Turkey on the Edge

Turkey, in the hot grip of the summer solstice, faces a hazy future. For a change, Turkey is suffering from an economic and financial crisis not of its own making. Its fiscal discipline and good behavior of recent years are going unrewarded as its economy contracts, its currency weakens, and its stock market gets ignored amid a historic emerging-market boom.

It's a sad state of affairs for this country of 71 million people, with the 17th-largest economy in the world and immense potential. Unlike those in the European Union, Turkey's population and workforce are growing, and its people, banks, and public sector are not heavily in debt. Its banks are downright healthy compared with those in Europe, the United Kingdom, and the United States.

Turkey matters be-cause it is a big, functioning, democratic Muslim state that could be an example to the rest of the Middle East, and could emerge as an anchor to the southern flank of the EU. Turkey has the biggest and arguably one of the toughest armies in Europe. From Gallipoli to Korea and Vietnam, the legend has grown: "Don't mess with the Turks."

However, at this moment Turkey is ailing. The economy collapsed last fall with those in the rest of Europe, and although there are a few tentative "green shoots," plenty of problems lurk. The premier investment bank, EFG, forecasts that real GDP will decline 4.5 percent this year and will rise only a feeble 3.5 percent next year. Unemployment is 14 percent, and is about 20 percent among the younger age groups. Inflation, despite the weak economy, remains in the range of 6 to 7 percent, and real interest rates are too high for a convalescing economy.

Rising oil prices are hurting big time. The federal budget is a shambles, investment money is flowing out, and the currency is anemic. The private sector's short-term debt has soared, and the fear is that the foreign exchange required to service and pay back that debt will push down the value of the Turkish currency, and set off a vicious circle as the debt grows ever more difficult to pay down.

Local sources estimate that Turkey needs at least $20 billion to service its foreign debt. Thus the recent visit of top World Bank and IMF officials was watched with great anticipation. Pre-sumably a loan (of maybe $15 billion to $20 billion) was offered, terms were discussed, but nothing has happened so far.

Why? Because the price of the IMF money is a stiff dose of austerity. Since the government faces an election in the next 12 months, it is very reluctant to endure IMF medications that might anger voters and lead to a defeat for the ruling party. In essence, the government is gambling that the economic recovery will be strong enough to solve Turkey's problems and make an IMF loan unnecessary.

This is not a wise gamble. Signing a deal with the IMF is crucial insurance. If the IMF provides Turkey with the money to bridge its financing gap over the next two years, the adjustment in the economy will be relatively painless. However, if there is no IMF loan, the lira will fall, the economy will weaken again, and there will be another, perhaps more severe round of wealth destruction.

Do the Turkish people understand these issues? Probably not, because they are diverted by the thin green shoots in their economy. In recent weeks, Istanbul buzzed at its usual frenetic pace and the Bosporus was jammed with tankers, freighters, and cruise ships. The hotels on the coast were packed with Germans, Russians, and Israelis working on getting tans and skin cancer. Signs that the local economy is rebounding include increasingly busy factories, with capacity-utilization rates at 70 percent in May, up from the trough of 64 percent in February. Domestic demand is clearly improving, but a sustainable recovery depends on Turkey's big export markets in the euro zone, Russia, and the Middle East.

If Turkey can maneuver through this crisis, the future could brighten quickly. Businessmen I spoke to in Istanbul in June said that over the next five years, even in a slower-growth world, Turkey's real GDP could grow 5 percent a year. Nominal GDP expansion of 10 percent is not unrealistic. Entry into the EU would raise these projections. From 2002 to 2007 real GDP growth averaged 6.8 percent, and it could happen again.

Turkish stocks now sell at an average price of just nine times earnings. Yet Turkey is not high on anyone's buy list of hot emerging markets: too many problems, too many false starts. Meanwhile, huge money continues to flow into emerging markets, which took in $1.19 billion in late June, and for the year to date have taken in $30.7 billion, compared with the previous full-year record of $40.8 billion. With a little luck, Turkey could get a play.