The Case of Turkey: Middle Income Trap or is it Different This Time?

Leiden University By Ilia Barboutev, PhD candidate Leiden University

Since the end of the Cold War and the seemingly decisive victory of neo-liberal economic prescriptions, numerous developing countries have experienced sharp and steady growth, eventually achieving what the World Bank defines as middle income status of a Gross National Income of around 12,000 USD per capita at current levels.

Nevertheless, many economies now seem stuck in what theoreticians call the middle income trap. Emerging markets can leverage their comparative advantage in lower labor costs to stimulate export driven growth, attract foreign direct investment due to comparatively higher rates of return relative to their risk profile, particularly in the real estate sector and in governmental securities, or rely on exporting natural resources during a global economic expansion.

However, due to rising labour costs in developing markets, rising interest rates in developed (and therefore lower risk) economies, and/or a glut in the global commodities market, emerging economies see a halt and often a reverse in their fortunes. In order for the pace of economic growth to be sustained, industries in emerging markets require the capacity to produce high value-added goods and services, while a growing domestic middle class should be nurtured to reduce the continuous need for exports.

While these two prescriptions seem rather commonsensical, they are seldom implemented. To understand why that is the case requires one to look deeper than simple macroeconomic indicators.

Modern economic orthodoxy continuously suggests the depoliticization of the economic study, profession, and practice. Typical prescriptions supplied by the International Monetary Fund upon struggling debtor states reflect this norm.

While the Fund rightfully claims that the depoliticization of certain key sectors would likely lead to a better economic performance overall, it fails to appreciate that the state capture of such sectors by often inefficient and inexperienced governmental loyalists is what actually underpins the very stability of the state. Therefore, IMF prescriptions and programs often go unimplemented not because of their inherent defects, but rather due to the political realities of the state involved.

A growing middle class and an educated workforce are certainly key drivers of economic growth and the wealth of developed, free-market democracies rests on continuously improving these twin pillars. However, in unstable regimes governing over socially and ethnically fractured countries, pursuing such policies could potentially lead to the downfall of a regime and widespread instability.

A larger middle class means a lesser reliance on the central government for economic activities. New power centers emerge which have the capacity to compete with governmental authority. In developed democratic states, this is not a big issue since economic power is dispersed and the transfer of political power across rival factions is already considered the norm.

In developing countries, a big businessman with political ambitions may use his power to mobilize the populace against a regime which has no intention of giving up or sharing the keys to the state. Furthermore, many regimes maintain their power by privileging certain social or ethnic groups, while excluding others from key economic sectors.

Therefore, authoritarian governments are often incentivized to discourage success and innovation outside their inner circle and/or group. An educated workforce further complicates the stability of a regime. Educated individuals demand certain services and a standard of public administration which authoritarian regimes and fractured states are incapable of delivering. Paradoxically an expanding middle class coupled with a highly educated workforce could bring about a regime’s downfall.

The modern Turkish Republic, particularly since emergence of the Justice and Development Party (AKP) and the party’s victory in the 2002 Parliamentary election provides a possible example of an economy stuck in the middle income trap.

The Turkish economy has nearly quadrupled in the period between 2002 and 2018 under the leadership of former prime minister and now President (and current presidential candidate) Recep Tayyip Erdoğan. Millions of people from the Anatolian countryside, a constituency historically excluded from the reigns of power since the fall of Ottoman Sultanate, have joined the ranks of the wealthy and powerful. Their regions have seen unprecedented development and the days when a military coup waited in the shadows to prevent their political ascendance seem to belong to the dustbin of history.

Nevertheless, as President Erdoğan is pursuing an election campaign to attain the long coveted strong executive presidency after the passage of the constitutional referendum in 2017, trouble looms on the horizon for the Republic’s economy.

In order to secure a decisive win, the President and his supporters have encouraged a loose monetary and fiscal policy in the hope of garnering the required 50%+ votes. The President has chosen to ignore the rising global interest rate wave, which threatens to sweep emerging markets. Key interest rates in Turkey are artificially kept low, the budget and current account deficits have widened significantly, inflation is holding steady at 10% and the Turkish Lira has hit record lows against other currencies.

In order to shore up pre-election economic growth, the AKP-led executive has handed out generous guarantees to small and medium-sized businesses, while pooling state owned assets such as highly profitable bank stakes and Turkish Airlines into a sovereign wealth fund to be used for securing infrastructure loans.

Nevertheless such a short-term over-leveraging comes at a cost and ignores a plethora of risks that no open market economy can evade, especially one that is heavily dependent of foreign direct investment to finance its current account deficit. So far, the executive has refused to acknowledge the risks. Instead, verbal attacks on rating agencies and radical theories deriding interest rates as the mother and father of all evils have been proposed. Statements about tightening the state’s grip over the economy have added more fear to the situation.

