Political Economy: Large Risks in Erdogan’s Harsh Stand

Prime Minister Recep Tayyip Erdogan of Turkey seems to like the concept of choking things. Over the weekend, Mr. Erdogan sent riot police into an Istanbul park with tear gas and water cannons to clear out the protestors. A week earlier, he had threatened to “choke” an alleged “high-interest-rate lobby” of speculators who wanted to push interest rates up and suffocate the economy.

Mr. Erdogan’s harsh actions against protesters and harsh words against investors could backfire economically. The country depends on foreign investors to fund its big current account deficit. If they turn tail in response to the mounting unrest, interest rates will indeed have to rise.

The protests, which began two weeks ago over allegations of authoritarianism on Mr. Erdogan’s part, set off by his insistence on bulldozing one of Istanbul’s few public parks, initially alarmed investors. The stock market plunged; the Turkish currency, the lira, fell; and government bond yields increased. Then, after the central bank intervened in the foreign exchange market and Mr. Erdogan offered concessions last week, investors calmed down.

But the use of riot police over the weekend stoked a conflict that had seemed on the point of resolution.

The problem is not so much that speculators have an incentive for jacking up interest rates. That would be perverse. Foreign investors own $140 billion worth of Turkish bonds and equities, according to Standard Bank. They will lose money if interest rates rise.

The risk rather is that investors will pull out their money if they lose confidence. The U.S. Federal Reserve’s indication that it may slow its bond-purchasing program has exacerbated that risk, as some of the money the Fed has been pumping into U.S. bonds has seeped into emerging markets like Turkey.

What is more, the Turkish economic miracle is not quite as good as it seems. The economy grew 2.6 percent last year, down from 8.5 percent the previous year, and the central bank had to increase interest rates because the economy was overheating and inflation reached 8.9 percent last year.

Turkey’s biggest economic weakness is its current account deficit, a sign that consumption has been growing faster than is sustainable. The deficit did fall to 5.9 percent of gross domestic product last year, after a 9.7 percent gap the previous year, as the economy slowed. But it is rising again this year. The April trade deficit was $10.3 billion, up from $6.6 billion last year.

Indeed, the sell-off in Turkey’s financial markets began a week or so before the police crackdown on protestors in Taksim Square on May 31. For example, two-year bond yields rose to 6 percent at the end of the month from 4.8 percent on May 17; and the stock market fell 8 percent between May 22 and the end of the month.

Until now, international investors have been happy to finance the deficit. Not only were they attracted by the strong economic growth, but they also liked Mr. Erdogan’s pro-market approach, the political stability they thought he had brought and the prospect that Turkey’s march toward a market democracy would be anchored by negotiations to join the European Union, said Timothy Ash, Standard Bank’s head of emerging markets research.

The “interest rate lobby” also liked the fact that the government’s debt was at 35 percent of G.D.P. and that banks had strong balance sheets, partly because they had been seared by the Turkish financial crisis at the start of the millennium. Meanwhile, the rating agencies Moody’s and Fitch recently raised the country to investment grade.

The problem is that the unrest is casting doubt on some of these positive factors. For a start, Turkey no longer looks so stable politically. Then there is the doubt being sown by Mr. Erdogan’s attack on speculators about the depth of his commitment to markets. Furthermore, the crackdown on protestors may undermine Turkey’s chances of joining the E.U. Last week, Germany suggested delaying the next round of negotiations.

The unrest could harm growth if tourists are deterred from visiting and Turkish consumers become more cautious.

A particular weakness is that the current account deficit has been largely paid for with so-called hot money: foreign investment chasing short-term returns. The share accounted for by foreign direct investment — long-term money that cannot easily run away — has been falling, according to Morgan Stanley. Meanwhile, the share made up by debt has been on the rise.

One measure of Turkey’s vulnerability to a loss of confidence is that it has an “external financing requirement” of $205 billion — about a quarter of its G.D.P. — over the next year, according to Standard Bank. This financing requirement is the sum of its current account deficit and the maturing debt it needs to repay or roll over. A more extreme measure of vulnerability would add the $140 billion of foreign-held bonds and shares. If this tries to flee, the lira could plunge.

Against this, the central bank has $130 billion worth of reserves, into which it dipped last week when it helped to stabilize the foreign exchange market. This war chest, though, is small compared with Turkey’s external financing needs. And the net reserves, after excluding foreign exchange deposited by the banking system, are $46 billion, according to Standard Bank.

So the central bank could not hold the line if the “interest rate lobby” really did run for the exits. In that case, Turkey would have to raise interest rates, which would damage economic growth.

And then the economic miracle, which Mr. Erdogan has presided over and which is one of the main sources of his popularity, might look like a conjuring trick. Instead of choking protesters, Turkey’s prime minister should try to make a genuine peace with them.

Hugo Dixon is editor at large of Reuters News.

Article source: http://www.nytimes.com/2013/06/17/business/global/17iht-dixon17.html?partner=rss&emc=rss