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The Turkish Economy: EU The Turkish Economy: EU Accession and Future Accession and Future Economic ProspectsEconomic Prospects

The International Economic Consultants’ The International Economic Consultants’ AssociationAssociation

14 February 200614 February 2006

Fadi Hakura, Turkey Specialist, Chatham House and Fadi Hakura, Turkey Specialist, Chatham House and Founder of ConkuraFounder of Conkura

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Order of PresentationOrder of Presentation

Brief Economic HistoryBrief Economic History Recent Economic PoliciesRecent Economic Policies EU Accession ProcessEU Accession Process Economic AchievementsEconomic Achievements Economic Impact of EU AccessionEconomic Impact of EU Accession Future Prospects for Turkish Future Prospects for Turkish

EconomyEconomy

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BriefBrief EconomicEconomic HistoryHistory

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Brief Economic HistoryBrief Economic History

Turkey enjoyed regular boom-and-bust Turkey enjoyed regular boom-and-bust economic cycles since the 1950s.economic cycles since the 1950s.

Excessive budgetary expenditures and Excessive budgetary expenditures and inflationary pressures were the norm.inflationary pressures were the norm.

Major economic crises in 1994, 1998 and Major economic crises in 1994, 1998 and 2000-2001.2000-2001.

2000-2001 crisis devastated all sectors of 2000-2001 crisis devastated all sectors of Turkish economy and society.Turkish economy and society.

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Recent Economic Recent Economic PoliciesPolicies

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Recent Economic PoliciesRecent Economic Policies

Since 2001, successive Turkish Since 2001, successive Turkish governments implemented a tough IMF governments implemented a tough IMF programme.programme.

Undercapitalised banks seized, shut down Undercapitalised banks seized, shut down or privatised. Number of banks slashed or privatised. Number of banks slashed from 80 in 2000 to 48 in 2005.from 80 in 2000 to 48 in 2005.

Energy and telecommunications’ markets Energy and telecommunications’ markets liberalised.liberalised.

Independent banking regulator created in Independent banking regulator created in 2001. 2001.

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Foreign investment and employment laws Foreign investment and employment laws streamlined. streamlined.

Primary fiscal surplus target of 6.5% of Primary fiscal surplus target of 6.5% of GDP. GDP.

Inflation-targeting since January 2006: 5% Inflation-targeting since January 2006: 5% in 2006 and 3% in 2007.in 2006 and 3% in 2007.

Turkish Lira free-floating.Turkish Lira free-floating. Privatisation radically accelerated: Privatisation radically accelerated:

$20,000 million of state assets sold to $20,000 million of state assets sold to private sector in 2005.private sector in 2005.

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Vodafone purchased Telsim – the Vodafone purchased Telsim – the second largest mobile operator – for second largest mobile operator – for $4,550 million in December 2005.$4,550 million in December 2005.

Top rate of income tax cut from 40 to Top rate of income tax cut from 40 to 35% in 2004. Corporate tax rate 35% in 2004. Corporate tax rate reduced from 30% to 20% in 2005.reduced from 30% to 20% in 2005.

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EU Accession ProcessEU Accession Process

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EU Accession ProcessEU Accession Process

Accession negotiations commenced Accession negotiations commenced on 3 October 2005.on 3 October 2005.

Accession process expected to take Accession process expected to take 10-15 years.10-15 years.

Speed of accession conditioned upon Speed of accession conditioned upon pace of implementation of EU rules pace of implementation of EU rules and standards.and standards.

100,000 pages of EU law and policy 100,000 pages of EU law and policy must be adopted and implemented.must be adopted and implemented.

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EU-Turkey Customs Union since 1996 ensuring EU-Turkey Customs Union since 1996 ensuring free circulation of goods and a harmonised free circulation of goods and a harmonised competition policy.competition policy.

Reuters’s survey of 30 emerging market Reuters’s survey of 30 emerging market strategists (7-9 February 2006): strategists (7-9 February 2006):

Median forecast of Turkey joining EU in 2016.Median forecast of Turkey joining EU in 2016.

20% chance of Turkey pulling out of negotiations 20% chance of Turkey pulling out of negotiations – range between 0 and 70.– range between 0 and 70.

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20% chance that the EU may 20% chance that the EU may suspend negotiations due to human suspend negotiations due to human rights or Cyprus issue.rights or Cyprus issue.

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Economic Economic Achievements Achievements

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Economic AchievementsEconomic Achievements

Economic growth has expanded Economic growth has expanded dramatically: 7.5% per year on dramatically: 7.5% per year on average in 2002-2004 and over 5% average in 2002-2004 and over 5% in 2005.in 2005.

