Economics: Turkey's bold war on debt

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The Independent Online
HOW DOES a democracy manage to effect radical economic change? When a country sees inflation take off above 100 per cent and the government finds that it cannot borrow in its own domestic money markets, you do not have to be John Maynard Keynes to know that it has a serious problem.

Such has been Turkey's fate this year. It makes Britain's economic difficulties look like chicken feed. Yet there are distinct similarities, not least in the conflict posed for governments by having to inflict pain on those whom they hope will vote for them.

Under the Prime Minister, Mrs Tansu Ciller, the Turkish government has set about trying to dig itself out of its hole. On 5 April, it announced an ambitious stabilisation programme, recently endorsed by the IMF. The result is an interaction between pure economics and the darker arts of political economy that is the nearest the economist can get to a laboratory experiment. Will it work? And how did Turkey land up in this position in the first place?

It is a salutary tale. There are always those who cannot see the wood for the trees; and for some Turks at least, the origins of the crisis are still a matter of controversy. But to most informed observers, the real origin of this year's financial crisis is crystal clear - it lies with the huge public deficit (PSBR), which in turn is related to heavy state involvement in all aspects of the economy.

This is a problem that had been building up for about 10 years. Turkey experienced rapid economic growth in the 1980s, accompanied by inflation, which went up to 70 per cent after 1988. This was high, but just bearable. But as the PSBR continued to expand, the growth became severely unbalanced. There was too much consumption, partly because in the five years from 1988 to 1993, the level of real wages almost tripled.

One consequence of this was that the current account of the balance of payments dropped into serious deficit. By 1993 it was running at more than 5 per cent of GNP. Yet another aspect of the situation had made this problem worse - the exchange rate. By the late 1980s, the pressure from the PSBR on the capital markets was creating difficulties for domestic borrowers. But in 1989 the Turkish capital markets were liberalised, allowing a substantial influx of foreign capital.

The result was that by 1991 the real exchange rate of the Turkish lira (TL) was 28 per cent higher than it had been three years earlier. This appreciation both helped to sustain the growth of real wages and to keep inflationary pressures in check.

The financial position, however, became steadily more perilous. In 1993 the PSBR was supposed to fall to 9 per cent of GDP. Instead it rose to 17 per cent. Moreover, within this total, the debt interest bill rose to more than 8 per cent of GDP. This left the country dangerously close to the debt trap - the situation in which interest on the debt grows so fast that the PSBR explodes out of control.

Meanwhile, because of extensive foreign borrowing, Turkey's external debt continued to grow, reaching some dollars 66bn (pounds 43bn) , or more than 40 per cent of GDP. Still the boom rolled on. The economy had grown by 61 2 per cent in 1992 and last year it grew by no less than 71 4 per cent. But the boom was sustained on borrowed money and borrowed time. The time bomb was ticking.

The plain truth is that the huge fiscal deficits meant that this year's financial crisis was an accident waiting to happen. The fact that the crisis broke when it did, and its severity, were due to an unfortunate combination of external events and government mishandling. First, the government tried to deal with the problem of the appallingly high cost of its borrowing by cutting short-term interest rates. The consequence was a loss of confidence and a rush into foreign exchange. Then, in mid-January, amidst this delicate situation, Moody's and Standard & Poor's, the US credit rating agencies, downgraded Turkish credit risk. As one former central bank governor put it to me: 'Up to now the opinion of these agencies had affected Turkey's international status but had not registered with the man in the street. Now everyone was talking about the Turkish downgrade.'

The result was a stampede into foreign currency. The Turkish lira began the year at 14,600 to the dollar. By mid-April it had hit a low of 41,000 to the dollar.

Because of the sheer volume of funding, the Turkish government had long relied excessively on short-term financing from the central bank, which then inflated the money supply. Now the government could not borrow any money in the domestic markets. Even after the 5 April package, it was forced to pay 50 per cent on three months' paper - not 50 per cent per annum, but 50 per cent over three months. This annualises to the vast figure of 406 per cent. So the government found itself paying what looked like a real interest rate of close to 300 per cent. Clearly this is the end of the line. Turkey either has to succeed in reducing state borrowing and regaining the confidence of the markets, or it will quickly descend into hyperinflation. What are the chances?

The stabilisation plan is nothing if not bold. It aims to cut the overall deficit by 9 per cent of GDP, more or less halving it. To put this into perspective, the whole Lamont/Clarke fiscal restraint programme in Britain amounts to about 4 per cent of GDP.

The retrenchment plans are extensive. Public sector charges have already gone up sharply, new taxes are planned, there is a freeze on government spending, and the public sector's wage and salary bill is set to be held to the originally budgeted amount, despite the much higher rate of inflation now projected. On top of this, the government is battling to raise money through privatisation.

So far there have been some encouraging signs. Most notably, the exchange rate has recovered to about TL31,000 to the dollar. Inflation was 24 per cent in the month of April alone, but it subsided in May and probably fell further in June. Whereas the economy seemed on the brink of extensive dollarisation in March/April, by June these pressures had subsided, and the Turkish lira was readily accepted everywhere.

The government is certainly determined and outwardly seems confident. Friends and foes alike point out that there is no way out of the crisis except the one the government has taken. The opposition parties are unable to present an alternative. Mrs Ciller's own fate hinges directly upon the measures succeeding.

Are they not bound to succeed as a result of sheer desperation? It depends what you mean by success. The very boldness of the plan invites scepticism. Virtually no one I spoke to, except the Prime Minister and senior public servants, even purported to believe that the new PSBR targets would be met. Rather, they endorsed the idea of shooting at a tough objective because, although it would not be met, even getting halfway there would mean a real achievement. There were suggestions that the IMF itself shares this approach to the Turkish problem.

Several business leaders I spoke to questioned how much money could be raised from privatisation in the near term. But all emphasised how important they thought this was to fiscal control and economic efficiency. And there was scepticism about whether, with such a narrow tax base and such a large black economy, the government would be able to raise much extra tax revenue, particularly given the developing recession. As one businessman said: 'Anyone can announce increased taxes: actually collecting them is a different matter.' This serves to re-emphasise the importance of controlling government spending, particularly on wages. Yet the fragility of the government's position, coupled with its need to face the electors in 1996, makes such tough policies a real challenge.

The most likely outcome is that disaster will be avoided and Turkey will return to something like the delicate inflationary equilibrium that existed before; only with a somewhat smaller public deficit, weaker growth of consumption, and a healthier current account. That might seem like failure to some, but sceptics would do well to remember the fundamental strengths of Turkey. Despite the inefficiencies, the overweening state structures and the instability, Turkish industry still managed to deliver impressive growth in the Eighties. Turkey is a young, dynamic economy with strong recuperative powers.

But this falls short of the ambitious plans of many prominent Turks. Mrs Ciller told me: 'This programme should have been implemented in 1987 or '88. If it had, we would have been a super-economic power. . . We are going to be a super-economic power. This is a tuning-up exercise. After it, the car will go very fast.'

Turkey does have massive potential, but realising it will require the full achievement of all Mrs Ciller's plans, not just the partial fulfilment that seems, on recent form, more likely. The economics of the problem are blissfully simple - it is the politics that create the difficulty. Does this ring a bell?

Roger Bootle is chief economist at Midland Bank. He has just returned from Turkey where he interviewed the Prime Minister, government officials and advisers, industrialists and bankers. The views expressed here are his own.

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