BACKGROUND: The capital markets can be driven as much by rumor as by fundamental economic realities. This was perfectly illustrated by the Turkish stock market over the last month: by end-March, the Istanbul Stock Exchange (IMKB) national-100 index slid towards historic lows, trading around 9000 points, on fears that several billion dollars in official U.S. monetary aid for the Turkish economy would not be forthcoming. By Monday April 7, the index had bounced back, rising to over 10,700 on news that money from the U.S. might be made available after all. Similarly, by Monday the Turkish lira had strengthened to around 1,692,500 to the U.S. dollar, from 1,760,000 two weeks earlier. Given the degree of popular domestic opposition to war in Iraq, Turkey’s new prime minister Recep Tayyip Erdogan has been reluctant to alienate his constituency by challenging the parliament’s rejection of basing U.S. troops. On the other hand he and his party are aware of how much the country needs Washington’s financial aid. Last week, the U.S. Congress reiterated its intention to make available cash grants and nearly $9 billion in U.S.-backed loans to Turkey. Ankara has now agreed to provide some logistical support for the U.S. forces fighting in the north of Iraq and has given them the right to make emergency landings at Turkish air bases. Markets remain skittish about Turkey. Investors no longer feel that the U.S. needs Ankara to facilitate its military operations in the north of Iraq, and the Turkish economy is reeling from the pressures of a $125 billion external debt burden, amounting to 60% of the country’s GDP. Turkey must now draw upon its $16 billion stand-by loan package, granted by the IMF after the country’s 2001 banking crisis. Nevertheless, Ankara continues with an expensive buildup of troops, now reportedly numbering about 40,000, on the border with Iraq. This action reflects the state’s fear that the Iraqi Kurds may take possession of the oil fields of Kirkuk and encourage a revival of Kurdish separatism within Turkey.

IMPLICATIONS: The war in Iraq is bound to have steep economic costs for Turkey and few if any short-term benefits. Firstly, Turkey lacks a significant domestic military industry, so increased defense spending will not do much to stimulate the economy. Secondly, although Turkey has fewer direct economic ties with Iraq than it did during the 1991 Gulf War, the current conflict is stressing the Turkish economy, as foreign exchange earnings decline largely because of falling tourism revenues, while prices rise for needed imports such as oil and military hardware. If the first stages of the coalition’s efforts at reconstructing Iraq do not lead to quick resumption of Iraqi oil production, the resulting lack of stability in Iraq’s economy will impact negatively on the Turkish Lira, on inflation and on interest rates, making credit even more expensive for the private sector. Indeed, in meetings with American officials over the last few months, members of the Turkish business community have claimed that a new U.S. military action in Iraq could end up costing Turkey over $20 billion, about 9 percent of its GDP, in the first year. The war is likely to be bad for public finances as well. Further disbursements of Turkey’s IMF facility depend on the government’s adhering to a tight budget, even to running a surplus of 6.5% of GDP, not including interest payments. To stay within the guidelines of its IMF program, the Turkish government will be forced to offset an increase in military spending with belt-tightening in other areas of the budget. It is clear however that cuts in social welfare spending will not be easily made by Erdogan’s largely populist AK party, which enjoys a rather shaky mandate to begin with. As a ‘war-related’ measure the government might raise taxes, which would reduce economic activity, but printing or borrowing more money are not very viable alternatives. The overall result of the war is to prolong a Turkish recession that has already lasted several years; to dissuade consumers from spending and entrepreneurs from investing.

CONCLUSIONS: To keep the economy growing and to avoid defaulting on its loans, Turkey needs trade. In this context, Erdogan’s January visit to the energy economies of Central Asia points to this urgent need. Pronouncements were made on such topics as importing electricity from Turkmenistan and speeding up the completion of the trademark Azerbaijan pipeline projects to run through Turkey. The benefits to Turkey are relatively secure and inexpensive future supplies of electric power, oil and gas, and revenues from tariffs on transit of the latter two commodities. However, most projects are still several years away from completion. In the meantime, the recession in Turkey depresses investment abroad through the high cost of borrowing money. Many in Turkey’s business community perceive the Central Asian countries as business-unfriendly places, and the potential profits are not high enough to justify the logistical and start-up costs to be incurred by Turkish businesses during a time of recession at home. The Central Asian energy economies themselves attract investment chiefly to their public sectors, as the private sectors are not developed enough to attract significant trade. Turkish investment in Central Asia will take off only when the domestic economy improves enough to justify all the costs to be borne by Turkish business. By turning down the U.S. money that was offered, Turkey has overplayed its Gulf War hand. This time around, policymakers failed to take into account the notion that perhaps the U.S. military can achieve most of its Iraq objectives without Turkish help. Indeed the perception of several commentators in the U.S. was that Ankara tried to blackmail U.S. into forking over more money—a charge that stung badly in Turkey. Nevertheless, that country’s need for financing is urgent enough to overrule the short-term concerns of party politics, and Turkey is likely to be more accommodating to the Bush administration’s policy in the region during the next phase of the war involving occupation of Iraq by U.S. ground troops.

AUTHOR BIO: Peter G. Laurens is Senior Associate, Fixed Income Credit Analysis at Carlson Investment Management LLC.