TURKEY SPOILS EMERGING MARKET STORY AS POLITICS GO HAYWIRE / THE TELEGRAPH

Turkey spoils emerging market story as politics go haywire

No country so rudely exposes the illusions behind the $8 trillion stampede into emerging markets more than Turkey

By Ambrose Evans-Pritchard, in Ankara

3:57PM GMT 19 Feb 2014
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Protesters tear a poster of Turkish premier Recep Tayyip Erdogan Photo: AFP

Turkey is the first big domino to fall in emerging markets, a cautionary tale for investment tourists who came late to the party and skipped the political fine print.

Its catch-up growth model reached exhaustion in 2007. The consumption boom that followed has been driven by inflows of hot money, all too like the earlier bubbles in Ireland and Spain.

Its showcase Muslim democracy came off the rails when police opened fire last June on demonstrators in Istanbul's Taksim Square and cities across the country, killing six and injuring 8,000. Amnesty International accused the government of human rights violations on a "huge scale”.

Matters have since gone from bad to worse. European diplomats say premier Recep Tayyip Erdogan is in such clear breach of the EU's Copenhagen Criteria on democracy and the rule of law that Turkey's accession bid is in doubt, and with it the implicit assumption that underpins foreign investment in the country.

No country so rudely exposes the illusions behind the $8 trillion stampede into emerging markets, though Ukraine must be ahead on points by now. Investors came to believe that all humanity is moving in the same direction, that free markets and open societies are ineluctable, that we really are seeing the "End of History" on liberal terms. "The West should wake up," said Kemal Kilicdaroglu, Turkey's opposition leader.

Muharrem Yılmaz, the head of Turkey's industry lobby Tusiad, issued an astonishing cry of alarm three weeks ago. “A country where the rule of law is ignored, where the independence of regulatory institutions is tainted, where companies are pressured through tax penalties and other punishments, where rules on tenders are changed regularly, is not a fit country for foreign capital." For this he was accused of "treason" by the prime minister.

The new twist - the "events of December 17" - is the eruption of a bare-knuckled power-struggle within Mr Erdogan's Islamist movement. It was triggered by corruption probes against party elites, including four cabinet ministers, but nothing is what it seems in Turkey.

Mr Erdogan retaliated with a purge of judges, prosecutors and police, as well as banking and TV regulators. Court orders were torn up. He claimed that a "parallel state" led by the Gulenist brotherhood - a sort of Islamist Opus Dei that runs elite schools and nurtures rising leaders - was trying to overturn democracy.

"Claims of a judicial coup cut no ice with us," said one EU diplomat. "The prime minister is circling the wagons to protect the new establishment. Anybody not considered sufficiently loyal is being forced out."

"There are no credible parliamentary balances to hold the executive to account. Erdogan cannot roll up democratic institutions like this. He was told in no uncertain terms in Brussels in January that these are persistent breaches of the Copenhagen Criteria, and imperil Turkey's accession process," said the official.

The upper echelons of the armed forces have already been decapitated by the "Ergenekon" trials, accused with a Stalinesque touch of plotting a military coup d'etat with a "black ops" campaign to blow up mosques and murder Christians. Defence lawyers say the documents were fabricated.

European leaders have so far bitten their tongues, merely expressing "concerns" in public. There is no plan yet to invoke the nuclear option of suspending EU talks. It would take a unanimous vote by all 28 EU states. Few wish to "lose Turkey" so soon after "losing Ukraine". But such drastic thoughts are circulating behind closed doors. That alone is a new strategic fact.

Discussions with officials from six different EU states left me in shock. Most think Mr Erdogan will stop at little to hold onto power. More than 100 journalists are already in prison, the highest number in the world.

The latest escalation is an internet law that would let censors shut down websites without judicial review, a foretaste of what we may see other in countries. Freedom House says Turkey is already blocking 29,000 websites. The new bill lets Turkey's leaders block "anything it does not want its people to know".

Vice-premier Ali Babacan told The Telegraph that the internet had become a jungle and must be tamed. "We have to protect the public against ill-willed people on the net who exploit freedom," he said.

