Democracy Lab

Turkey's Economy: Now for the Hard Part

The years of easy growth are over. Turkey can only sustain its economic success by undertaking bold reforms. The second in our series of Lab Reports on Turkey.

By most accounts, the Turkish economy has done reasonably well during the past decade. But the current state of affairs is nevertheless unsustainable and a rethink of the country's growth model is a must if Turkey is to break through the so-called "middle income trap." Why is this so? What is to be done? What stands in the way?

Democracy Lab's In-Depth Reports on Turkey

  • LAB REPORT 1: The Height of Hubris, by Cenk Sidar
  • LAB REPORT 2: Turkey's Economy: Now for the Hard Part, by Murat Ucer
  • LAB REPORT 3: Either With Us or Against Us, by Vanessa H. Larson

Turkey's macroeconomic journey over the past decade can be broken down into three broad phases. The first came right after Turkey's own currency and banking crisis of February 2001 and lasted until the global crisis of 2007 to 2008. Most macroeconomic indicators improved during this period. The public debt-to-GDP ratio was halved from a post-crisis peak of 75 percent, while inflation likewise dropped from around 70 percent to single digits. Thanks to a major reform of the banking sector, credit started flowing back into the economy. GDP per capita rose from around $4,000 a decade ago to almost $11,000 (in current U.S. dollars) in 2013.

The second phase began with the global financial shock of 2008, which initially sent Turkey's economy into a sharp decline: It contracted by some 5 percent that year. But recovery came remarkably quickly. Significant policy easing and an exceptionally low interest rate environment at home and abroad allowed for average growth of 9 percent over the next two years. At the same time, indebtedness grew: The credit-to-GDP ratio rose from 30 percent prior to the global crisis to 65 percent of GDP, while household debt rose from around 30 percent to some 50 percent of disposable income. The corporate sector's currency mismatch -- the gap between the sector's foreign currency-denominated liabilities versus assets -- rose sharply to $170 billion, from $70 billion in 2007, exposing it to substantial currency risk.

Now the country has entered a third phase. Trend growth is slowing visibly as the economy oscillates more or less at the mercy of global shocks such as the eurozone crisis or the reductions in quantitative easing by the United States Federal Reserve. In the meantime, public spending has quickened while private investment remains sluggish, suggesting that the private sector-led growth that Turkey's government once liked to boast about is losing momentum.

The good news is that, despite this volatility, the economy has proven relatively resilient, with growth this year forecast at around 3-3.5 percent. The bad news is that both GDP per capita and labor productivity have virtually stagnated since 2007. Moreover, inflation and the current account deficit as a percent of GDP have both remained high, at around 8 percent and 6 percent, respectively, during the past few years.

Given the current trajectory, it will be well-nigh impossible for Turkey to achieve Erdogan's ambitious plan to make Turkey the 10th-largest economy in the world (which includes raising dollar-based per capita income another 2.5 times, to $25,000). To do so, per capita income would have to grow by a massive 10 percent per year through 2023.

Optimists argue that Turkey has already done something similar before, so it should be possible to replicate it. But this argument overlooks the unique factors that contributed to the transformation of the past decade: the steadily increasing global interest in emerging markets; a pragmatic government that stuck to the blueprints and policy anchors of the post-crisis IMF program and the EU accession process; and efficiency gains that were relatively easy to reap, given the low starting base. Put differently, there was a lot of "low-hanging fruit" to be plucked, and successive governments (led by Erdogan's Justice and Development Party, or AKP) did a good job building infrastructure, helping the so-called "Anatolian tigers" to flourish, providing basic access to health and education, and so on. But growth will now have to come from more sophisticated sources -- such as technology and improvements in human capital -- as the old ones, like construction, run out of steam. Unfortunately, Turkey's readiness to undertake such efforts is debatable, to say the least. (In the photo above, a man looks out at a stalled construction site in Istanbul.)

An additional reason why repeating past performance is difficult is that Turkey achieved its current near-$11,000 per capita income at the expense of escalating macro imbalances, most notably in its current account deficit. Turkey got rich fast, but did so by living beyond its means. The current account deficit (the gap between spending and income) has trended steadily upwards over the past decade, reaching 8 percent of GDP at the end of last year, after averaging below 1 percent in the previous two decades.

