The Next Breakout Nation: Turkey

[This was a response memo for my Politics of Development class at the Harvard Kennedy School]

The next star performer in development is Turkey. The reasons why Turkey is most likely to grow the fastest in the next decade can be classified into four categories: (i) favorable demographics; (ii) strong macroeconomic reforms; (iii) governance improvements; and (iv) future benefits from joining to the European Union (EU). As Turkey works to meet the required EU convergence criteria regarding debt levels, inflation, for example, international investors will continue to see the country as investment grade. A long run strategy of inclusive growth needs to be adopted in order to expand opportunities for employment. A key problem in the interim is overheating due to high short term capital inflows.

Turkey has a large population of 74 million, which makes it an ideal market for domestic entrepreneurs. In addition to this, Turkey is also enjoying a demographic dividend with the share of the active population (those aged 15-64) at 67% and the elderly (65+) and the young , less than 15 years old at 7% and 26% respectively.
These demographics offer a window of opportunity because the country has more workers (demographic transition tends to come also with increased female participation in the labor force, which further increases the size of the country’s labor force in this “window” of time). Moreover, these workers have less dependents which gives them more ability to save and more incentives to save (as they will have fewer children to support them in the future); and they can afford to better educate their children – so they can accumulate human capital at a faster pace. Geographically speaking, Turkey is strategically located as a bridge between Europe and Asia and commands control of the connection between the Black and the Mediterranean Seas. This makes it a boon for foreign direct investment, with increased prospects for employment for the young population.

On the macroeconomic side, Turkey has made strong reforms that position it to breakout in the next five years. During the 1980s and 1990s, Turkey went through a period of turmoil characterized by hyperinflation and financial repression. Banks invested in high yielding government bonds, which made lending to the private sector unattractive. The ability to tame hyperinflation down to single digits has led to macroeconomic stability under Prime Minister Recep Erdogan. This in turn has made Turkey a model for Islamic countries in the Middle East and has allowed businesses to focus on the long term. In Breakout Nations: In Pursuit of Next Economic Miracles, Ruchir Sharma (2012) argues that Turkey is laying the ground work for broad-based economic development. Crucial infrastructure projects including high speed train routes, nuclear energy plants, and Canal Istanbul–currently the only connection between the Black and Mediterranean seas. Annual GDP growth has rebound from a negative 4.8% in 2009 during the crisis to 9% in 2010, 8% in 2011 and a disappointing but still positive 2.2% in 2012 according to the World Development Indicators.

The importance of institutions has been highlighted elsewhere, particularly as they relate to growth. While the problem of endogeneity plagues this area of research Acemoglu and Robinson (2005) use instrumental variables approach to argue that institutions cause growth. One indicator for the state of institutions in Turkey is the Global Governance Indicators shown in the appendix. We see that Turkey has improved since the early 2000s in the following areas: control of corruption; rule of law, regulatory quality; and government effectiveness. In terms of control of corruption Turkey is significantly better off today than it was in 2002. This has positive implications for how growth will be shared going forward. Unlike Russia, Turkey is a much more stable democracy because it has genuine power bases in the legislative, judiciary, military that can still counterbalance the executive. Continued improvement in this regard will make it less likely for Turkey to fall into the middle income trap characterized by a vicious cycle of extractive political and economic institutions, which do not create the incentives needed for people to save, invest, and innovate.

Chief among Turkey’s weaknesses is the problem of overheating. Although growth has been robust (9% and 10% in 2010 and 2011), the external sector contributed negatively toward that. According to the 2012 IMF Staff Report[1], the net import intensity of GDP rose to an all-time high as nominal import growth accelerated to around 40 percent—about twice the rate of exports. As a result, the current account deficit expanded from over 6.5 percent of GDP in 2010 to 9.25 percent of GDP in H1 2011 (IMF 2012). The financing gap that has resulted from this situation has been filled by short term capital inflows–not foreign direct investment as was the case pre-crisis. The obvious risk with such flows is their effect on appreciation of the Lira and of course sudden stops. This makes Turkey vulnerable to speculative attacks and compromises its external competitiveness.

In conclusion, Turkey is poised to be the next breakout nation thanks to (i) favorable demographics; (ii) strong macroeconomic reforms; (iii) governance improvements; and (iv) future benefits from joining to the European Union (EU). A major risk of overheating is appreciation of the Lira and sudden stop. A policy of depreciating the Lira and a competitive labor market will transform Turkey’s current deficit into a surplus, and lower wages will bring in more FDI and longer term financing.

Appendix