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 What
would be the impressions of an outside observer visiting Turkey in the last days
of 1995, chatting with the business community, shopping around in İstanbul, listening
to government officials in Ankara and looking at the latest figures for the economy?
In 1995, the GNP growth rate is a healthy 7 %, maybe more; there is no deficit worth
mentioning at the Current Account (US$ 70 million in the red for January-October,
but US$ 150 million in the black for October-October); Wholesale Price Index (WPI)
inflation at 65 % is not far from long-term trend values (average inflation for 1987-95
is 55 %); the Customs Union Agreement with the EU is ratified by the European Parliament;
the country holds a national election with 85 % participation; and everywhere there
is a general feeling of optimism and self-confidence. It would be difficult for our
visitors to believe that only a year ago the economy was in the middle of the biggest
financial and economic crisis recorded in its history; that in 1994, GNP had shrunk
by 6%. Nowhere is the capability of the economy for quick adjustment more evident
than in its relations with the outside world. Let us review the figures. In 1993,
with imports of US$ 29.800 million, there was a current account deficit of US$ 6.400
million; in other words Turkey was financing 22 % of its imports by foreign borrowing.
In 1994, the current account had a surplus of US$ 2.700 million, mainly due to a
substantial fall in imports, which decreased by 21 % to US$ 23.300 million. Then,
in 1995, while imports increased by 50 % to US$ 34.500 million (16 % above their
1993 level), the current account shows only a very small deficit, of US$ 200 million.
The adjustment came through impressive gains in foreign exchange earnings: compared
to their 1993 level, exports jumped by 43 % and invisible revenues and transfer payments
by more than 50 %.
The monthly data confirm
this quick reaction capability of the economy. Throughout 1993, the monthly current
account deficit averaged US$ 530 million and this trend continued into the first
quarter of 1994, when the first signs of the crisis became apparent. In April, however,
the current account showed a surplus of US$ 350 million; and in the 10 months from
April 1994 to January 1995 the current account generated a total F/X surplus of US$
4.500 million, averaging US$ 450 per month, corresponding to a monthly adjustment
of roughly US$ 1.000 million. This is the numerical expression of what I call the
flexibility of the economy and its rapid adjustment capability to changing circumstances.
When domestic demand collapsed and the depreciation of the TL made exports profitable,
Turkish firms immediately changed their production patterns and markets.
The second dimension
of flexibility is the relative stability on the bankruptcy front during the crisis.
By April 1994, banks were charging their private sector clients nominal interest
rates of 300 % or more while domestic demand was contracting rapidly. Normally, the
combination of such interest rates with falling demand and output results in a large
number of small and medium-sized companies and even some large ones going broke,
unable to meet their liquidity constraints. This, in turn, disrupts the whole economy
further, especially through its negative effects on the financial system already
weakened by rapid depreciation of the currency and surging inflation, and therefore
deepens the depression. None of this happened; Turkish firms of all sizes managed
to stay afloat despite the adverse conditions.
Paradoxically, one
reason behind this immunity was the relative weakness of the financial institutions,
itself a natural outcome of the long period of high inflation: the average firm had
very little debt compared to its total assets. Most private sector investments had
been financed through profits, especially in the smaller enterprises which constituted
the backbone of the economy, simply because bank credit was not easily available.
The average entrepreneur in Turkey is underleveraged and financially healthy because
it is so difficult to get loans from the financial system. Obviously, this constrained
the growth and dynamism of the economy in boom periods; but saved it from disaster
and destruction in times of crisis. On closer inspection, another link, this time
with the parallel (or so-called "black") economy can be detected. The balance sheets
and P/L accounts of most firms grossly understate their real assets and profitability.
This, of course, also provides the banks with the justification for their reluctance
to lend to these firms.
I now come to the third,
and in my view the most important aspect of the flexibility that I am trying to describe:
the flexibility of the labor markets. From January to June 1994, the real wages fell
by an astonishing 30 % (that is in TL terms; in US$ terms the average wage or salary
had gone down by more than 50 %) throughout the country. At the peak of the crisis,
after WPI had increased by 32 % per month in April 1994, many small firms asked their
workers to choose between nominal reductions in wages or redundancy. The workers
opted for the jobs. Under pressure from the shopfloor, even militant trade unions
agreed to serious real wage cuts, provided some form of job guarantee could be secured.
Still, all firms downsized their labor force, skilled and unskilled alike, to reduce
their costs in the face of the crisis. Unemployment in the classical sense, of previously
employed labor, remained a major problem until exporters could absorb some of the
unemployed. But conditions of excess supply still prevail in the labor markets.