The current account deficit problem is complex, driven by a chronic savings deficit and a host of competitiveness shortfalls, like low skill sets, poor tertiary education, rigid labor markets, and a lack of firm-level innovation and scale. (It does not help that the country's net annual energy import bill also runs to $50 billion.) Turkish households drew down their savings too fast, owing largely to unprecedented ease of access to credit, and productivity increases, though not insignificant, failed to keep up with the rapid real appreciation of the lira, particularly during 2003 to 2007. In fact, more than half of the growth in Turkey's dollar-based income per capita during this period was driven by the real appreciation of its currency.

So what is to be done? The answer is to start focusing on the supply side of the economy by improving productivity -- and to hope for the best, because even then, Erdogan's ambitious targets will be very difficult to achieve. Any short list of the necessary structural reforms required would include improving higher education, increasing the flexibility of labor and product markets, addressing the segmentation in the business sector, broadening the tax base, making the budget more flexible, and tackling the informal economy.

The necessity for these reforms is generally acknowledged -- as in the government's own 10th Five-Year Plan -- but there are a number of obstacles in the way of making them a reality.

For a country to reform, society at large should feel the need for and demand it. But the Turkish business community continues to muddle through as low global interest rates continue to drive short-term money its way. The public at large also appears content, thanks to the rapid income growth of the past several years and enhanced access to basic utilities and infrastructure, a comprehensive welfare network, and the creation of (albeit mainly low-skilled) jobs. There are calls for Turkey to move up in the value-added chain, coupled with warnings about the "middle income trap," but these do not translate into specific policy suggestions or an actionable debate on what needs to be done.

The other problem is the ever-increasing polarization of society. There is too much animosity between pro- and anti-government circles and too much self-censorship (on behalf of opinion leaders) to conduct a healthy discussion on the challenges facing the country and the ways of dealing with them. Anyone who makes even the most commonsensical arguments can expect to be accused of membership in the "interest rate lobby" (an international cabal conspiring against Turkey) or to be targeted by pro-government media.

In fact, there is an obvious solution to Turkey's problems: the adoption of tighter macroeconomic policies in the short term to contain demand, and structural reforms in the medium term to raise potential output. But this is politically costly. In the current highly charged political context -- several major pending elections, numerous regional headaches (wars in Syria, Iraq, and Gaza), and a potentially historic grand bargain on the Kurdish problem -- economic reform is a distraction that could cost the government crucial votes. Growth, too, will have to be around 4-5 percent in order to hold the unemployment rate down to its already high levels of around 9 percent. Needless to say, this is the priority for Erdogan and the AKP.

So reforms are unlikely to gain momentum any time soon. We will have to watch instead where president-to-be Erdogan will take us. Unlike previous leaders, he does, at least, think big: Just consider his infrastructure mega-projects, including a third bridge and a third airport for Istanbul and digging a canal parallel to the Bosphorus.

Unfortunately, the economics of Erdogan's vision does not quite add up. At the risk of oversimplification, it rests on two pillars: ultra-low interest rates and centralized, often capricious decision-making. The fixation with ultra-low interest rates is very risky when, as in the case of Turkey, economic growth depends on a continuous inflow of funds from abroad. Moreover, attempts to push interest rates far below inflation -- based on the distinctly unorthodox argument that high interest rates are the cause of high inflation, not its result -- are sure to amplify the macro imbalances, and will ultimately backfire badly.

Centralizing decision-making may sound benign, and perhaps even desirable in a country that has a long history of ineffective coalitions. But this approach, too, has huge risks. In the hands of an extremely powerful and popular leader, centralization is more likely to lead to weaker institutions and a drift away from a rules-based policy environment. Evidence for the latter has already been piling up. Even leaving aside broader questions about the future of Turkish democracy, recent developments such as the politicized use of tax inspections, verbal attacks on the Central Bank, and attempts to curtail the powers of Turkey's Court of Audits add up to a full-blown crisis of institutions.