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Turkey settles into stable growthTurkey settles into stable growth

Source: PNC Financial ServicesSource: PNC Financial Services

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Inflation rates decreased from 73% in Inflation rates decreased from 73% in early 2002 to 8.1% in October 2005.early 2002 to 8.1% in October 2005.

Total central government deficit has Total central government deficit has shrunk from 15% of GNP in 2001 to shrunk from 15% of GNP in 2001 to 5% in 2005.5% in 2005.

Public debt has declined from 90% of Public debt has declined from 90% of GNP in 2001 to 70% in 2005.GNP in 2001 to 70% in 2005.

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Kicking the habit of high inflationKicking the habit of high inflation

Source: IMFSource: IMF

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A happy economic picture: High A happy economic picture: High economic growth and low inflationeconomic growth and low inflation

Source: OECDSource: OECD

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Domestic interest rates have slumped Domestic interest rates have slumped from 75% in 2002 to 15% in October 2005.from 75% in 2002 to 15% in October 2005.

Net FDI static at $800 – 1,000 million Net FDI static at $800 – 1,000 million during the 1990s. Reached $4,000 million during the 1990s. Reached $4,000 million in 2005.in 2005.

According to the World Investment Report According to the World Investment Report 2005, Turkey climbed from 572005, Turkey climbed from 57thth to 35 to 35thth position in terms of FDI inflows. position in terms of FDI inflows.

2020

Effect: appreciating Lira moderated by productivity Effect: appreciating Lira moderated by productivity improvementsimprovements

Source: Central Bank and BNP ParibasSource: Central Bank and BNP Paribas

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Economic Impact of Economic Impact of AccessionAccession

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Likely Impact of Accession Likely Impact of Accession

Enhanced FDI inflows: e.g. BNP Paribas Enhanced FDI inflows: e.g. BNP Paribas purchased 50% of TEB Bank; Fortis purchased 50% of TEB Bank; Fortis merged with Disbank; GE bought 25.5% merged with Disbank; GE bought 25.5% stake in Guaranti Bank.stake in Guaranti Bank.

European Commission granted Turkey European Commission granted Turkey “market economy” status, a key criteria “market economy” status, a key criteria for EU membership.for EU membership.

Lower risk premiums on Turkish Lower risk premiums on Turkish government securities: government securities:

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Impact of EU Accession on Risk PremiumsImpact of EU Accession on Risk Premiums

Turkey’s Euro EMBIG subindex, spread over Bunds, bpsTurkey’s Euro EMBIG subindex, spread over Bunds, bps

Source: JP Morgan ChaseSource: JP Morgan Chase

0

200

400

600

800

1000

1200

1400

Jan-00 Jun-00 Nov-00 Apr-01 Sep-01 Feb-02 Jul-02 Dec-02 May-03 Oct-03 Mar-04 Aug-04 Jan-05 Jun-05

Aug 04 –S&P

upgrade to BB-

March 01 – EU Council adopts EU-Turkey Accession Partnership

Dec 02 – EU Council says that for first time Turkey could start EU entry talks

Dec 04-Eu Council sets date for start of EU entry

talks

Oct 05-EU entry

talks start

TR’30

TR Euro EMBIG sub-index

Turkey: Annual spread compressionBenchmark RO’12

Turkey: Annual spread compressionBenchmark RO’12

spread ch Years to EU entry

2000 99.0 62001 65.3 52002 57.2 42003 -333.6 32004 -73.0 2Jan - Oct 05 -31.7 0.9

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Extensive deep restructuring of Extensive deep restructuring of Turkish economy and public sector.Turkish economy and public sector.

Prescriptive EU rules and standards Prescriptive EU rules and standards on public procurement, sectoral on public procurement, sectoral liberalisation, employment laws, liberalisation, employment laws, environment, public procurement, environment, public procurement, State aid (public subsidies) and many State aid (public subsidies) and many other areas. other areas.

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EU accession maybe a significant driver for EU accession maybe a significant driver for underlying economic growthunderlying economic growth

Source: Deutsche Bank ResearchSource: Deutsche Bank Research

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… … and incomeand income per capitaper capita

Source: Deutsche Bank ResearchSource: Deutsche Bank Research

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In fact 1996 EU-Turkey Customs Union experience In fact 1996 EU-Turkey Customs Union experience demonstrates impressive Turkish export potentialdemonstrates impressive Turkish export potential

Source: State Institute of StatisticsSource: State Institute of Statistics

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Daniel Gros and Kemal Dervis estimate Daniel Gros and Kemal Dervis estimate long-term annual economic growth could long-term annual economic growth could be 3-6 percentage points per year ahead be 3-6 percentage points per year ahead of that in Western Europe and 1-3 of that in Western Europe and 1-3 percentage points ahead of that in percentage points ahead of that in Central/Eastern European countries. Central/Eastern European countries.