The fall in the purchasing
power of wage and salary earners was even more pronounced in the public sector, including
the civil service. Traditionally, the collective bargaining process in public sector
companies constitutes a guideline both for the salary increases in the civil service
and for wages of the unionized labor in the private sector. Faced with unsustainable
public sector deficits, the government had no alternative to keeping nominal wage
and salary increases well below the inflation rate, even at zero in the critical
spring of 1994. Normally, public sector trade unions and civil servants react to
such measures by heavy protests, work-to-rules, wild-cat strikes, etc. Such was the
shock of the crisis on labor markets that none of this happened; amid complaints
and cries of foul play, work went on as usual. In a sense, nominal wages provided
the anchor against hyperinflation during the crisis.
Finally, a few words
of praise about the financial markets are in order. Turkey liberalized capital flows
only in 1989; most financial markets are very young and obviously lack the experience
and the expertise of their older brothers in the established financial centers of
the world. Yet, all through the crisis, their behavior was very wise, at least as
wise as that of any other market. It was the markets that rapidly understood the
policy mistakes of the government and acted to correct these. Thus, they prevented
the crisis from getting out of hand. In the winter of 1994, they forced the government
of Ms.Çiller to abandon the populist and unorthodox economic policies that
would result in a very serious balance of payment crisis. By depreciating the TL,
by refusing to lend to the Treasury or the Central Bank for any longer than overnight,
the financial markets established themselves as the architects of the Stabilization
Program signed with the IMF. Since then, they have been watching every economic policy
move by the government very closely; by moving to F/X and increasing the yields or
shortening the maturity of T-bills, they acted as an additional center of control
and discipline for the Stabilization Program.
The trouble with the public sector deficit
 How and
why did an economy with so many positive attributes dive into a crisis in the first
place? The answer lies in the deficiencies of Turkey's public finances. There is
a structural (secular) part to this problem; unsustainable public sector deficits
have been one of the main characteristics of the Turkish economy since the 1950s,
as can be judged by the steadily rising rate of inflation: the average annual inflation
for the period 1950 to 1980 is 15 %, moving up to 50 % in the 1980s, reaching finally
its current level of 75 % in the 1990s. The second part of the problem is of a cyclical
nature: populist policies, in the form of large wage and salary increases in the
public sector coupled with generous employment opportunities were initiated in 1989
by Mr. Özal and were sustained thereafter for political reasons by successive
governments. This led to a substantial deterioration in the fragile financial positions
of the state. By 1993, the total deficit in the public finances reached an astonishing
15 % of GNP. Total revenues were less than current expenditures, implying that the
government had to borrow from domestic and international markets just to pay its
wage bill.
I don't wish to bore
the reader with all the relevant data, so I will focus on a single item, public sector
savings. These fluctuated between 6 to 8 % of GNP until 1990, allowing the government
to finance the main body of the public investment (itself fluctuating around 8 to
10 % of GNP) from its own resources; the remaining funds came mainly from foreign
borrowing. From 1990 to 1993, the situation deteriorated rapidly: in 1993, public
consumption was 13 % of GNP while public saving was a shocking - 3 %, implying that
more than 20 % of public consumption was financed through borrowing. By the end of
1993 the financial markets began to realize that Ms. Çiller's government had
to borrow every month in order to pay the salaries of state employees and that this
could not continue forever.
As is the case with
any other government, a large public sector deficit and negative savings mean insufficient
tax revenues and over-generous public expenditures. On the revenue side, the main
problem has been (and still is) the narrowness of the tax base and widespread tax
evasion. Both are structural problems, going all the way back to the 1920s. The inability
of the governments in Republican Turkey to impose direct taxation on agriculture
for political reasons is viewed by many (including this writer) as the main cause
of the relatively slow and late industrialization of Turkey in the last 70 years.
The closed command-economy structure prevailing until the mid-1980s was instrumental
in concealing the fundamental shortcomings of the tax system. Income tax had almost
become an employment tax on the formal sector of the economy, and the rest of the
population paid their taxes when they bought the products of this sector at inflated
prices. Pressures of competition in an open economy forced the state to lower the
tariffs of this employment tax, but no effort was made to broaden the tax base or
to fight tax evasion in order to offset lost revenues.
All observers of the
Turkish economy agree that reform of the entire tax system is urgently needed. Income
tax should cover all types of economic activity and all sizes of firms, while tax
rates, still prohibitively high by international standards, should be lowered to
reasonable levels. This in turn requires an all-out war by the tax authorities on
tax evasion. A similar reform of property tax and the body of indirect taxes is also
necessary. Unless these reforms are undertaken, future Turkish governments will not
have the tax revenues they need in order to meet their expenditures.