Turkey is at an inflexion point. The first half of its boom since 2002 was a genuine catch-up story. A bail-out by the International Monetary Fund set the ground rules. Mr Erdogan followed the script, helped by roaring global growth.

Renault and Fiat built state-of-the-art car plants in Bursa. Foreign direct investment (FDI) flooded in, lured by Turkey's access to EU markets, but also by its potential as an export hub to the Middle East. An 80m-strong Ottoman Tiger was bursting on the scene.

Yet such models have their limits. The middle income trap awaits, once the low-hanging fruit has been picked. Countries cannot rely on imported machinery and low wages to drive growth forever.

The air is thinner at the technology frontier. Intangibles matter: the rule of law, free thought, social mobility and education; and Turkey is making hash of it on all fronts. Average years in school are 6.5 compared with 11 in the EU. The labour participation rate for women is 32pc. These are 19th century levels. Turkey is not Korea.

The failure to make the jump to the next level is already clear. Turkey's economy hit the buffers in 2007. FDI has slowed to almost nothing. Progress up the technology ladder has wilted. The past six years have been a consumption bubble, leaving a current account deficit of 7.6pc of GDP funded by hot money flows.

"Turkey is trying to grow at speeds far above its investment rate (12.6pc) and no country can do that for long. Low savings means they will be hit even harder by rising global rates," said an official.

The IMF warns that Turkey is on an "unsustainable" path and risks a sudden stop in capital flows as the US Federal Reserve tightens the spigot of dollar liquidity.

Gross external financing requirements have reached 25pc of GDP per year. Turkey's foreign asset position has fallen off a cliff since 2008, dropping to -53pc of GDP, (the red line is 30pc). Short-term foreign debt has jumped five-fold to $90bn since 2007, and has to be rolled over continuously.

"Turkey was no different from Russia, Brazil or India. It was a typical emerging market benefitting from a huge wave of liquidity," said one official. "They thought convergence would happen whatever they did, so they could just sit back and reap the gains. But this can end very badly when it is undisciplined."

The shock hit in May 2013 when the Fed turned hawkish. Mr Erdogan thought he could keep the party going in defiance of gravity. The central bank - attentive to his mystical monetary doctrines and hatred of the "interest rate lobby" - kept its foot pressed to the floor, with interest rates below -2pc in real terms. It burned through Turkey's foreign reserves in a doomed bid to defend the currency, reducing import cover to two months.

This was a fiasco. The lira fell 20pc against the dollar as inflows dried up, and 10-year bond yields rose from 6pc to almost 11pc. The authorities capitulated in late January with a "shock and awe" rate rise of 550 basis points, calculating that the risk of a further collapse in credibility was even greater than the damage from a monetary squeeze.

Turkey's saving grace is that it is not trapped in fixed exchange system with a viciously overvalued currency, unlike East Asia in 1998 or the eurozone's Club Med bloc today. Public debt is just 35pc of GDP and all in lira.

Yet the mantra that emerging markets are insulated from a 1998 crisis because they no longer borrow in dollars is wishful thinking. The Bank of International Settlements fears some may be just as vulnerable now to Fed tightening because their companies and banks have tapped global capital markets like never before, leaving them at the mercy of a Fed-driven rate shock. “The deeper integration of emerging market economies into global debt markets has made [them] much more sensitive to bond market developments in the advanced economies,” it said.

In theory, Turkey should be Europe's great hope. With an average age of 29 and the freshness of an reawakening society, it should be the answer to demographic atrophy in the Christian countries.

But by intervening in Syria on the Sunni Muslim side and dismantling the secular state of Kemal Ataturk brick by brick, Erdogan has brought Turkey's sectarian disputes bubbling to the surface. It is no coincidence that all six of the dead protesters were - loosely - in the Shia Muslim camp, either Allowites or Alevis.

And by pursuing a neo-Ottoman foreign policy in the Middle East, he has created strategic confusion and tested Turkish claims of European identity to breaking point. That has consequences.

Between theory and fulfilment lies a political chasm. Russia, Brazil and India have their own variants of such destructive reflexes, to lesser degrees. Sustained economic take-off is harder than it looks.