002 – 2009 and is expected to exceed 6% in 2010. Per capita income has risen to about $10,000. The US Dollar index of the Istanbul Stock Exchange rose a healthy 20% in 2010. Foreign trade is booming. The banks avoided the toxic asset crisis that hit so much of the United States and Europe and now enjoy healthy capital adequacy ratios. On Jan. 14 spreads on Turkish 5-year Credit Default Swaps were only 143 basis points compared with 1,005 bp for Venezuela, 965 bp for Greece or 541 bp for Argentina. All in all an enviable performance.


But, behind all that a glitter there are major structural weaknesses that could slow down or even de-rail this strong performance. Turkey has been one of the main beneficiaries of a benign environment for emerging markets, and the rush of volatile money into the country over the past few years has literally papered over the weaknesses. Fund managers desperate for decent returns have fled the near-zero interest rate environment of the American and European markets for higher interest rates available in emerging markets like Turkey.

The major crack in the structure is Turkey’s gaping current account deficit, basically the country imports far more than it exports. Exports have shown impressive growth from $36 billion in 2002 to an estimated $112 billion in March 2010. Unfortunately, import growth has been even more impressive from $51 billion to $180 billion in the same time. The size of the gap by itself is worrying, but manageable. The real problem is that this deficit has become a permanent and growing feature of the Turkish economy while the methods of financing it are deteriorating. Essentially, Turkey depends upon short term, very volatile inflows to finance this long term and growing deficit.

The problem is not just that Turkish citizens have suddenly developed a taste for fancy European cars, Cuban cigars, or Hermès scarves. They have, but consumer items are still a small percentage of total imports. The deeper and more serious nature of the Turkish current deficit is exhaustively covered in a paper prepared by the staff of the Central Bank in March 2010. Unfortunately this paper is available only in Turkish, and it did not get the exposure it deserves.

The main conclusion of the paper is that since the 1980s the structure of the Turkish economy has changed rapidly from one based on agriculture, textiles, leather goods, and a few raw materials to one where foreign trade and manufacturing play a much larger role. Today the growth engines of the Turkish economy are major industries like automotive, home appliances, televisions, steel, and processed foods. And each of these relies heavily on imported raw materials and equipment.

Another major problem for Turkey is that it imports just about all the oil and natural gas it uses. That bill alone amounted to about $30 billion in 2009. It only gets worse as the economy grows and uses more oil and gas. Turkey has also benefitted from relatively depressed gas prices and moderate oil prices of the past few years. This situation could change for the worse at any minute as energy demand increases sharply with improving economies in Europe and the United States and prices begin to escalate.

Even excluding oil and gas imports, the authors of the Central Bank study did a survey of major Turkish companies that revealed imported raw materials and equipment averaged 67% of total manufacturing expenses in 2007. Sample import percentages were 87% in petroleum/chemicals, 83% in electronics, 65% in electric equipment, 58% in transport, and only 25% in furniture. Turkey does have large forests to provide plenty of wood for furniture.

According to the study, it is precisely those sectors with heavy import content that have fuelled the sharp increase in Turkish exports. Since 1996, for example, the share of textiles and clothing in Turkish exports has fallen from about 15% to less than 8% in 2008. The share of agricultural product exports fell from just under 10% to about 3% in the same time. Meanwhile the share of automotive exports has risen from 4% to 14%. Exports of other major industries that were small or non-existent in the 1980s, i.e. home appliances and televisions, have also surged in the last 10 years. These industries also have high import content.

One of the factors aggravating this situation, according to the report, is that the supply chain in Turkey is underdeveloped. Manufacturers are forced to look outside for inputs. A couple of examples highlight this dilemma. A friend of mine brought a group of colleagues from Silicon Valley to Istanbul to establish a company producing high quality internet and VOIP products. All the engineering work is done in Istanbul, but he has to have the manufacturing done in Taiwan. Turkey simply does not have companies capable of supplying the required high quality work. Another friend has a company producing very good cotton shirt fabric for export mainly to Europe. Despite the fact that the company is located less than five miles from one of Turkey’s largest cotton fields he imports every gram of cotton from the United States and Egypt. He said domestic cotton is more expensive and much lower quality. Even the best weaving machines have to be imported.

The government is trying to address these problems by working to improve the technological component of domestic companies as well as encouraging home grown technology companies. This is admirable, but the results will not show for a very long time long time. And time is a luxury Turkey does not have.

Turkey has to continue on a high growth path to address its serious unemployment issue. The official unemployment rate in 2009 was 14%, and was even higher in the urban areas. The relatively young and growing population is only going to put more pressure on these employment statistics. The conundrum is that the faster it grows the larger the deficit becomes.

Further complicating the issue are the national elections scheduled in about six months. It is unreasonable to expect any government to exercise restraint in the pre-election period. Deputy Prime Minister and Economy Minister Ali Babacan and his colleagues in the Treasury have done a very good job up to now controlling the economy and managing the country’s debt. Their skills will be sorely tested in the next few months.