On the expenditure
front, things don't look very bright either. The administration is over-centralized,
over- manned, under-equipped and generates more waste than services. The fight against
Kurdish terrorism and the end of the Cold War increased substantially the military
expenditures of the state. Public sector companies are large inefficient units, no
longer able, in an open economy, to pass their high costs on to the consumer, and
therefore running huge deficits. Privatization efforts so far have not been impressive.
Even though some sort of consensus exists in favor of it, Turkish political parties
are built precisely upon those clientalist practices that the public sector companies
permit. The social security system is already bankrupt, partly due to populist measures
that allowed early retirement, and partly because their funds have been appropriated
over the years by the cash hungry Treasury. Altogether, a total restructuring of
the administration itself is urgently needed.
These are difficult
reforms. They require strong and courageous political leadership and a stable parliamentary
majority, neither of which is yet in sight despite a newly elected Parliament. It
would be more realistic to assume that most of the problems haunting the public finances
of the country will be with us for the next few years. The only exception could be
privatization: the inability to tackle all the other issues may force the new government
to concentrate on privatization, with the hope of using the proceeds from privatization
to reduce temporarily the public sector deficit. It is also worth noting that the
current state of the public finances bar any government from going back to the wage
and salary levels of the populist cycle which collapsed in 1994.
A final word of optimism.
If the aforementioned reforms were to be undertaken quickly, the Turkish state would
find itself in a financially sound situation, because public debt, both domestic
and international, is still at reasonable levels. Even pessimistic estimates of the
net foreign debt are not higher than US$ 60.000 million, not more than 35 % GNP.
Despite very high nominal interest rates, high inflation helps keep the domestic
debt still at less than 20 % of GNP, a proportion almost negligible by European standards.
Together, these imply a very modest public debt/GNP ratio of 55-60 % on official
figures; this can be even lower if the informal economy (estimated to reach 20 %
of the official national income) is included in the calculations of the GNP.
Towards a happy (customs) union?
 Turkey's
last adventure in Europe started in 1963 when the Treaty of Ankara granted her the
special status of "Associate Member" of the European Economic Community. An invitation
by the EEC in 1978 to apply for full membership along with Greece was turned down
by Mr.Ecevit, then Prime Minister, on the grounds that the Turkish economy still
needed a period of autarky for rapid industrialization. After the market reforms
that liberalized the economy in the 1980's, Mr. Özal applied for full membership
in the European Community in 1987 but, by then, the EC was in the middle of the birth
pains of the European Union and the application was politely rejected. Finally, both
parties agreed to the implementation of the original agreement by giving Turkey another
special status, that of a Customs Union.
As of January 1st,
1996, all tariffs and customs between the EU and Turkey were abolished and Turkey
started the application of the common tariffs for third countries. Some sectors (namely
the automotive industry temporarily and agricultural products indefinitely) were
treated separately. Those parts of the Turkish legal system and regulations dealing
with foreign trade are being modified to conform to the rules and regulations of
the EU. For all practical purposes, Turkey is now an integral part of the European
single market.
Of course, there were
(and are) worries about the potential negative effects of the customs union with
the EU on Turkish industrialization. However, most of the discussions took place
within an ideological context, with the Islamist conservatives and secular nationalists
both taking a stand against the agreement for religious motives or for the sanctity
of national sovereignty. Some sections of the Turkish industry, like those producing
strictly for the heavily protected domestic market, also tried to raise their voices,
but the overwhelming majority of the business community supported the union despite
anxieties about the problems of competitiveness stemming from high TL interest rates
and the ensuing overvalued TL. Again, the customs union was seen as a "meta-economic"
choice that the country had to make in order to progress further towards becoming
a modern and prosperous democracy. If it implied some short-term costs, then these
had to be accepted and paid. The attitude of the Turkish population was not very
different: the man in the street had hopes that the union would result in better
paid employment opportunities for himself and his children, eventually leading to
the free circulation of labor, when he could go and look for well-paid jobs in Europe
if he could not find them in Turkey.
Are there really any
short term costs? If so, how big are they? And will they be offset by long term benefits?
These questions beg serious study. From a theoretical perspective, there should be
both short-term costs and long term benefits. The costs will be of micro-economic
nature, associated with the adjustment process of Turkish firms to the new environment
of customs-free competition. In domestic markets, Turkish producers will confront,
larger European companies, with better technologies, easier access to finance, and
more experienced in modern marketing methods. Some of them will not be up to this
challenge; they will either change ownership or go bankrupt. Some industries, artificially
kept alive by protection, may face extinction. All these adjustment costs are real,
yet it is exceedingly difficult to calculate them; these will be determined in the
on-line, real-time world of the markets.