Despite the achievements of the last decade, the economy now seems to be on an unsustainable course. Most sober observers consider Turkey to be one of the emerging markets most vulnerable to change in the global environment. For the moment, the complacency of short-term investors is buying time. Since Erdogan and the AKP were the architects of Turkey's success so far, investors are unlikely to jump ship just because the party seems insufficiently committed to orthodox reform or because the president's autocratic behavior poses a potential threat to future growth. And the global environment -- monetary policy in the United States, in particular -- is still very accommodative, and likely to remain so in the near term. So long as that is the case, short-term investors are likely to continue indulging in "Turkey risk."

But this won't work forever. A new, supply-side-focused game plan is needed if investor interest in Turkey and the popularity of Erdogan and the AKP are to be sustained. To some extent Erdogan is now the victim of his own success. Under his rule, the average Turk has acquired access to credit cards, modern infrastructure, health care, and housing. With that access comes a sense of entitlement -- and the expectation that these improvements will continue. Half of the Turkish population is younger than 30, and Erdogan's popularity may gradually erode if growth does not provide the incomes and jobs this generation now takes for granted. Moreover, stalling growth and international wariness about Erdogan's political direction mean that Turkey may have trouble finding the financing it needs. As it is, most financing is of a short-term nature, while foreign direct investment flows have slowed substantially.

Where, then, do we go from here? First, the good news: The main risk facing the Turkish economy at the moment is probably not a full-blown financial crisis. Balance sheets in the public and banking sectors are relatively strong; any excesses (in construction, for example) are relatively manageable for now. Yet there is a real danger that the economy could continue to stagnate, returning to the boom-bust cycles that plagued Turkey in the 1990s.

There is also little doubt that the next decade is shaping up to be far more difficult and volatile than the last -- unless there is a return to the sound principles that served Turkey so well in the first decade of this century: building institutions, improving skills, and opening up the public sphere for debate on the way forward. These were the policies on which the AKP focused in its earlier years. Hubris should not trap its leaders into thinking they can dispense with them now.

BULENT KILIC/AFP/Getty Images

Graphic Designer: Chloe Chik

Background image 1: OZAN KOSE/AFP/Getty Images

Background image 2: Uriel Sinai/Getty Images

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Democracy Lab

The Height of Hubris

Why an Erdogan victory in Turkey's presidential election is likely to trigger the biggest opposition backlash yet. The first in our series of Lab Reports on Turkey.

Turkish citizens are preparing to vote in an epochal Aug. 10 election that could see Prime Minister Recep Tayyip Erdogan assume the presidency -- a hitherto largely ceremonial office that he and his supporters now aim to transform into a new power center. (If he doesn't win outright with at least 50 percent of the vote, he'll face his next challenger in a runoff on Aug. 24.) Erdogan is betting that a victory at the polls will ensure his dominance over his country's political scene for years to come. The government and sympathetic media are already touting the likelihood of a landslide victory for the prime minister, clearly keen to ensure just such an outcome.

Democracy Lab's In-Depth Reports on Turkey

  • LAB REPORT 1: The Height of Hubris, by Cenk Sidar
  • LAB REPORT 2: Turkey's Economy: Now for the Hard Part, by Murat Ucer
  • LAB REPORT 3: Either With Us or Against Us, by Vanessa H. Larson

Erdogan's increasingly authoritarian behavior in recent years already has many Turks concerned about the fate of their hard-won democratic achievements. Lately, Erdogan has shown little interest in preserving a system based on checks and balances and the separation of powers. The prime minister's harsh crackdown on his political opponents and his combative rhetoric strongly suggest that he would like to see Turkey become a decidedly illiberal democracy, one in which he and his party can use the mandate of the ballot box to rule as they please, with little or no consideration of dissenting views. So it's easy to understand why Erdogan's critics are viewing this election as a virtual referendum on the future of Turkey's democratic institutions.

They are right to worry. Even so, Turkey's democracy is proving more resilient than many of its defenders give it credit for, and there is good reason to believe that genuine democracy will prevail regardless of the outcome of this election. As the past year's nationwide protests have shown, a large number of Turks are determined to reject Erdogan's autocratic ambitions. Their supporters in the media, civil society, the justice system, and the bureaucracy are coming together, laying the groundwork for a democratic bloc that is determined to prevent a majoritarian takeover by Erdogan and his allies.

