Turkey and the EU

From MS GEF

Turkey: The Real Stake of Turkey-EU Negotiations

Serhan Cevik and Eric Chaney | London

We need to put Turkey’s relations with the European Union into a historical context, before analysing its convergence path. The process of “Europeanisation” started centuries ago during the Ottoman Empire, with the realisation of scientific and institutional progress in the west. But it really accelerated to a revolutionary pace in the early decades of modern republic under the reign of Ataturk, overhauling archaic institutions and bringing economic rejuvenation to the agrarian society. Unfortunately, despite such significant progress, a dreadful sense of inertia descended over the country, and political frictions slowed institutional modernisation. Consequently, although Turkey applied for associate membership status in the European Economic Community in 1959, the EU waited until 1999 to confirm the candidacy status and until 2005 to start accession negotiations. Nevertheless, Turkey’s difficult relations with the EU have always played a fundamental role in its institutional and economic development.

Bringing political and economic institutions into line with European standards will transform Turkey’s economy and social standing, but it would be naïve to expect accession talks to be straightforward, without any challenges. The experience of the last twelve months is an obvious case in point. First, despite the encouraging steps forward in recent years, Turkey still has a long list of political and socio-economic requirements to complete. Second, Europe’s enlargement fatigue and the unresolved Cyprus conflict will keep obstructing Turkey’s accession process, even if Turkey meets all the conditions without any delay. Indeed, Turkey’s membership aspirations have always been an important feature in the “widening versus deepening” debate in Europe, but the prevailing rhetoric suggests a deeper resistance to further integration and enlargement. In our view, these underlying shifts in Europe’s political climate are likely to place new stumbling blocks (such as the argument on the Union’s absorption capacity) in front of Turkey’s accession process.

One of the major concerns is the income inequality between Turkey and the EU and regional income disparities within Turkey. Turkey’s per capita GDP in purchasing power standards was just 29.8% of the EU-25 average in 2005, even below Bulgaria (31.9%) and Romania (32.9%). Furthermore, although the latest figure represents a 16% increase from the country’s relative income level of 25.7% in 2001, it is still below the average of 30.5% in the 1990s. As a result, Europeans perceive Turkey’s young and growing population as a threat that could lead to a wave of immigration. However, we believe that such figures alone are not enough to reach a gloomy conclusion. As a matter of fact, an encouraging process of convergence is already underway and the Turkish economy should continue catching up with the EU over the medium term. Even in the near future, we are likely to see further improvements that would raise Turkey’s per capita income to 34.2% of the EU-25 average (or about 40% if we take into account the conversion of national accounts to the European standard) by the end of 2008.

Many fear Turkey’s growing population with an average age of 26.5, but we see it as a demographic gift that could help the country achieve faster convergence. After all, working-age population is the basis for employment and income growth. Turkey’s problem has always been the low level of employment limiting the speed of convergence. While the share of the working-age population in total population stands at 71.2% (compared to 64% in Europe), the number of employed is just 45% of the working-age population (compared to 63.8% in Europe). The employment rate is partly a function of the level of labour force participation, which unfortunately stands at 49.3% compared to 72% in Europe. However, if Turkey improves the state of the labour market and brings its employment rate to the European level, the number of employed could increase by almost 50%, or by 11.6 million workers. Put differently, Turkey can potentially create new jobs that would be approximately half of the entire employment in the ten new members of the EU. Given the significant difference between per capita GDP and per worker GDP, that would imply a level of per capita income that is already at about 50% of the EU-25 average, even with today’s figures. In other words, Turkey’s demographic characteristics that may look like a threat now are actually an indication of its great potential to accelerate the pace of income convergence.

Macroeconomic normalisation and structural changes have acted like a “technology shock” raising the rate of productivity growth to a higher plateau. And given the favourable demographic trends, we estimate Turkey’s potential growth rate at around 7.5% — three times the EU-25’s potential. Of course, having a great potential is no guarantee for catching up with the rest of Europe at an accelerated pace. Maintaining the actual growth rate close to the potential growth rate, without triggering inflation pressures, is a challenging task that requires prudent macro policies and, more importantly, a wide-ranging set of structural reforms to remove microeconomic bottlenecks. As discussed above, one of the important building blocks for such a scenario is improving the economy’s labour absorption capacity. Greater flexibility in the labour market, together with the rationalisation of the tax regime and bureaucracy, would certainly help accelerate job creation and reduce inefficiencies in traditional sectors of the economy. For example, gross value added per worker in the agriculture sector is less than one-third of those figures for services and manufacturing sectors. In other words, sectoral productivity differentials (reflecting structural problems) also explain regional income disparities and the low level of per capita income relative to the EU average. Therefore, by improving labour-market conditions, Turkey can enhance its potential growth rate and keep its actual growth rate close to its potential.

Turkey may have the potential to boost employment growth, but that is not an automatic process even with more flexible labour-market regulations. Educational attainments are crucial, especially in today’s global economy. Even though we have seen a steady improvement over the years that will no doubt make the next generation of workers better equipped, Turkey’s human capital endowment remains low compared to other countries. For example, the share of the adult population with upper secondary education is 25% in Turkey, as opposed to the OECD average of 56%. This is partly a result of “gender gap” in educational attainments that also leads to an unusually low female participation in the labour force. Therefore, Turkey needs a comprehensive strategy to improve human capital endowment across the board. That is of course necessary but not sufficient to achieve higher productivity and income growth. After all, labour productivity depends on the capital-to-labour ratio and total factor productivity, not just the quality of human capital.