Again, the problem is not so much the size of the current account deficit itself as the deteriorating means of financing it. Ideally one would match the long-term built-in nature of the current account deficit with long term funding that comes with foreign direct investing. This number, unfortunately, is dropping sharply in Turkey. For years it was an insignificant amount, and then took off in 2005 when it reached $10 billion. The peak was 2007 when FDI amounted to $22 billion. By 2009 it had fallen to $8.4 billion, and will be even less in 2010. The result of this decline is that Turkey has to rely even more heavily on debt and portfolio flows to cover the gap. The conditions for the past few years have been ideal for doing for doing just this. Even though Turkey has not yet been given an Investment Grade rating by the rating agencies, its superior debt management has resulted in moderate interest rates for its debt. In addition, the herd of portfolio managers seeking higher returns has been flocking to emerging markets.

So far so good, but this beneficial environment can change overnight with moves by central banks in the United States and Europe to end quantitative easing programs and tighten their monetary programs. Sooner or later this will happen. But only the very brave, or foolish, are willing to predict exactly when. However, as we have seen so many times in the past, when this happens there will be a stampede into the ‘new’ opportunities leaving countries like Turkey somewhat in the lurch. Turkish officials have done a good job managing the economy through the global crisis, but the real challenge could lie in the future when global investment trends that are completely out of their control change suddenly leaving a very large hole in their accounts.

Keep The Patient Alive

The European Union’s remedies for the economic problems of Greece and Ireland remind me of the American military approach to Vietnam. Destroy entire villages in order to ‘save them from communism.’ The EU and IMF efforts to rescue the Greek economy from its well-noted self inflicted wounds seem to be destroying any chance the country has to achieve any growth at all, let alone the growth required even to begin to repay its debts.


The indictment of the Greek economy is very long, and every one the charges is valid. Irresponsible borrowing, bloated government sector, ridiculous bureaucracy, interesting national accounting, failure of tax collection, protection of several industries, over-generous pension system, corruption, etc., etc. In short, Greece had preserved in aspic the last Soviet economy of Europe. It was a colourful museum display, but sadly ill-suited to the real world. The announcement late in 2009 that the country would have trouble repaying its debts was merely the rude awakening from the decades-long nightmare suffered by anyone who had tried to do business in Greece.

However, the self-righteous anger of the Germans and others at having to bail out this fiscally-challenged distant relative is overdone. Their mutually exclusive insistence that Greece do a root-canal on its entire economic structure by becoming, well, more German and simultaneously repay its debts on time is ensuring that Greece slides ever deeper into a hole from which it will emerge only with great difficulty.

Anyone who can count to 10 without using his fingers knows that Greece will have to, at the very least, reschedule some of its debt and get an extension on repayment of the €110 billion European bailout. The economy has ground to halt. Consumers aren’t spending what little cash they have. Banks are hoarding their funds and not lending very much. Even the almost daily demonstrations have lost their zip.

Sales of electronic consumer goods were down 30% in October. Car sales in September were down 44% in September. These figures, bad as they are, don’t tell the whole story. One leading retailer told me the damage extends beyond declining sales. Suppliers, once happy with long payment terms, are now demanding faster payment. Insurance cover for the goods is getting more expensive. Terms of whatever bank loans he gets are becoming more difficult. All of these issues cause a company’s cash to drain rapidly.

The only items that seem, based on observation, to have resisted sales decline are cigarettes and coffee. Coffee bars are filled with people – and smoke. Greece did at one time enact a non-smoking law. But the public outcry about having to cope with the unbearable stress of changing their economic lives without the comfort of a smoke was too much for any government. Besides, in a country where no one can collect income tax, how zealous are they going to be about stopping someone from lighting up in a restaurant?

The long term prescription for the Greek economy is correct. All the deeply ingrained imbalances absolutely must be corrected, but right now the patient needs food and water if it is not to become a permanent ward of the European Union. Exactly how this is accomplished is a problem for the European leaders, but the reform process must be accompanied by a serious amount of cash if the Greek economy is to reach sustainable recovery.

The trouble is that the leaders of the European Union appear as confused as the man on the street. The prime minister of Luxembourg and the Italian minister for the economy and finance recently wrote an essay in the Financial Times that called for issuing Euro-wide bonds. In the very same newspaper the German finance minister poured cold water on that idea. The next day German Chancellor Angela Merkel officially drowned the idea at birth. EU president Herman Van Rompuy says ‘something’ must be done. He says the fate of the European project is at stake. With so many people hyper-ventilating it is difficult to plot a smooth course.

Austerity alone is not going to solve the problem. Trying to force austerity on people like the Greeks who associate it something cold and northern is a little like forcing Ann Widdecombe into one of Carla Bruni’s bikinis. There will be slippages. Sooner rather than later the people of Ireland, Greece, Portugal and Spain simply will no longer accept the degradation of their life styles for what they believe is only the salvation of the banking system. This could open the door to large-scale social upheaval and the emergence of people with dangerously simplistic answers. Then, instead of carefully planned re-scheduling we could wind up with immediate in-your-face defaults as a popular policy tool. Argentina provides a clear example of the attractions of this course for unscrupulous politicians. The results for the financial stability of Europe would be much more severe than voluntary, carefully planned action.

But the first goal should be to keep the patient alive. In contrast to the Europeans the Americans seem to be focusing on immediate health issues as the Federal Reserve continues to pump money into the economy. Long-term therapy is a luxury usually reserved for patients who at least have a pulse, and right now the economic pulse of Greece and others barely registers.