The long term benefits,
again of the micro kind, are already implicit in the costs. Those Turkish companies
that survive will, by definition, have to be at least as large, cost-efficient, technologically
advanced, etc. as their European counterparts. The economy will be allocating its
scarce resources more rationally, into sectors where it has a real competitive advantage,
therefore improving upon the overall productivity and efficiency of its factors of
production. This means higher growth rates of both GNP and employment, easing the
tensions of unemployment. Of course, the union is also expected to accelerate much-needed
reforms of the regulatory framework, like consumer protection, competition policy,
intellectual property rights, etc. which, though difficult to quantify, constitute
the institutional infrastructure of successful economic performance.
However, the customs
union may have other short term benefits, of macro economic nature, for Turkey. One
item is the possibility of a substantial rise in Foreign Direct Investment (FDI)
as a result of the customs union. Until the mid-1980s, Turkish economic nationalism
discouraged foreign investment while the size of the closed domestic market limited
investment opportunities by multinational companies. In the last years, the situation
started to change and annual FDI began to stabilize at US$ 1.000 million. This is
still very low, compared to the size, potential and advantages of the Turkish market.
Annual figures like US$ 4.000 million or more seem very feasible. FDI has important
micro economic effects, like increased competition, better technology, etc., but
would also provide the Turkish economy with much needed savings without having to
borrow from abroad. It would also ease any problems that may arise in the trade balance
and the current account during the early phases of the union.
Another potential short-to-mid-term
benefit of the union, much valued by the public opinion, is based on the hopes that
it would impose fiscal discipline on the Turkish government (and the political class),
as the conditions of the Maastricht Treaty for monetary union are doing for many
of the European governments. For the government and the politicians, one way to sell
unpopular fiscal measures to the public could be to put the blame on the EU. Anything
which cuts public sector deficits, thus leading to lower inflation and interest rates,
will definitely be a welcome contribution to faster growth in the Turkish economy.
The land of the future
More than a century
ago, Disraeli is rumored to have said "Turkey is the land of the future and it shall
remain so". Well, the first part of the diagnosis is certainly true today; whether
the second part will also remain true will depend on what the Turks do in the coming
few years with their politics.
Chronic high inflation
caused by unsustainable public sector deficits, themselves the result of populist
policies and fiscal irresponsibility of successive governments are the main structural
problems facing the otherwise flexible, dynamic and healthy Turkish economy. If (and
when) this political problem is solved permanently, the Turkish economy will be capable
of generating very high growth rates; not far from those of the successful economies
of the Pacific region. I often ask my friends in business to imagine Turkey with
an inflation rate of less than 5 % and interest rates of less than 10 %; I can see
the sparks in their eyes, as they visualize all those modern factories that they
could then build, and all those shining products that they could then ship to the
rest of the world.
This is why predictions
about Turkey end up being either white or black. If fiscal problems remain, and macro
economic policy consists of alternating phases of tight and loose monetary policy,
average growth rate for the next half-decade will probably not exceed 4 %. There
will be big fluctuations coupled with dangers of balance of payments difficulties
after each phase of loose money. Inflation, the real cause of all the instability
in the economy, will remain at dangerously high levels, carrying the risks of hyperinflation
and/or financial crisis at any major political event. If, on the other hand, a serious
effort to curb the fiscal deficit is undertaken, after one or two years of relatively
slow growth (say a growth recession, of 2 to 3 %) to consolidate the dysinflation,
the economy will take off easily towards average (secular) growth rates of 6 % or
more, which would reflect much more adequately its potential for growth and development
than the image of its dismal performance in the last few years conveys.
We should also keep
in mind that slow growth caused by unsustainable public sector deficits is not just
an economic issue; it also has many unwanted social and political consequences. First
and foremost is the problem of unemployment. Slow growth of the GNP implies stagnating
employment. Yet, the Turkish population is young and growing fast and the old days
of disguised unemployment in rural areas are over: more than half of the youth live
in the cities, looking for urban jobs. If the economy cannot offer them jobs and
incomes, there will be increasing social and political tensions. This will also adversely
affect the already strained distribution of income. Turkey needs to close the gap
between the small minority of "haves" and the large majority of "have-nots". Rising
unemployment and decreasing social expenditures will only aggravate the situation.
There are reasons aplenty
both for optimism and pessimism when we look into the current state of affairs in
Turkey. The country is at the crossroads; it has actually been there for nearly 6
years already. It must restructure its public finances, privatize its state sector,
reform its central and local administration and radically reduce its public sector
deficits in order to resume high growth with stability. Otherwise, there will be
instability and no more growth. It is that simple. Like every crossroads, you just
can't sit there and wait and hope to get somewhere. You have to take a road, hopefully
the right one. That's why we have to look into the future; at least, to prove at
last that Disraeli was half-wrong.
Dr. Asaf Savaş Akat
Department of Economics,
İstanbul School of International Studies.
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