Even though fiscal consolidation and restructurings in the banking sector have led to a better allocation of capital, domestic savings are inadequate to finance Turkey’s investment requirements. This is why it needs a sustained increase in foreign direct investment, which had remained at an annual average of $720 million (or 0.4% of GDP) and accounted for a mere 2% of capital spending between 1985 and 2003. But that was not surprising, given macroeconomic volatility and structural limitations keeping foreign firms away from the Turkish market. The good news is that macroeconomic normalisation and institutional improvements in the investment climate have already led to a breakthrough in FDI flows — surging to $9.8 billion (or 2.7% of GDP) in 2005 and around $20 billion (or 5.2%) this year. Obviously, the EU accession process plays an important role in attracting FDI and therefore accelerating productivity growth. It has happened in numerous other countries, and Turkey should enjoy a similar injection of low-cost capital with positive externalities. Coupled with higher educational attainments, the FDI-driven accumulation of new technologies and know-how would support the rise in total factor productivity growth, which already increased from 0.5% a year in the 1990s to 4.8% in the last four years.

Estimating the path of income convergence is an empirically challenging task, but our simple model based on growth rates and population dynamics provides useful insights and reasonable accuracy. Full income convergence is not necessary at this stage, or even at the time of accession. Hence, we instead focus on two alternative scenarios — uninterrupted accession process towards full membership or prolonged “Europeanisation” with no membership status. In our “accession” scenario, Turkey’s trend GDP growth would reach 7.5% a year, as opposed to 2.5% in Europe, thanks to the rising share of the qualified workforce and capital inflows. That would bring per capita income from 29.8% of the EU-25 average in 2005 to 48.5% (even excluding the likely revision in national accounts) by 2015. In our “sub-optimal” scenario, negotiations would fail, but “Europeanisation” would continue, albeit slower and with higher political risks. Trend GDP growth would be only 4.5% and leave Turkey lagging behind China and India. All in all, we still believe that the likelihood of an absolute breakdown of Turkey’s relations with Europe is negligible and the accession process, though more challenging than for other candidates, will help accelerate the speed of income convergence.
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Turkey: Looking Beyond the Wall of Noise

Serhan Cevik | London

Turkey is moving into an election cycle, but we should look beyond the wall of noise. It is the time of the year when we update our economic analysis and roll out new projections looking into 2008. However, before we even get there, a challenging period of elections and global fears will greet us next year. Turkey has so far enjoyed an unprecedented era of uninterrupted expansion and become the fastest growing OECD country in the last five years. But as the burst of global volatility earlier this year reminded us, it has a troubling exposure to liquidity-driven capital flows and remains sensitive to noise and global sentiment. One of the main sources of market noise next year will be the country’s political cycle, starting with a presidential election in May and then general elections in November. We will regularly survey the political landscape over the coming months, but for now we believe that political developments (including the EU accession process) are unlikely to unsettle the favourable business cycle. And on the external front, although global imbalances may result in bursts of financial volatility, Turkey is less vulnerable to a US-led global slowdown (see When Atlas Sneezes, October 25, 2006). All in all, Morgan Stanley’s forecasts point to a mild correction in global GDP growth from 5% in 2006 to 4.3% next year and then 4.5% in 2008. Furthermore, the projected strength of Europe should keep the composition of growth favourable to the Turkish economy, given its extensive links to the continent.

Macroeconomic normalisation reflects fundamental improvements, in our view. On our estimates, Turkey will continue growing faster than the global economy in the coming years. We expect real GDP growth to slow from 7.4% in 2005 and 5.8% in 2006 to 5.6% next year, but reaccelerate to 7.2% in 2008. In our view, tighter financial conditions and slow recovery in real disposable income growth will moderate domestic demand growth, as the rate of increase in consumer spending eases from 8.8% in 2005 to 5.3% in 2006 and 4.4% next year. However, we are confident about income generation and financial penetration over the medium term, and thus expect private consumption to grow 6.2% in 2008. On the other hand, investment spending is more sensitive to transitory shocks and exhibits higher volatility. As a result, the annual growth rate of gross fixed investment expenditures is likely to lose pace from 24% in 2005 to 13.2% in 2006 and 7.5% next year. But we see this deceleration as a healthy sign of consolidation after a 104% cumulative increase in the past four years, and we expect a 12.8% increase in 2008. Overall, while domestic demand moderates toward a more balanced growth path, the rise in exports should support the economy and even help bring stabilisation in the current account.

Inflation should remain high in the first half of next year, but then start declining. The Turkish economy, albeit standing on stronger footing, still faces a number of challenges — mainly stemming from exogenous factors (like higher energy prices) and domestic excesses that emerge during the normalisation phase. In our view, the best policy anchor to manage these risks is the correction of fiscal imbalances. And thanks to prudent policies, the budget deficit has already narrowed from 15.2% of GDP in 2001 to about 1.2% this year, making the Treasury a net debt payer for the first time ever. The marked reduction in the public sector’s dis-saving rate not only improves debt dynamics but also supports the disinflation process. This is why we prefer looking beyond short-term volatility and focusing on fundamental drivers of the secular shift toward price stability. With sustained productivity gains that have outpaced wage growth and expanded the country’s supply frontier, we expect inflation to decline from 9.8% in 2006 to 5.8% by the end of next year and 3.6% in 2008.

The extent of monetary easing should be limited next year but accelerate in 2008. In our view, the Central Bank of Turkey will keep interest rates unchanged in the next six months, as it has to bring disinflation — firmly and visibly — back on track. Once inflation starts moving toward the “uncertainty” range, the authorities should be in a position to ease their monetary stance by 150 basis points in the second half of 2007 and 300 bps in 2008. That may not be immediately exciting for financial markets, but we think maintaining stability in a challenging year would be priceless, nonetheless.