With the Coup Crushed, Turkey Now Needs an Economic Revolution

After a period of steady growth and a big increase in living standards, the economy has faltered. But political instability could hamper vital reforms.

Istanbul’s Levent financial and business district.
Murad Sezer, Reuters

The shock that Turkey experienced over the weekend with the coup attempt and its political consequences is liable to hurt a national economy that had already been suffering a slowdown and was desperately in need of reform.

Although the country’s economy grew at an impressive rate over the past decade, attracting foreign investors, economists were warning even before the attempted coup that political instability and frequent elections were threatening the economy and that major reform was necessary.

The instability may intensify now.

In an effort to avoid this and to solidify his rule, President Recep Tayyip Erdogan has undertaken a number of purges beyond the arrest of hundreds of soldiers on suspicion of wider involvement in the coup. Turkish media reported over the weekend that the country’s Supreme Board of Judges and Prosecutors, which is responsible for compliance and discipline in the judicial system, dismissed 2,745 judges and prosecutors as well as 10 members of the council itself.

Although most of the country’s population took no part in the failed coup, many Turks are not supporters of Erdogan and oppose his increasingly autocratic style. Turkey’s educated middle class generally views his efforts to strengthen his position and to take control of the media as an abuse of human rights and sees the increasing influence of Islam as a step backwards.

Nevertheless, Turkish journalist Alaattin Kilic told Russia’s RT news website that because Turks have lived through so many coups and coup attempts in the last half century, they will support any democratically elected government over a military regime, even if they don’t agree with the political course democracy is taking.

Many in Turkey give Erdogan, who was elected prime minister in 2003 and president in 2014, credit for an increase in the standard of living since 2003.

From that year, the country’s economy grew by an average of more than 5% a year, even during the global economic crisis. Since 2006, foreign investors have put more than $50 billion into stocks and bonds in Turkey and the middle class has grown from about one-quarter of the population in the mid-1990s to 60% of the total in 2014.

Healthcare, education and transportation have greatly improved and there has been a wave of construction in major cities.

The prosperity of Erdogan’s first years as prime minister was to a large extent due to the International Monetary Fund, which required his government to carefully monitor spending, increase budget transparency, give the country’s central bank greater independence and to take steps to make markets more open.

Waning reform drive

Nevertheless, when the IMF’s remedy bore fruit, and in light of the European Union’s reservations over Turkish membership, the incentive to carry out the reforms waned.

Two Turkish economists, Daron Acemoglu from the Massachusetts Institute of Technology and Murat Ucer of Koc University in Istanbul, noted in research that they recently published that although Erdogan’s government did an exemplary job of maintaining fiscal discipline, in other respects, its economic management was less impressive.

Once it amassed enough power, they wrote, the government made a 180-degree about-face, with the control of those at the helm increasing, along with an increase in corruption and unexpected arbitrary decision-making.

So, for example, business owners who didn’t have friends in government were hurt and media companies were excluded from other sectors if they didn’t toe the Erdogan line. The government’s critics claim that companies with the right connections not only get government contracts but also access to transactions involving government land as well as advance warning of regulatory or zoning changes.

Despite the terrorism and political instability of recent years, Turkey’s economy has been relatively stable, in part thanks to private consumption, which represents 70% of the economy. Nevertheless, the economy has experienced a slowdown. In the first quarter of the year, growth was an impressive 4.5% year on year, but that was primarily the result of a 30% increase in the minimum wage in January, which spurred consumer spending. The IMF expects growth to slow to a 3.5% pace in 2018.

At 4.5% of GDP, Turkey’s current account deficit is still high, even after the price of oil drop and slumping demand for imports of other goods due to the weakness of the Turkish lira. The Oxford Economics consulting firm expects that a drop in tourism due to terrorist attacks will lead to a 5% current account balance this year and 5.4% in 2017.

These declines leave Turkey dependent on foreign investors to cover the deficit. The country’s external debt has grown rapidly, from 38% of gross domestic product in 2008 to 55% of GDP in 2015, and more than 90% of it is denominated in foreign currencies rather than the Turkish lira. An additional fall in the value of the lira could lead to a mismatch between corporate debt and what companies can permit themselves to pay, and there is concern over possible flight of foreign investment.

“Investment shrank in the first quarter. Reviving it requires greater political and economic stability,” Zumrut Imamoglu of TUSIAD, Turkey’s main business lobby, told The Economist magazine prior to the coup attempt.

Increasing the savings rate, which is now very low, would reduce Turkey’s dependence on foreign investors. Without such reforms, Imamoglu added, growth will plummet at some point.

Until now, however, Erdogan’s rhetoric shows a preference for quick fixes over comprehensive reform.

Several months ago, he lashed out against Turkey’s central bank, taking it to task for maintaining interest rates too high and stifling investment. And, contrary to the conventional economics, he claimed a lower interest rate would depress inflation. Ultimately the president’s pressure led the central bank to adopt a looser monetary policy and the results were predictable: The annualized inflation rate in June rose to 7.6%, well beyond the official 5% target.

Cevdet Akcay of the Turkish bank Yapi Kredi told The Economist that inflation has become less sensitive to monetary policy. That will make it hard for the central bank to bring it down without a sharp increase in interest rates, but that in turn would hurt the economy.

Avoiding real reform

In addition, instead of improving the investment climate on a broad basis, Erdogan has divvied up subsidies and tax benefits.  Two weeks ago, the government unveiled a plan to encourage investment that includes an exemption from purchase taxes on investments, cuts in the stamp tax on contracts and subsidies for research and development.

Not including interest, the budget remains at a surplus, but that’s mostly thanks to one-time sources of revenue. And for the meantime, a law aimed at increasing tax collections is stalled in parliament.

The Turkish economy is also suffering from a variety of domestic problems, and ponderous regulation makes it hard for small businesses to grow and become more efficient. The World Economic Forum ranked Turkey 131st among 144 countries in the efficiency of its labor market. Most economists agree that without substantial structural reform, the slow growth in the country will persist.

A report from the Organization for Economic Cooperation and Development that was released just hours before the Turkish coup attempt called on the Turkish government to invest more in education and research, to expand trade ties with other countries and  strengthen the rule of law to increase productivity and increase exports. The organization also called on the government to keep its promises for reform in governance, in the labor sector and in taxation, and noted that they have been delayed due to repeated elections in Turkey. The country, the report said, is no longer experiencing cycles of highs and lows but rather widening external deficits while its position with respect to external investment has deteriorated.

Last Friday, before the failed coup, the parliament in Ankara passed a series of laws designed to encourage investment and improve the business environment, including steps to curb bureaucracy and costs to employers. It also included steps to encourage Turks’ rate of savings by making pension plans more attractive.

But even before the events of the past weekend, investors were concerned that reform plans would be carried out slowly as a result of political instability caused by Erdogan’s attempts to amass power.