Brighter Times for Turkey?

The nation's economic stability has fueled a stock-market rally, though, as in all emerging markets, risks remain

by Palash R. Ghosh

Turkey's stocks are appreciating at a rapid clip. Straddling Europe and Asia, Turkey teeters between Western secular democracy and ancient traditional culture. But this vast nation of 73 million has a modern, robust economy and may one day join the European Union.

The incumbent Justice & Development Party's (AKP) resolute, general election victory in mid-July appears to indicate that Turkish voters support the party's fiscal reforms, which have resulted in economic stability and growth for the past five years. Prime Minister Recep Tayyip Erdogan's program of budget discipline and EU membership talks also seemed validated by the public, and they rewarded him with another five-year term.

Indeed, in response to AKP gaining an unprecedented 47% of the popular vote, the Istanbul Stock Exchange (ISE) soared to an all-time peak and the Turkish currency, the new lira, reached a six-year high the day after the election.

However, Turkey's emerging-market status and its long history of political turmoil means it remains subject to many investment risks. Between the powerful military, right-wing nationalists, secular leftists, Kurdish separatists, and Islamic fundamentalists, Turkey seems permanently embroiled in social and political crises.

Good for the Market

In fact, Erdogan triggered this national election when he nominated his foreign minister, Abdullah Gul, as president. AKP's opponents protested and Turkey's military warned it might intervene—all because Gul is perceived as an Islamic radical and a threat to Turkey's traditional separation of religion and state. On May 1, the Constitutional Court barred Gul's candidacy. These events took the ISE-100 index down by 7.1% in just two trading days. Consequently, Erdogan was forced to move the election to July from November.

"This election result was the best we could have hoped for," says Daniel Grana, portfolio manager and head of the emerging-markets equity team at Putnam Investments. "If AKP fell short of a majority, it might've brought back Turkey's bad old days of weak coalition governments. If AKP had scored more than a two-thirds majority, they might've been able to push through some constitutional changes, which would likely have prompted the Turkish military to step in and challenge the government—something the markets would react very negatively to."

Turkey's chronic political instability is precisely what makes its economic recovery since the financial crisis of 2001 nothing short of astonishing. The AKP (which took power in November, 2002) instituted a series of economic reforms in tandem with a $10 billion loan from the International Monetary Fund.

First Term Results

Grana says AKP enacted fiscal discipline and showed a willingness to privatize and use interest rates to cool inflation. The party launched discussions with the IMF on economic reforms, and with the EU to enact political reforms.

Indeed, under Erdogan's first regime, according to data from Deutsche Bank Research (DB), Turkey's $400 billion economy delivered real gross-domestic-product growth of about 7% annually; inflation dropped from 21.6% in 2003 to 9.5% last year; net foreign direct investment soared from $1.3 billion in 2003 to a record $19.2 billion in 2006; and the country's public debt, as a percentage of GDP, fell from 79.8% in 2003 to 62.8% last year.

In addition, the ISE has quintupled in value since Erdogan took office. Turkey's central bank has kept its policy rate at 17.5% (among the highest in the emerging markets) for the past year, but in mid-July indicated it may cut rates in the fourth quarter. Erdogan has also accelerated privatization, including the sale of the state-owned phone operator, and plans to find buyers for state-owned electricity grids and a state-owned lender.

Top-Performing Emerging Market

"Turkey has recognized the merits of liberalization," says Julian Mayo, co-manager of the U.S. Global Investors Eastern European Fund and director of London-based investment manager Charlemagne Capital. "Foreign direct investment has increased multifold, trade with the EU has risen markedly, and some of the huge, state-run inefficient businesses have been privatized. Moreover, by Turkish standards, the decline in inflation has been remarkable."