World Bank finds that Turkey’s per capita World Bank finds that Turkey’s per capita income will increase by 1.5% per year with income will increase by 1.5% per year with EU accession.EU accession.

Turkey could converge to per capita Turkey could converge to per capita income of today’s Poland by 2020 income of today’s Poland by 2020 (Deutsche Bank research).(Deutsche Bank research).

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But there are significant environmental But there are significant environmental costs…costs…

EU environmental rules: Anil Markandya EU environmental rules: Anil Markandya (World Bank) forecasts total compliance (World Bank) forecasts total compliance costs of €28,000 million (“fast reform” costs of €28,000 million (“fast reform” scenario) to €49,000 million (“slow scenario) to €49,000 million (“slow reform” scenario).reform” scenario).

Expenditures to be spread over Expenditures to be spread over approximately 17 years.approximately 17 years.

OECD indicates that Turkey currently OECD indicates that Turkey currently spends 0.5% of GDP on the environment. spends 0.5% of GDP on the environment. So, levels need to triple or quadruple. So, levels need to triple or quadruple.

Appropriate policy mix could cut Appropriate policy mix could cut compliance costs by about half.compliance costs by about half.

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… … and agricultural changesand agricultural changes

Agricultural reform: World Bank predicts Agricultural reform: World Bank predicts budgetary costs of €3,000 million (without budgetary costs of €3,000 million (without EU compensation) and €1,200 million (with EU compensation) and €1,200 million (with EU compensation).EU compensation).

Agricultural value-added at €2,145 million Agricultural value-added at €2,145 million (with EU subsidies) and €341 million (with (with EU subsidies) and €341 million (with 35% of EU subsidies).35% of EU subsidies).

EU policies will lead to 1.87% increase in EU policies will lead to 1.87% increase in real household incomes in the medium-to-real household incomes in the medium-to-long term.long term.

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Accurate projections highly Accurate projections highly dependent on developments in CAP dependent on developments in CAP reforms. reforms.

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Future Prospects for Future Prospects for Turkish EconomyTurkish Economy

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Future Prospects of Turkish EconomyFuture Prospects of Turkish Economy Future of Turkish economy is Future of Turkish economy is strongly strongly

positive subject to a number of positive subject to a number of issuesissues..

Absolute necessity to tackle corruption – Absolute necessity to tackle corruption – 3.5 score by Transparency International 3.5 score by Transparency International 2005 [10= no corruption].2005 [10= no corruption].

Turkish GDP would jump 5-6% if corruption Turkish GDP would jump 5-6% if corruption cut to the level of Portugal enjoying a cut to the level of Portugal enjoying a score of 6.5 by Transparency International score of 6.5 by Transparency International 2005 (Netherlands Bureau for Economic 2005 (Netherlands Bureau for Economic Policy Analysis).Policy Analysis).

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Undertake radical public sector and Undertake radical public sector and institutional/governance reforms and improve institutional/governance reforms and improve quality of regulations/rule of law – public sector quality of regulations/rule of law – public sector restructuring boosted productivity by 40% in restructuring boosted productivity by 40% in 2000-2004 (Morgan Stanley) 2000-2004 (Morgan Stanley)

However, below Eastern/Central European However, below Eastern/Central European standards (World Bank). standards (World Bank).

Job-creation: Estimated Labour Force Participation Job-creation: Estimated Labour Force Participation Rate is only (approximately) 40% vs. 65% in Rate is only (approximately) 40% vs. 65% in Spain - 0.5 million new workers enter labour force Spain - 0.5 million new workers enter labour force each year.each year.

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Labour force participation and Labour force participation and unemploymentunemployment

Source: State Institute of StatisticsSource: State Institute of Statistics

3636

Capitalise on “demographic window of Capitalise on “demographic window of opportunity” – dependency ratio expected opportunity” – dependency ratio expected to decline from 60% in 2000 to around to decline from 60% in 2000 to around 45% in 2030 (UN) –45% in 2030 (UN) –

Major cause of the East Asian economic Major cause of the East Asian economic “miracle” between 1960-1990s.“miracle” between 1960-1990s.

