The Turkish Economy at the Crossroads: The Political Economy of the 2018 Financial Turbulence.

• Author: Gur, Nurullah
• Position: ARTICLE - Report

Introduction

In 2018, the Turkish economy underwent one of the most severe financial speculations of its history. The U.S. dollar/Turkish lira exchange rate climbed from 3.75 to 4.90 in the first five months of 2018, the lion's share of the increase coming in May. The lira faced an even harsher depreciation in August as the exchange rate peaked at 7.22, before decreasing gradually below 6.00.

Although many posited that the currency shock emanated mainly from high levels of current account deficit and inflation, this "economic" explanation is clearly not enough, particularly for a country such as Turkey with its considerable economic strength and the level of its financial depth. (1) In order to explain the sudden and severe volatility in the exchange rate, the following factors should also be taken into account: the constant crisis-mongering to create a perception that economic governance would be disrupted after Turkey's transition to a presidential system, the manipulations with regard to foreign exchange markets, the banking sector, and the financial speculations fed by the then strained relations between Turkey, and the United States (U.S.). (2)

Turkey is not unfamiliar with exchange rate shocks and financial crises. The 2000-2001 economic crisis, which emanated mainly from the flawed economic policies of incompetent coalition governments along with the political and financial hangover of the "post-modern coup" of February 28, 1997, in the Turkish economy, as well as uncontrolled globalization, still has a prominent place in people's memories. The Turkish economy weathered the destructive effects of this crisis and made significant progress thanks to the political stability following the 2002 elections and resulting economic/financial reforms. The GDP per capita has more than tripled to around $10,000 and public debt as a percentage of GDP declined markedly from around 70 to 28 percent. Inflation rate retreated to single-digit levels sustainably after 34 years of very high rates, while exports skyrocketed from $36 billion to more than $168 billion. The Turkish industry sector has also expanded dramatically. Between 2002 and 2017, the industry sector grew by 163 percent, significantly surpassing overall economic growth, which stood at 131 percent. The share of the industry sector in the economy increased from 17.7 to 20.1 percent. (3) Moreover, the banking sector has grown substantially as the credit volume to GDP ratio, which averaged 18 percent between 1980 and 2002, expanded forcefully from 13.3 percent in 2002 to 45.3 percent in 2010, and 64.7 percent as of 2018. (4) As a result of these developments, the finance industry grew by 287 percent and its share in the GDP widened from 2.6 to 4.2 percent between 2002 and 2018. (5) Alongside the financial deepening, the banking sector has also grown significantly stronger on many key indicators, including capital adequacy ratio, non-performing loan ratio, the level of credit portfolio diversification and profitability. Note that in this period the research and development spending to GDP ratio has more than doubled and poverty has almost been eliminated thanks to high growth performance and higher levels of social spending. (6)

While the Turkish economy has been on a markedly rising trend since 2002, Turkey encountered a series of severe internal and external shocks. The 2008-2009 global financial crisis, the long-lasting shockwaves in the aftermath of the so-called Arab Spring (particularly the Syrian civil war), the Gezi Park events, the December 17-25 "judicial coup" attempt, the PKK and Daesh-led terrorist attacks, most prominent being the July 15 military coup attempt in 2016, and finally the financial attacks in 2017 and 2018 have all had markedly adverse effects on the Turkish economy. Despite all of these and to the astonishment of many, Turkey, as of the first quarter of 2019, has remained the third fastest growing country in the G20, behind China and India. (7)

This article aims to analyze the financial turbulence that Turkey experienced in 2018 from a political economy perspective. The second section briefly summarizes the course of the Turkish economy from the 2000-2001 economic crisis to the 2008-2009 global financial crisis, in order to better understand the financial and economic pillars that the Turkish economy has been built on, particularly with the help of the first and second-generation reforms. The third section discusses how, and in what ways, Turkey tried to achieve a new success story by implementing second generation reforms after the 2008-2009 global financial crisis, only to be hampered markedly by politically motivated internal and external shocks since 2013. The fourth section focuses on the developments before and after the financial turbulence in 2018. The fifth section discusses economic and financial vulnerabilities Turkey needs to eliminate, or mitigate, in order to have a stronger economic base and financial structure and to be able to withstand possible financial turbulences in the future. The sixth section concludes with a general assessment.

