Turkey : a common framework for economic and diplomatic analysis


For an investor, human rights issues have become a real operational risk—a reputational risk notably, because European companies are under the scrutiny of active shareholders, while ethical rules of conduct are increasingly integrated into management.

Osman Kavala

When it comes to Turkey, European investors and diplomats face the same difficulty: how to manage the ever-widening gap between this country’s geopolitical and economic inescapability, and its growing unpredictability? In other words: it is impossible to lose interest in Turkey, but the horizon for forecasting is shrinking, and we must grope our way through. This singular dissonance between the importance of a country and our ability to predict its evolution has growing operational consequences. On one hand, it complicates the design and implementation of long-term strategies, whether financial or geopolitical. On the other hand, it creates short-term risks, especially in the financial and exchange rate sphere, where unpredictability means volatility.

Investors and diplomats therefore share the same analytical and operational difficulties. In fact, it derives from two internal and external factors, which echo each other, feed each other, and progressively change the global universe of risks, in economy, finance and geopolitics.

Internally, the evolution of the regime towards increased authoritarianism and centralization, especially during the last ten years, strongly impacts the Turkish institutions and society, but also external policy—as the erosion of institutions leads to an alignment of internal and external politics. Externally, the influence of geopolitics is stronger. For example, take Turkey’s growing direct involvement in regional conflicts, whether in the Middle East or the Caucasus, or its complex relations with NATO and the EU, as well as with Russia, Egypt, Iran, Israel and the Gulf states. Moreover, the connection between external and internal security issues has intensified.


The “pivotal state” behaviour?

The way in which these changes unfold is not neutral for the risk universe of investors and diplomats. Indeed, the mechanics of Turkey’s transformation is a mixture of shocks—financial or political—but also of progressive—sometimes less visible—change of institutions as well as productive structures. These two dynamics ultimately combine to change the country. But the repeated shocks create a “magnifying glass-effect,” leading analysts to constantly over or underestimate the Turkish risks. Concern is at its peak during the disruptive event, but it disappears quickly afterwards, even sometimes too quickly! This effect probably explains why financial markets focus too much on the short term (the shock) and sometimes not enough on the long term (the transformation of institutions and related risks).

The hypothesis of a “shock strategy” that is deliberately implemented is now on the table. Turkey’s status as geopolitical “pivotal state” provides a logical explanation. Indeed, this specific status raised the level of what could and can be accepted by the international community, in finance as well as in politics. Crucially, it has probably been integrated as such by the Turkish state. This behavior has already been observed elsewhere, but the novelty here is that this shock strategy is deployed comprehensively, from geopolitics to economy and finance. For example, it was very daring to replace the head of the Central Bank at a time when financial markets were concerned about the critical level of foreign exchange reserves at the Central Bank... For many other countries, it could have led to a definite loss of confidence from the markets and a financial crisis.


And, of course, risks impact strategies

These political and geopolitical developments do translate into operational risk categories for European investors.

The most obvious risk relates to business environment: transparency loss and increased regulatory arbitrariness, both pointed out by the World Bank’s KKZ governance indicators. Notably the perceived corruption indicator shows a deterioration of the situation in Turkey. The impact of these indicators is huge and immediate, since they are included into many sovereign and country risk ratings—therefore affecting the Turkish sovereign risk premium, i.e. the cost of refinancing public debt. Fortunately for the Turks, the latter is rather limited by international standards, although increased by the COVID crisis.

The second major category of risk is purely political. For investors, it is slightly different from business climate questions, although obviously related. On this topic, they perceive multiple political bottlenecks, which mechanically limit their visibility and their long-term commitments. The first one lies in the gap between the signals of a weakening central power (regional elections; disputes within the AKP; corruption cases undermining the AKP’s image as a “clean party”) and those which point to the strengthening of the same power, around the personality of the President (constitutional change, post 2016 purges, lasting legitimacy among about a third of the population). At the end of the day, those contradictory signals are difficult to reconcile in order to produce a balanced central scenario. Moreover, the tentative political synthesis between Islam and nationalism is also very difficult to read in terms of operational consequences for investors.

That’s not all: two other risks derive from current political developments. First, the pervasiveness of a security and intelligence logic in the institutional framework feeds an active policy of information control. In this area, nothing new under the sun, but the COVID crisis has accelerated a trend already pointed out a long time ago. Second, the human rights question. For an investor, whatever his convictions, human rights issues have become a real operational risk—a reputational risk notably, because European companies are under the scrutiny of active shareholders, while ethical rules of conduct are increasingly integrated into management. Moreover, if the Americans, and even Europeans, continue to establish new geopolitical lines of differentiation around the concept of democracy—setting up a “club of democrats,” using sanctions as a central political tool, human rights issues will gain greater impact on investment choices. Now if the banks start to integrate more democracy indicators into their risk control systems, this will definitely change their strategy and Turkey will be penalized.


The impact of geopolitics on production structures

Finally, these political and geopolitical changes are gradually transforming the entire economic environment. In the Global Militarization Index produced by Bonn International Center for Conversion, Turkey is one of the countries in the region where the level of militarization is accelerating rapidly, gaining 12 ranks between 2016 and 2019. This is a very important long-term trend, impacting many sectors, directly via the continuous growth of the Turkish defense industry or indirectly, through the reallocation of funds. As an example, 60 per cent of the Turkish army’s gear is now being produced domestically, compared to 25 per cent in 2003. The war in Karabakh has shown the effectiveness of Turkish drones, convincing Poland and Ukraine to pass contracts.

Economic policies are also influenced by geopolitical and political changes, notably through a strong President’s preference for growth. On the positive side, this partly explains the take-off of GDP per capita, which surpassed that of Malaysia in 2011, Chile in 2013, and Russia in 2015. On the negative side, however, this preference for growth has distorted the economy. It has reinforced the magnitude of the credit and overheating cycles, which have shaken this economy one after another, for the last ten years. It has also progressively weakened the exchange rate—all the more so as the latter now incorporates a real geopolitical “risk premium.”

It is precisely the defense of the Lira, in repeated cycles, which has depleted the central bank’s foreign exchange reserves. To the point that, Turkish liquidity indicators—which compare the country’s short-term financing needs to its foreign exchange reserves—have this year exceeded international rating agencies’ alert threshold, raising concerns about an external rollover risk.

Of course, this can be analyzed from a cyclical perspective, but it can also be seen as the long-term result of political preferences for growth, creating structural biases in monetary policy choices. Moreover, cycles of Lira depreciation have eroded confidence in the currency. The Turks themselves do not trust their own currency, increasingly dollarizing their bank deposits and rushing into Bitcoin and other cryptocurrencies.


What about the risk perception of European investors?

It is twofold, but with a dissonance that is difficult to manage in strategic terms. On one hand, there is a clear vision of the risks linked to this extension of the political domain, explaining the loss of confidence in certain assets and reducing the maturity of investments. The principle of a chronic exchange rate risk has been integrated into market expectations, and foreign investors have withdrawn from the domestic government securities market.

On the other hand, investors are also measuring the strong resilience of the private sector and the dynamism of the real economy. Moreover, the private sector has absorbed the Lira depreciations, as well as political shocks, without any apparent effect on its dynamism, especially in exports. As a result, large Turkish companies seem for now to be escaping the gradual international loss of confidence in the country, as is testified by the refinancing of their short-term foreign currency debt on international markets. But if a financial crisis was ever to happen, this is probably how it will start: with an unexpected loss of confidence in a big private actor.