Happens only once in a country’s lifetime. Happens only once in a country’s lifetime.

3737

Deeper liberalisation of factor and product markets Deeper liberalisation of factor and product markets (European Commission) – e.g. 112 weeks of wages for (European Commission) – e.g. 112 weeks of wages for firing a worker vs. 35 weeks in High Income OECD firing a worker vs. 35 weeks in High Income OECD countries (World Bank):countries (World Bank):

“ “Index of Economic Freedom” (Wall Street Journal / Index of Economic Freedom” (Wall Street Journal / Heritage Foundation” rated Turkey’s economy as Heritage Foundation” rated Turkey’s economy as “Mostly Unfree”.“Mostly Unfree”.

Stimulate FDI inflows.Stimulate FDI inflows. Lower and simplify taxes further. Lower and simplify taxes further. Improve business environment - Cut red-tape even Improve business environment - Cut red-tape even

more.more.

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““Legalise” the informal economy – half the Legalise” the informal economy – half the size of formal economy.size of formal economy.

Maintain primary fiscal surplus target of Maintain primary fiscal surplus target of 6.5% of GDP after IMF programme ends in 6.5% of GDP after IMF programme ends in 2007. 2007.

Debt “overhang”: Foreign currency Debt “overhang”: Foreign currency sovereign debt rating of B1 (Moody’s), BB- sovereign debt rating of B1 (Moody’s), BB- (S&P) and Ba3 (Fitch-IBCA). (S&P) and Ba3 (Fitch-IBCA).

Below “investment grade” of Baa3Below “investment grade” of Baa3

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Maintaining expansion of trade: Exports at Maintaining expansion of trade: Exports at 30% of GDP in 2003 could 40% of GDP by 30% of GDP in 2003 could 40% of GDP by 2010 (Deutsche Bank Research).2010 (Deutsche Bank Research).

Reorient education away from rote Reorient education away from rote learning to critical thinking: 0.98 for South learning to critical thinking: 0.98 for South Korea, 0.91 for Bulgaria vs. 0.8 for Turkey Korea, 0.91 for Bulgaria vs. 0.8 for Turkey [1= best] according to the World Bank [1= best] according to the World Bank Education Index.Education Index.

4040

Current account deficit of 6.5% of GDP - Current account deficit of 6.5% of GDP - 70% financed by “hot money” (ie. non-70% financed by “hot money” (ie. non-resident portfolio investments and non-resident portfolio investments and non-resident deposits). Does not seem to be a resident deposits). Does not seem to be a major worry because:major worry because:

Private-sector investment-driven rather Private-sector investment-driven rather than consumption-centric.than consumption-centric.

Rapid increase in productivity: total factor Rapid increase in productivity: total factor productivity growth was 5.2% in 2002-productivity growth was 5.2% in 2002-2004 vs. 0.5% during the 1990s (Morgan 2004 vs. 0.5% during the 1990s (Morgan Stanley) – reflects institutional/structural Stanley) – reflects institutional/structural efficiency improvements rather than just efficiency improvements rather than just cyclical factors. cyclical factors.

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Structural changes in Turkish economy: Shift from Structural changes in Turkish economy: Shift from low productivity manufacturing (e.g. textiles) and low productivity manufacturing (e.g. textiles) and agriculture to high-productivity manufacturing agriculture to high-productivity manufacturing (e.g. automotive) and services.(e.g. automotive) and services.

Primary budget surplus of 6.5% of GDP. (What will Primary budget surplus of 6.5% of GDP. (What will happen after end of IMF programme in 2007? happen after end of IMF programme in 2007? Maastricht criteria ill-suited for Turkey. Leaves it Maastricht criteria ill-suited for Turkey. Leaves it too vulnerable to external shocks.) too vulnerable to external shocks.)

Turkish Lira is free-floating. Moderately Turkish Lira is free-floating. Moderately overvalued based on productivity weighting.overvalued based on productivity weighting.

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25% of current account deficit due to high 25% of current account deficit due to high oil prices.oil prices.

Privatisation proceeds could cover more Privatisation proceeds could cover more than half of deficit over next two years.than half of deficit over next two years.

Average maturity of new domestic Average maturity of new domestic government borrowing increased from 10 government borrowing increased from 10 months in 2004 to 34 months in 2005 months in 2004 to 34 months in 2005 (Turkish Undersecretariat of Treasury).(Turkish Undersecretariat of Treasury).

… … But high current account deficits unlikely But high current account deficits unlikely to disappear in short-to-medium termto disappear in short-to-medium term..