That effort will have consequences, for the presidential vote is merely the prelude to an equally important parliamentary election scheduled for June next year -- one that will offer a long-awaited opportunity for Erdogan's critics to give concrete political form to their dissatisfaction (which is likely to have intensified by then, given Turkey's dimming economic prospects). The opposition will do everything that it can -- within the democratic framework -- to block Erdogan's Justice and Development Party (AKP) from gaining the parliamentary majority that he needs in order to realize his plan for vastly expanding the executive powers of the presidency.

As a result, even if Erdogan wins a landslide victory in the presidential election, the resistance to him is only likely to deepen. His two main rivals at the polls offer clearly competing visions of Turkey's future. Elder statesman Ekmeleddin Ihsanoglu is the former head of the Organization for Islamic Cooperation (OIC) and the joint candidate of the two main opposition parties. Selahattin Demirtas, 41, was formerly the co-leader of Turkey's major pro-Kurdish party and now co-chairs an alliance of left-leaning parties.

As leading Turkish political strategist Necati Ozkan stated in a recent commentary, the three candidates represent the main visions for Turkey. Erdogan's polarizing and authoritarian political style, Ozkan notes, offers Turkey a Vladimir Putin-style approach to governance in which elections merely serve to legitimize strong, one-man rule. Ihsanoglu represents a model where the presidency stands above the fray of party politics, acting as an important check on the power of other elements within the country's democratic system. Demirtas, as a representative of Turkey's sizable Kurdish minority, necessarily favors a federalist system with more rights for the Kurdish population. Demirtas, however, has also been very successful in reaching a wider audience during his political campaign by focusing on civil liberties, democracy, and the rule of law. Neither of these two men is likely to win the presidency. Yet the political alternatives they stand for are likely to assume considerable importance in the months to come.

This year's presidential election marks the first time that Turks are directly electing their president in a popular vote. (Previously the president was selected by parliament.) Erdogan has long pushed for direct election of the president as part of his broader plan to refashion Turkey's political institutions. He wants to do away with the checks and balances of the current democratic system and to replace them with a parliamentary system with broad presidential authority. He has made no secret about his scorn for the current limits on executive power. In December 2012, he described the separation of powers as his government's main obstacle to effective action.

Such thinking is part and parcel of Erdogan's concept of electoral democracy. He is a strong believer in unfettered majoritarian rule; the candidate who receives the most votes should be allowed to govern essentially at will. The distinctly illiberal aspect of this worldview has become increasingly apparent over time -- and especially since the start of the Gezi Park protests a little more than a year ago. The protests, which began in opposition to an unpopular Istanbul urban development project, soon widened to encompass a wide range of discontent with Erdogan's administration. Rather than acknowledging the demonstrators' concerns, the government responded with a violent crackdown. At various turns, Erdogan has denounced the protests as a foreign plot, banned social media and imposed censorship on the press, and ordered financial investigations against those who have sponsored the demonstrations.

Last year, leaked tapes showed Erdogan making direct calls to media group owners to give instructions and complain about negative publicity. After a major corruption scandal involving senior government officials surfaced last December, government officials failed to address the allegations and even covered up the ongoing parliamentary investigation of the three ministers who resigned after revelations about their alleged malfeasance. All of this has eroded Turkish citizens' trust in their institutions, including the court system and the news media, which are increasingly viewed as subject to the prime minister's whims.

Laws recently passed by parliament, which is dominated by the AKP, are part of the same trend. The laws, which tighten government control over the judiciary and the Internet while expanding the remit of the intelligence agencies, are all clearly designed to strengthen the AKP's grip on various aspects of daily life. In addition to these bureaucratic measures, however, Erdogan has also inflicted serious damage to Turkish democracy with his use of discriminatory rhetoric. In order to consolidate his voter base, he willingly inflames religious, sectarian, and ethnic divides. ("I was called a Georgian," Erdogan noted in an interview earlier this month. "I apologize for this, but they even said [something] worse: They called me an Armenian.") This is a particularly dangerous game at a moment when the Middle East is already gripped by sectarian conflict. 

