Clear and Present Danger
Turkish public debt is one of the highest amongst emerging markets, and despite the most opportune global and domestic economic backdrop and fairly tight fiscal and monetary policy, it has been rising rapidly during 2003. It has become a social and economic malaise, which, like a black hole, swallows any revenue that comes near it and distorts the nearby economic and social spheres.
The time for piece-meal solutions is over: now is the time for action. But what action would be most appropriate?
By the end of August 2003, the Turkish public debt had reached USD185bn, of which USD128.5bn was domestic market debt with a duration of less than two years.
The Treasury will pay USD43bn in interest this year, amounting to 18.3% of expected GDP. Currently, domestic debt instruments make up around 43-45% of the balance sheet of the banking system.
In the international context, there are very few nations that have faced similar debt statistics and managed to avoid disaster. But, talk to anyone in Ankara or Turkey's vibrant banking community nowadays about the debt problem and the most likely reaction is: "What debt problem?" Superficially, it is true that the debt profile has shown an amazing turnaround this year. Average interest cost is about 10-12%, which is sustainable, given a 5.5% non-interest surplus (NIS) and 5.5% GDP growth. The administration predicts that by the end of the year, public debt as a percentage of GDP will decline from a high of some 80% to slightly below 70%. That would seem to make the debt problem a problem of the past.
However, the ugly truth is that the debt situation would be getting worse this year, had it not been for two miraculous developments: the remarkable strength of the Turkish Lira and the USD8.5bn care package from the US. A good portion of domestic debt (25.6%) is linked to foreign exchange, on which the Treasury is paying negative interest, and perhaps more importantly, there are very strong valuation effects associated with calculating the external debt to GDP ratio at an appreciated exchange rate.
According to Eurosource proprietary research, this effect could be anywhere between 12-16% of GDP. The loan from the US, even if it is not drawn on, signals to the markets that as long as Turkey cooperates in Iraq, its debt is implicitly under the guarantee of the US Treasury.
But it is not at all apparent that this situation is sustainable, especially considering that the Turkish public was resolutely opposed to involvement in Iraq under any circumstances.
The moment the financial community begins to suspect that Turkish debt is unsustainable, default premia will rise further, with some investors running for the door, resulting in financial crisis. But this is not necessarily a bad side effect of the debt overhang. In fact, it could be beneficial; a sort of bloodletting. More accurately, it is the chronic economic inefficiency and social inequity caused by the debt that is becoming lethal for Turkish society.
Crowding out is the foremost and best-known side effect of high public borrowing, which should be exacerbated by the shallowness of the Turkish financial system. There is some evidence that the high debt burden and the slow-down in Turkish GDP growth after 1994 are correlated. Turkey's State Planning Organisation has asserted in all of its five-year development plans that the non-inflationary growth rate of the economy is 7-8%, while actual growth averaged 4.5% to 2.5%, depending on the base year. Perhaps, the cost of the debt overhang, along with high and chronic inflation explains the output gap.
Yet, there are more subtle ways in which the debt overhang distorts economic activity. Successive administrations employed a perverse method, under the divine guidance of the IMF, to deal with the debt problem. They levied excessive taxes on energy, telecommunications and incomes to pay off the debt, instead of broadening the tax base. Turkish tax/GDP ratio rose from 14% in the early 1990s to 24-25% by 2002, while the number of taxpayers did not similarly increase. Taxes in arrears, including social security contributions, reached TL28qn, or 8% of expected 2003 GDP. As a result, the official sector is crumbling under high taxes and energy costs, while a flourishing parallel economy with almost no marginal returns on equity gains strengthens by the day. The system, in the end, punishes the successful and law-abiding at the expense of the corrupt.
Three scenarios moving forward: to summarise, Turkey's debt overhang is a very serious economic and social problem, the damage of which is increasing by the day in terms of lost output, worsening income distribution and a pervasive feeling that the system is lining the pockets of a few at the expense the many. The question remains: what can be done?
What Turks wish for most of all is high-growth, low inflation. Leaving things to time, while pursuing a tight fiscal-monetary mix appears to be the preferred method of solving the debt problem by successive governments in Turkey. High growth, low inflation and a non-interest surplus of 4-5% per annum can reduce Turkey's dismal debt ratios to international norms by 2008-2009, according to the Treasury. The rub here is sustaining this kind of performance over half a decade. With the exception of the golden 1960s, there has been no such episode in Turkish economic history. It is unlikely that a rapidly globalising world is going to give her such an opportunity now. Also, with each passing year during which the surplus of a nation is sucked down the black hole of debt, social resentment and the subsequent call for even more radical policy action will become more pressing.
Consequently, Turkey is likely to face erratic growth, moderate inflation and the drama visited on nations by moral hazard. There is the great danger that the current policy advocated by the IMF: namely that fiscal discipline coupled with huge NIS will turn Turkey into the next Argentina. There is already some evidence of that. Even though the Turkish economy has grown for seven quarters running at the time of writing, there has not been visible improvement in employment. Keeping prices of basic inputs and marginal tax rates high to achieve a NIS means disposable incomes will not keep up with GDP growth. It is highly possible that continuing on the same path would depress growth in 2004, an election year, compelling the government to eschew discipline.
But, since Turkey is so strategically important, the West will keep the country afloat by throwing it a lifeline every time it gets into trouble. This is the recipe for slow death, because Western loans are earmarked to pay off investors, not to relive the burden on the taxpayer. This is why the IMF is so despised in Turkey.
However, given the economic and social costs of the leave it to time approach, it is high time to get pro-active. The wisest course of action would be fiscal reform, supply side tax cuts and partial restructuring. Fiscal reforms should be comprehensive, making government expenditures completely transparent, reforming the tax system and cutting waste and inefficiency. The savings will be used to cut user and income taxes, thereby stimulating productive activity.
This should broaden the tax base and raise fiscal revenues, signalling to the market a higher debt-paying capacity, with a lag of course. Once the administration gets its house in order, it will be time to talk to lenders about voluntary restructuring. For Turkish governments, even the moderately Islamist Justice and Development Party (AKP), restructuring is taboo.
This is because Turkey has always bargained from a position of weakness. If Ankara can prove that it is able and willing to pay off the debt, investors could be more amenable to persuasion. It seems likely that many would, if they are properly compensated for the risk of longer holding periods. Basically, the Treasury should be offering a much reduced default risk, in return for lower returns.
Simple maths reveals the efficacy of this strategy. Through August 2003, the Treasury paid USD36bn on a debt stock of USD185bn, conjecturing that by the end of 2003, debt would reach USD200bn, and total interest expense USD40bn. In other words the Treasury pays roughly 20% interest on debt. If by restructuring the interest can be cut to 10%, the Treasury will have freed up roughly USD20bn this year alone, part of which could be placed in a sinking fund to redeem investors. It is feasible and the most optimal solution to the debt problem, but will anyone rise to the challenge?
The author would like to thank Dr Murat Ucer for data and very valuable insights on debt dynamics.