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November 09, 2012, Friday

Upgrading Turkey

Fitch Ratings, the global credit rating agency, finally upgraded Turkey to investment level. Concretely, this upgrade means that Fitch considers Turkish Treasury bonds to have a very low default risk. Now, large global funds will be able to invest more in Turkish financial papers. As expected, markets reacted very positively to this decision. The İstanbul Stock Exchange (İMKB) broke its historical record while the market interest rate fell to as low as 6.8 percent.

Albeit the credit risk, for a long time in credit default swap (CDS) markets, Turkish assets were traded at the same level as investment grade countries and this upgrade is certainly a positive event for the Turkish economy. Nevertheless, it represents some challenges in the short term as well as in the medium term. The reasoning by Fitch for its decision is important in this context. According to Fitch, the Turkish economy merited the upgrade for the following reasons: Its so-called “soft landing” is well under way, its macro financial risks have recently improved, the public debt ratio to gross domestic product (GDP) continues to fall and its banking sector is still strong.

Except for the “soft landing” argument, the others have been already widely recognized by the business and financial communities. Indeed, the public debt ratio declined to below 40 percent at the end of last year and is expected to fall to 37 percent by the end of this year. I would like to note that this is the third best performance in the EU, including Luxemburg! The budget is more or less under control despite the decreasing tax revenues because of low growth and the banking sector, well monitored by the Banking Regulation and Supervision Agency (BDDK), remained far from the risky assets.

The critical point in Fitch's argument is obviously the good note given to the soft landing process. I have discussed the “soft” and “hard” landing scenarios many times in this column but let me remind you again briefly that since August 2011, the Turkish government, together with the central bank, has tried to shift the domestic demand-led growth to a more balanced growth, albeit a lower one, for the simple reason that the domestic-led growth provoked a huge current account deficit (CAD), almost 10 percent of GDP. This deficit was absolutely unsustainable, risking an exchange rate shock sooner or later. One should note that the rebalancing or soft landing process worked till now. Since the third quarter of 2011, exports are increasing more rapidly than imports and, as a result, the CAD is decreasing; estimates show that it declined to about 7 percent in the third quarter of this year.

So far so good, but the question with the soft landing process is whether the new growth regime based on exports can be sustained. I think that there are basically two problems that have to be handled properly. In the short run, the central bank has to be able to prevent the appreciation of the Turkish lira. A recent research note published by the central bank shows that in the countries upgraded to investment level, portfolio investments or, if you prefer, hot money flows, intensify. The adverse effects of these sudden flows are obvious: An appreciation of the local currency erodes export competitiveness or the sterilization of foreign currency flows by the central bank which risks encouraging domestic demand as money supply and bank loans grow. Admittedly, either an appreciation or sterilization would not be consistent with the soft landing process. That said, Turkish Central Bank Governor Erdem Başçı, well aware of this risk, declared recently that the array of disposable instruments, including interest rate easing and “reserve options,” will be used to avoid an appreciation of the Turkish lira. Certainly, this will not be an easy task.

The second problem is of a political economy nature. The soft landing process is under way but the ongoing growth rate is lower than expected. Last year's medium-term program stipulated that the decline in growth would be limited to 4 percent for 2012 and then reach its potential level of 5 percent. Unfortunately, it is now widely accepted that this year's growth stayed around 3 percent. Comparing it with other pitiful European growth rates, 3 percent seems more than acceptable, but it is definitely insufficient with regards to the high unemployment rate -- currently at 9 percent -- despite its dramatic decline thanks to high growth in the recent past. Turkey needs at least a 5 percent growth in order to continue reducing unemployment; with a 3-4 percent growth, an increase in unemployment is highly probable since the number of jobs created would not be enough to compensate for the labor force increase.

Fitch, which forecasts a 3.8 percent growth for 2013, does not care about unemployment and it cannot be blamed for this, but a democratic government does care. The incumbent Justice and Development Party (AK Party) will be facing a period of three successive elections starting from March 2014. I do not think that the AK Party will accept increasing unemployment. It can be tempted by the siren songs.

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