Ignoring the pressures on the lira has the potential to trigger a crisis for which the Central Bank of Turkey is ill prepared.

First, the Central Bank has seen its foreign exchange reserves gradually erode. Without sufficient reserves in foreign currencies, the Central Bank would be ill equipped to provide support for the lira by engaging in market operations aimed to stave off its decline. In the short-term, it could exchange its foreign exchange reserves, thus stemming the downward pressure on the lira, while a more robust policy response is agreed to.

Second, the country runs a widening current account deficit, which in practice means that it buys more from the world markets than it sells. When an individual buys more than what they spend, the difference will inevitably have to be made up by someone else. In the case of Turkey, the country relies on foreign investment to make up the difference between imports and exports. If foreign investors begin to worry about the erosion of their lira-denominated assets, the risk of capital flight due to asset fire sales increases significantly. If investors do decide to exit the Turkish markets, they would sell off their holdings and put tremendous downward pressure on the lira, thus creating spiraling inflation and exacerbating an already fragile economic climate.

Third, the Turkish economy is woefully unprepared for the coming wave of rising interest rates in the developed world. In order to reduce the painful impact of the global financial crisis, the Federal Reserve in the US and the European Central Bank set interest rates to 0% territory thus eroding returns on debt instruments, but lowering borrowing costs for businesses and consumers in those countries. Investors demanding higher returns looked to emerging markets where compensation is higher to due to the increase in risk.

As interest rates are likely to go up in the developed world, where risk is perceived to be lower, emerging markets would have to respond by offering higher interest rates on governmental and private sector securities. This would inevitably lead to a rise in interest rates throughout the broader economy and hurt commercial borrowers and mortgage holders, while increasing the amount of non-performing loans held by banks and making credit more scarce. While all emerging markets that rely of foreign direct investment will be affected, those with wide current account deficits are most vulnerable.

Fourth, while foreign investors took advantage of higher interest rates in Turkey, Turkish companies and the government have borrowed extensively overseas in the foreign currencies of low-interest developed economies. Since the money has to be repaid in a currency other than the Turkish lira, the costs for such borrowers rise significantly. A recent report estimates that for every 1 cent drop in the Turkish lira vis-a-vis the US dollar, Turkish borrowers have to pay back an additional 5 billion liras. Turkish non-financial companies hold over 337 billion dollars in foreign currency liabilities, equivalent to nearly 40% of the entire national economy.

Fifth, the Turkish government risks a short-term liquidity crisis due to the current monetary policy inaction. Governments rely on the bond markets to fund their short-term liabilities. They offer their bonds during auctions at a risk-adjusted premium relative to a benchmark. Either a premium is demanded on top of the face value of the bond or a discount is offered for assets deemed to be of a higher risk. As Turkey’s risk profile continues to grow, investors would demand a greater discount on Turkish securities relative their peer group, thus forcing the country to effectively borrow less money at higher rates of interest. This would further damage its financial position despite a very low debt-to-GDP ratio and filter down through the economy, effectively enforcing either more expensive or less accessible credit terms on private borrowers.

Markets seem to be demanding action from the Central Bank. While this could provide some temporary respite and perhaps set the stage for a short-term rally of the lira against other currencies, it is no panacea. An interest hike would at least temporarily arrest the lira’s decline, help reduce inflation, narrow the current account deficit and increase the purchasing power of consumers and businesses that buy their inputs from abroad. Nevertheless, there is no free lunch. Higher interest rates will inevitably increase the cost of credit, shutting many out of the banking system, raise interest payments to indebted consumers and businesses, increase non-performing loans held by financial institutions, and potentially reduce the profit margins of exporters.

Monetary policy alone will not solve Turkey’s deep structural problems, nor will it help it to avoid being stuck in the middle-income trap. The present economic challenges are largely the result of political choices and their solution is to be found in the realm of politics.

The current economic struggles are a part of a modernization process, which arguably began in 1839, during the Ottoman period. The problems and solutions identified during the time of the famous Tanzimat Reforms remain largely the same, namely how to minimize social tensions between various groups, to create a cohesive society, and to foster a system of inclusive economic and political institutions. The modern Turkish Republic remains sharply divided between Turks and Kurds, Religious and Secular, Nationalists and Liberals, Progressives and Traditionalists. As long as they maintain their willingness to resort to violence against one another and/or to exclude each other from the economic and political spheres, the Turkish Republic will be unable to attain the status of a developed economy.

A way to bridge the huge gap between people can be found in improving the quality of education and encouraging a greater awareness of their shared history. A nation state, much like an economy, is a constantly evolving process, rather than a finished product.