Turkish Tailspin

After weeks of domestic turmoil, is Ankara losing control of the economy?

As the protests in Turkey enter their third week, Turkish Prime Minister Recep Tayyip Erdogan remains defiant, claiming during his weekly speech to the Justice and Development Party's (AKP) parliamentary group meeting that law enforcement acted with "common sense" when it responded violently to anti-government protests and that he would "expand the powers of the police." The prime minister's speech came just days after he dispatched riot police to clear demonstrators from Istanbul's Gezi Park, sparking renewed clashes in cities across the country. The violence has since subsided and demonstrators have taken to standing silently in public to express their discontent, but weeks of unrest have taken their toll on Turkey's financial markets and eroded investor confidence -- an ominous sign for Erdogan, whose electoral success has depended in large part on the strength of the economy.

Erdogan and other senior members of the ruling Justice and Development Party (AKP) have blamed the protests on "foreign circles" uncomfortable with Turkey's economic and political progress. The country's economy minister, Zafer Caglayan, even went as far as accusing an international "interest rate lobby" of conspiring to seize $1.5 trillion from Turkey in the past 30 years. He was echoing previous statements by the powerful prime minister, who has paid special attention to Turkey's own interest rate over the years. In particular, Erdogan has argued that the rate should remain close to zero in order to prevent the same "interest rate lobby" from taking advantage of Turkey.

It remains unclear who exactly is behind the prime minister's nefarious -- if non-existent -- interest rate lobby, though one pro-government newspaper has identified it as a secret alliance between Jewish financiers, members of Opus Dei, and the Illuminati -- all of whom are working together to tame Turkey's impressive economic growth. More prosaically, Erdogan is probably referring to the chorus of investors, financial journalists, and other analysts who have called for Turkey's benchmark interest rate to be raised to combat inflation. (The prime minister favors low benchmark interest rates in order to help stimulate the economy).  

Following the 2011 election, most observers expected Turkey to tighten its monetary policy so as to dampen inflation and slow its overheating economy. However, the independent Turkish Central Bank (TCMB) opted to cut the benchmark interest rate instead. It argued that following standard monetary policy and raising interest rates would attract more short-term portfolio funds -- of the type Turkey relies on to finance its current account deficit, which as of April stood at roughly 6 percent of GDP -- but also make the country more susceptible to external shocks, since these investments can move quickly out of markets.

The TCMB, therefore, opted to pursue a rather unorthodox strategy aimed at curbing the appreciation of the Lira and decreasing bank loans. The policy, known as an interest rate corridor, allows the government to vary its rates between the lower benchmark rate and the much higher overnight lending rate. In essence, the policy represents a compromise between the independent TCMB and Erdogan -- which in turn raises questions about the prime minister's influence in Turkish financial decision-making.

The policy has had mixed results. On the one hand, the economy slowed considerably, with GDP growth cooling from 8.8 percent in 2011 to 2.2 percent in 2012. On the other hand, private lending continued at a high pace, despite the TCMB's higher overnight lending rates. The engineered slowdown did help narrow the current account deficit -- driven to unsustainable levels by Turkey's roaring GDP growth -- and curb inflation, but worries about the country's reliance on short-term financing persist. Going forward, there are signs that Turkey's economic balancing act may be coming to an end.

Turkey's perpetually high current-account deficit -- which varies between 6 and 10 percent of GDP -- is a long-term structural issue for the economy. In order to finance the current account deficit, Ankara relies on both foreign direct investment (FDI) and short-term portfolio flows. But Turkey's long-term FDI has slowed, leaving the country at the mercy of portfolio flows and vulnerable to external shocks -- whether it be independent actions by the U.S. Federal Reserve or the European Central Bank, or domestic political unrest. The bottom line is that Turkey's dependence on speculative money -- which goes out as easily as it comes in -- puts the economy at risk.

In a worrying sign for the Turkish economy, money has recently begun to flee developing country markets for bonds in the United States. And while the retreat from investing in emerging markets began before the protests erupted in Turkey, the unrest has certainly called into question the country's political stability and hastened the monetary retreat from Turkish markets.

The capital flight began in late May, after Federal Reserve Chairman Ben Bernanke telegraphed his intention to taper the $85 billion in bonds that the Fed is buying each month. If the Fed does decide to slow down its stimulus plan and U.S. bond yields continue to rise, countries with high-current-account deficits -- like Turkey -- are particularly vulnerable.

Also worrying for the Turkish economy is the poor performance of its currency. In May, the Lira hit its lowest value against the U.S. dollar in 17 months. The protests have exacerbated this downward trend and eventually forced Turkey's central bank to intervene to prevent the Lira from depreciating further. On June 12, it auctioned off $250 million to Turkish banks to help prevent the further depreciation of the Lira. While the auction did manage to stabilize the currency, Turkey's capacity to intervene further remains limited. One potential option to combat this weakness is to raise interest rates, but Erdogan has remained steadfastly opposed to this option, maintaining that low interest rates are vital for Turkey's economic success.

Despite these difficulties, the Turkish economy grew at an annualized rate of 3 percent for the first quarter of 2013, though this is well short of the country's 4 percent growth target for the year. In reality, the economic picture is far more complicated than the economy minister -- or Erdogan -- would like Turkish voters to think. While blaming phantoms may appeal to some segments of the AKP's base, it papers over the political and economic conundrum now facing Turkey's leadership.