Turkey's Economy from the 2000-2001 Crisis to the Global Financial Crisis

In the 1990s, political instabilities and bureaucratic incapacity resulted in recurrent political and economic crises in Turkey. The rapid and uncontrolled financial liberalization without a solid regulatory framework, the siphoning-off of the public resources by unregulated banks and many others, and the "post-modern coup" of February 28, 1997, severely damaged the Turkish economy and triggered the 2000-2001 economic crisis. (8) This macroeconomic predicament resulted in yet another Turkey-IMF deal.

The constituents' anger towards the politicians caused a tectonic shift in Turkish politics with the 2002 general elections, as unprecedentedly all political parties that had been in the parliament before the elections could not pass the 10-percent threshold and were left out. As the winner of the elections with a clear majority in the parliament, the then one-year old AK Party formed a single-party government in 2002. The AK Party had taken over an economic wreck of chronic inflation, massive public debt, and an eviscerated banking sector with a malfunctioning and underperforming real economy, not to mention high levels of poverty and income inequality. (9)

As a result of the first-generation economic reforms made by the AK Party, along with the favorable global conditions in terms of risk appetite and liquidity, the Turkish economy successfully bounced back from the crisis and recovered rapidly. It moved even considerably further with the elimination of important long-term structural problems such as chronic inflation, under-regulated banking systems, and high levels of public debt thanks to the reconstruction of the banking sector, tight monetary and fiscal policies, and various economic reforms. (10)

Turkey had suffered from very high inflation rates (more than 50 percent on average), from the 1970s to the 2000s because of a vicious cycle consisting of fiscal profligacy, monetization of the government debt to a high degree, and very high interest rates that increased the debt burden even further. After this cycle had been shattered in 1997 by the elimination of monetization through a protocol signed between the Turkish Treasury and the Turkish Central Bank (TCMB), it was greatly reduced thanks to the fiscal discipline achieved under the AK Party rule during the 2000s. (11) Furthermore, the TCMB adopted an inflation-targeting regime with a firm, and sometimes excessive, commitment to price stability and low inflation rates in 2002. As a result of these developments, inflation rates in Turkey decreased to one-digit levels, averaging 8.2 percent between 2004 and 2017.

While the Turkish government pursued a tight fiscal policy and achieved fiscal discipline as part of the IMF deal, it also increased social spending considerably in almost all areas, particularly health and education, resulting in a much-expanded and deepened social policy base. (12) This situation differentiated Turkey as a success story among countries who had signed stand-by agreements with the IMF. This positive dissociation was completely meaningful, because while the IMF prescribed that the Turkish government should cut down spending in almost all areas, the government took the other way and expanded social spending decisively. To put it another way, Turkey achieved economic stability and inclusive growth at the same time by implementing market-friendly policies, countercyclical Keynesian economic policies, and social policies. (13)

Alongside the marked amelioration of the macroeconomic outlook, the steps taken along the EU membership process and the democratization of the public sphere caused a significant improvement in foreign investors' confidence in Turkey. (14) The Turkish economy, capitalizing on the favorable global liquidity conditions, successfully attracted foreign investments at record levels. Along with this, TCMB's extremely tight monetary policy and the strong inflow of foreign capital resulted in a significantly overvalued lira. Despite this, Turkish exports rose tremendously thanks to the strong emphasis and financial support for exports in various dimensions by the government as well as a proactive foreign policy approach with a view to find new markets around the globe. (15)

On the other hand, when this economic/financial transformation was happening, the AK Party had to engage in a political struggle as the elected-government with undemocratic forces in the judiciary and military, where bureaucratic and military tutelage was still strong, and held the conviction that they were "ruling the roost" The "e-memorandum" submitted by the military against the government, the high-court decision (famously known as the "367 crisis") to prevent the parliament from electing the president, and ultimately the closure case of...