Will War Worries Hit Turkey's Economy?

Oil prices have reached record highs, but economic effects on Turkey itself are yet to be seen as the government considers sanctions or military action

U.S. Secretary of State Condoleezza Rice was in Istanbul on Nov. 2 and 3 for a multilateral conference on the future of Iraq, and on Nov. 5, Turkish Prime Minister Recep Tayyip Erdogan will meet George W. Bush at the White House. Hanging heavily over both events: the prospect of a military incursion by Turkey into northern Iraq—a situation both Rice and Bush are pressing hard to prevent.

Turkey's saber rattling is the latest turn in a long-running battle with a militant faction known as the PKK, or Kurdish Worker's Party, that wants to establish an independent Kurdish state. PKK rebels have staged attacks in Turkey since 1984 and this year have carried out their deadliest killings since renouncing a unilateral cease-fire in 2005. The PKK's strength and sophistication have grown since the U.S.-led invasion of Iraq created a semi-autonomous Kurdish region in northern Iraq.

Two separate PKK attacks in October killed 25 Turkish soldiers, and the resulting public furor put intense pressure on the government in Ankara to act against the rebels. In mid-October, Parliament authorized the military to conduct cross-border operations into northern Iraq to kill PKK guerillas in their camps. The U.S. is trying to avoid such an incursion, which could destabilize the already fragile Iraqi government and unleash broader regional conflict.

Strong Currency an Advantage

That possibility already has sent a shiver through world oil markets, helping drive prices to record highs above $95 a barrel. The toll on world economies is only starting to be felt. The question now is how much damage a military strike might cause to the booming Turkish economy. After all, the country already has a current-account deficit of nearly 8% of gross domestic product and an annual energy bill of about $30 billion—and each $1 increase in oil prices adds one-tenth of a percentage point to Turkey's deficit.

The answer is that Turkey looks far better placed to withstand the turmoil of a cross-border war than it would have even a half-decade ago. The biggest difference is in the strength of its currency, the lira, which is trading at more than $0.85, close to a six-year high. In the 1990s, the drumbeats of war likely would have hammered the lira.

One reason the currency is so strong—and looks likely to stay that way—is that interest yields in Turkey are still around 16%, despite signs of declining inflation. High returns continue to attract investors into lira-denominated bonds. Investors also like Turkey's rising inward foreign direct investment and its improving overall economic condition. Two years ago the European Commission said the country had graduated from "emerging" status to fully functioning market economy.

Growing Export Markets

Those fundamentals seem to trump any short-term concerns about military activity. Deutsche Bank (DB) economist Tevfik Aksoy made a recent swing through London and Frankfurt to meet clients, and says they are "all basically comfortable and see that Turkey's situation is not going to be reversing overnight."

To be sure, investors don't like Turkey's big current-account deficit, but there are signs it could start to come down. Turkey has diversified its export markets and increased trade with neighboring countries. According to official statistics, exports grew by 14.4% in the first nine months of 2007, compared to last year, reaching $80 billion for the period. Economist Banu Tokali with brokerage Finansinvest projects exports will maintain their strong growth for the remainder of the year, ending 19% higher than in 2006.

Though the strong lira raises export price tags, it also has shielded Turkey so far from rising prices for oil, which is denominated in dollars. Oil expenditures this year have barely exceeded last year's figure. That, in turn, has helped keep inflation in check. Turkey's consumer price inflation, which fell below 10% in 2005 for the first time in years, should end 2007 at around 8%. The Central Bank is targeting an inflation rate of just 4% by the end of 2008.

Limiting Business at the Border

What could go wrong? Manufacturers complain that the Central Bank isn't cutting interest rates fast enough, and that the resulting overvalued lira hurts the competitiveness of Turkish exports. Economists warn, too, that should the lira begin to depreciate, built-up inflationary pressures in the economy will be released.

And, of course, military action still could shake global markets or lead to a pause in Turkish investment. That's why Turkey continues to weigh alternatives to a ground invasion, including economic sanctions against the Kurdish region of Iraq. It could limit business at the Iraqi-Turkey border or cut electricity sales to northern Iraq. And, of course, the Turkish military continues to battle PKK rebels inside Turkey, as well as selectively bomb their camps in northern Iraq.

New Treasury Minister Mehmet Simsek, who was an economist at Merrill Lynch (MER) before returning home to run on the winning AK Party ticket in July, says the Turkish economy can handle the pressures resulting from any possible military action in Iraq. Growing exports and continuing fiscal reforms will keep the economy on track, he promises—and for now, investors appear to be accepting his word. But if talks between Turkey and the U.S. flounder and Turkey invades Iraq, investors could be in for a bumpy ride.

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