The protests have already dented Turkey's tourism industry -- a key source of revenue for financing the current account deficit -- and the combination of a slumping EU economy and the various crises in Middle East has made it harder for Turkey to export its way out of economic malaise. Ankara will therefore have to rely on domestic demand to fuel economic growth, which will inevitably increase the country's current account deficit -- in turn making it even more vulnerable to the whims of the U.S. Federal Reserve. While Turkey's economy is not going to collapse because the continued protests, the future is nonetheless gloomy. As a result, the AKP will most likely continue to focus on placing the blame elsewhere, rather than face the combined pressures of domestic unrest and central bank decisions abroad -- both of which may have a profound impact on the Turkish economy going forward. While Erdogan has no influence on the Fed, he could opt to try and mimic the protesters and stay silent, in order to at least dampen the growing feeling in some financial circles that he has lost touch with reality.


National Security

Time to Pull Our Troops from Europe

It'll help solve the Eurozone crisis. Seriously.

While traveling this week to Europe, President Barack Obama has an opportunity to begin a bold initiative to realign the transatlantic relationship and advance America's interests in further European integration. The G8 summit began Monday morning with the announcement of a new U.S.-European economic initiative -- the Transatlantic Trade and Investment Partnership -- which could open up a U.S.-EU free trade zone. That is an excellent start. But, as the United States continues to pressure its NATO allies to increase their domestic military capabilities and lessen their reliance on the United States, European allied defense spending remains a serious irritant in transatlantic relations -- and it's the wrong priority.

Impressions of European "free-riding" on the United States for military operations have been deepening in Congress and among the American public for years now. This resentment was foreseen long ago by George Kennan, who warned in 1948 that NATO incentivized European dependence on the United States, writing, "Instead of the ability to divest ourselves gradually from the basic responsibility for the security of Western Europe, we will get a legal perpetuation of that responsibility." Kennan believed, rightly, that "the political will of the U.S. people is not sufficient to enable us to support Western Europe indefinitely as a military appendage." Yet, even since the Cold War ended, the United States has sought an expansive role for NATO while criticizing allies for not spending more on defense -- without realizing its own role in perpetuating European dependency.

NATO has become politically unmanageable, militarily dysfunctional, and now risks strategic irrelevance. Operations in Kosovo, Afghanistan, and Libya demonstrated serious difficulties in decision-making by consensus and dangerous operational inefficiencies. When America sought to "lead from behind" in Libya, it was, months into the war, still providing the primary enabling forces. In the recent French intervention in Mali, the United States was called on to supply similar, and expensive, capacities to sustain military operations. America's European allies have no incentive to change this burden-sharing problem knowing the United States will fill operational gaps, freeing them to make massive cuts in the name of austerity.

The primary and enduring security problem in Europe is the ongoing Eurozone crisis, which has forced sharp budget cuts across Europe and strained relations in the European Union. Thus, the last thing that Washington should do is ask allies to increase defense spending. America's European allies, collectively, have substantial capabilities; the problem is not how much they spend, but rather how they coordinate. President Obama should change the incentives for America's NATO allies to produce mutual gains across the Atlantic and strengthen the ties that bind America and Europe.

First, he should limit America's NATO role to Article V collective defense, which, in the current environment, means its main contribution to NATO would be ballistic missile defense. Second, given the current threat environment, he should announce further reductions in America's troop presence in Europe, especially U.S. Army forces. By 2015, land forces will be about 30,000 troops -- but these should drop close to zero. Third, the United States should state clearly it will help the allies build and sustain the capacity to fight a Libya-style war and a Balkans-style peace operation without American involvement. Fourth, he should relocate U.S. European Command, Eucom, to the United States -- modeling it after Central Command, which is based in Tampa, Florida.

Eucom has become largely a supporting command; it once had a major role in Persian Gulf security and broader contingencies like Afghanistan, but Centcom now has the lead for operations in the Gulf and South Asia. It has pre-deployed assets in the Gulf that no longer make European deployments essential. The United States could retain its presence in Europe by keeping air command facilities at Ramstein, special forces and partner training centers in Stuttgart, and the U.S. naval command at Naples, while sharing the supreme allied commander position with a European or Canadian based on mission needs. The bulk of U.S. land forces in Europe would be decommissioned, brought home, or allocated to other theaters. Meanwhile, the United States should rotationally exercise with its European allies, but primarily on its own territory.

At its core, the military imbalance in NATO is an economic problem for the United States because it ties up resources and encourages allies to avoid sharing in essential military equipment and major defense reform. It is also a problem for Europe because the existing incentives move individual European nations away from deepening their integration on defense cooperation -- and thus, over time, saving money. A shift in the security burden would create a better foundation on which to advance the broader trade agenda by fast-tracking the U.S.-EU trade agreement now being negotiated. As this negotiation moves forward, however, the temptation to advance "buy American" in defense capabilities could become an obstacle -- as Americans have often viewed interoperability as meaning "based on American platforms." If Congress sees real action being taken to balance the security burden-sharing arrangement across the Atlantic, this could be an essential step towards removing potential obstacles in the broader trade deal.

Advancing this important trade agreement will show American confidence in the transatlantic relationship, which is vital to the global economy at a key moment, given the continuing threat of the Eurozone crisis. This week and in the weeks to come, the president should engage America's closest allies and friends -- particularly Britain, France, and Germany -- on this matter. Presidential leadership can also help to break the legacy of decades of bureaucratic resistance in Washington to rebalancing the transatlantic relationship. It is time for the United States to make clear to its European friends that it is their moment to assume lead responsibility for their security -- and that the United States will help them. If there is any place in the world where the United States can hand over lead responsibility for security matters, it is in Europe -- and the time is now.

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