So far, of course, Erdogan has succeeded in riding the support of his core constituency -- conservative Sunni Muslims -- to the heights of political power. Yet he now faces several big obstacles on the road ahead. The first is short term. After August, the president-elect will find himself governing within a system that still places serious constraints on the power of presidency: It is the prime minister, not the president, who bears responsibility for the implementation of policy. Erdogan and his party were able to marshal enough support to push through direct election of the president through parliament back in 2007, but they did not manage to change the current powers of the presidency.

If Erdogan decides to transform the presidency from the figurehead position it is now, he may run up against the constitution, which prohibits the president from interfering in the purview of the prime minister. The system as it currently exists requires a certain degree of harmony between the president and government since the president has the authority to approve or reject the laws passed by the parliament. If they disagree, political deadlock may result. Erdogan may be able to get around this, to some extent, through his choice of an interim prime minister to replace him when he leaves office. But there are some indications that his selection for the post may create dissatisfaction within his party and outside. (So far no one outside the ruling circle seems to have any idea who will replace Erdogan as the prime minister.)

By far the biggest roadblock on Erdogan's path toward the accumulation of greater power, however, is the parliamentary election next summer. In order to give the new presidential office the broad powers he wants, Erdogan will need to change the constitution -- and that requires a clear majority for his coalition in parliament. The governing coalition will be able to amend the constitution outright if it has two-thirds of the seats in parliament (367); a three-fifths majority (330) will be enough to pass amendments that must then be approved in a national referendum. In Turkey's last parliamentary election in 2011, the AKP fell just short of the two-thirds threshold. But this time, post-Gezi Park, Erdogan and his allies will be facing the legacy of an unprecedented year-long wave of national discontent. Turkish civil society has been galvanized by Erdogan's power grab, and the effects are likely to have a discernible effect on the elections.

Erdogan is very clear about his ambitions. He recently said that a "president elected by the people and not by parliament ... is a turning point for democracy," while a "popular election will invest the presidency with strong legitimacy and real meaning." That is why the opposition will have a perfect opportunity to challenge this popularity and legitimacy in next June's vote -- and "opposition" refers here not just to the formal political opposition but also to the broad array of critical media voices, civil society groups, and others who have contributed to Turkey's political debates of late. A weak showing for the AKP in the parliamentary elections will almost certainly interrupt Turkey's progress down the authoritarian path that Erdogan has prescribed for it.

At the same time, if the AKP fails to gain enough votes to establish a government, the prime minister and president will represent divergent political interests -- even though both will have been elected by direct vote. This is a recipe for chaos. The question of which party, and which vision, truly represents the national interest will present a fundamental dilemma. Though optimists might invoke the relatively benign experience of cohabitation in France, the model has only limited applicability to present-day Turkey. Erdogan's version of majoritarian governance lacks the checks and balances that could be relied upon to support the survival of French democratic institutions.

All these personal and institutional circumstances are likely to promote instability. Yet the most decisive factor will probably be the economy. There has been a strong correlation between the AKP's popular support and the country's economic growth rates after 2007. Lately, however, that growth has been slowing perceptibly. The economy is unsustainably dependent on capital inflows. Rising inflation, high government spending, and overall debt levels also pose risks.

Turkey's foundational values are being sorely tested. Erdogan's misuse of his executive power, the judicial system, and the bureaucracy has stoked the fears of secularists and Islamists alike. Even if Erdogan wins the presidency this Sunday, his effort to expand the powers of the office will fuel a backlash that could potentially cost his party its dominant role. In any event, Turkey faces profound uncertainty for the next few years to come. The country's democrats can only hope that the two elections, presidential and parliamentary, will ultimately result in a return to the country's liberal ideals. Turks have grown accustomed to strong democratic institutions, independent media, and a strong, pluralistic civil society. They deserve nothing less.

Top Image: ADEM ALTAN/AFP/Getty Images

Graphic Designer: Chloe Chik

Background image 1: OZAN KOSE/AFP/Getty Images

Background image 2: Uriel Sinai/Getty Images

Background image 3: BULENT KILIC/AFP/Getty Images