Europe’s new frontier

Prime Minister Erdogan’s turnaround efforts have brought Turkey to Europe’s doorstep. Now the real work begins to get his country inside.

Recep Tayyip Erdogan went the extra mile -- literally -- in his campaign to bring Turkey into the fold of the European Union. The Turkish prime minister traveled to Brussels eight times last year to press his case for membership, visited Berlin four times and Paris twice to counter the considerable anti-Turkish sentiment in Germany and France and made countless other stops in capitals from London to Luxembourg to lobby for support. This unprecedented shuttle diplomacy flummoxed his own officials when they sought to track him down after a Brussels visit in November.

“We tried to reach him in the Hague,” says Engin Solakoglu, spokesman at Turkey’s mission to the EU, “but he had already moved on.”

Mr. Erdogan’s peripatetic efforts, backed up by equally determined campaigning by business executives, academics, human rights groups and other civic leaders, paid off last month when the EU agreed to open membership negotiations with Turkey in October. The historic decision offers the prospect of fulfilling the ambition of Kemal Atatürk, the republic’s founder, to modernize the country through deeper ties with the West, for which it also holds out even further-reaching geopolitical goals: turning back the tide of Islamic fundamentalism by demonstrating that a moderate Muslim country can gain acceptance in Europe.

“If the EU is able to have a mutual understanding with Turkey, it will mean the EU would be able to get inside this huge world” of Islam, says Mehmet Dulger, head of the Turkish Parliament’s foreign affairs committee. “The stakes are big. Europe is a superpower of peace and cooperation.”

The opening of EU negotiations also promises to help sustain a dramatic economic turnaround that has seen Turkey go from near-bankruptcy three years ago, when the International Monetary Fund bailed it out of its deepest financial crisis, to become one of the fastest-growing economies in the world. Gross domestic product rose by nearly 9 percent in the first three quarters of 2004 and is expected to increase by at least 5 percent this year. Inflation, a Turkish nemesis for a generation, last year fell into single digits for the first time since the 1970s and is forecast to decline to 8 percent this year. The central bank is crowning that achievement this month by wiping six zeroes off its currency and introducing the new Turkish lira, worth about 70 U.S. cents. The central bank also gave the economy an immediate boost after the EU decision by cutting its key short-term lending rate by 2 percentage points, to 22 percent.

“The EU decision will give a stamp of approval to investors of the world,” asserts Soli Ozel, an adviser to the chairman of Tusiad, the Turkish Industrialists’ and Businessmen’s Association. “We need to have that stamp to get sustained growth of 6 to 7 percent.” BNP Paribas’ $217 million purchase of a 50 percent stake in TEB Mali Yatirimlar, Turkey’s tenth-largest private bank, in November gave a timely indication of the potential investor interest (see box).

For all of the dramatic progress, however, Erdogan can’t afford to relax. The path from negotiations to actual membership is a long and tricky one, both for Turkey and the EU, and success is far from guaranteed. Negotiations are expected to take nearly a decade, and EU leaders, wary of admitting a populous Muslim country with a history of political and economic instability, are deliberately leaving open the possibility that the talks may end in something short of full membership. The recent flap over a short-lived government proposal to criminalize adultery, which threatened to derail Turkey’s EU candidacy in September, underscored the potential for mutual misunderstanding.

Turkey also faces some daunting economic challenges. The government has to reduce a massive debt burden while repaying the IMF, carry out fundamental tax and pension reform and help the economy create jobs for the nearly 900,000 Turks entering the labor force each year. High real interest rates of about 12 percent threaten to act as a brake on growth. The government also needs to jump-start a stalled privatization process and transform the country’s poor record of attracting foreign direct investment, which at an annual average of $1 billion over the past five years is less than one tenth what Mexico receives. FDI was projected to more than double last year, to about $2.5 billion, but roughly half of that total represented investment in vacation homes and other property.

The country must catch up in other areas, too. Turkey’s per capita GDP, in terms of purchasing power parity, stood at E5,800 in 2003, just 28 percent of the EU average, trailing Bulgaria and Romania’s 30 percent and well behind Poland’s 46 percent. Agriculture occupies one third of the work force but accounts for only 12 percent of output. Finding jobs for that army of surplus labor will tax policymakers for years.

“There’s always going to be a certain reservation about whether negotiations will lead to EU membership, and the risk of an economic relapse,” says Tevfik Aksoy, chief economist at Deutsche Bank in Istanbul. “The process will be very long and painful.”

The difficulties aren’t only on the Turkish side. Indeed, Turkey’s membership bid has opened a wider debate within Europe about the potential risks of a multiethnic society, increased immigration and a lack of political cohesion in an increasingly large and diverse bloc. The tensions are most evident in France, a country concerned about its fading influence within the EU. President Jacques Chirac, a supporter of Turkish membership, has come out in favor of an eventual national referendum on Turkey in an effort to prevent widespread popular concerns about the country from affecting a separate French referendum later this year on the new EU constitution. Nicolas Sarkozy, Chirac’s rival and the new chairman of his party, believes the EU should limit Turkey to a special relationship that stops short of full membership.

“The debate on Turkey is in fact a debate on what sort of Europe we are looking for, what sort of Europe we are looking to build in the next few years,” says Joost Lagendijk, the Dutch head of the Green Party/European Free Alliance in the European Parliament. Lagendijk supports Turkey’s membership as a way of anchoring the country to the West and projecting European values of democracy and tolerance in the Middle East. “This accession will determine the character of Europe to a much greater extent than the ten countries that acceded in May.”

Bringing Turkey into the EU will be a huge task, but the country’s commitment to that goal, and to economic and political reform more generally, appears beyond doubt. In the past two years, the conservative Justice and Development Party (AKP) government has abolished the death penalty, lifted a ban on use of the Kurdish language in broadcasting and schools and begun asserting civilian control over the military. It has also hit the tough budget targets set by the IMF, brought an end to decades of hyperinflation, introduced genuine transparency in public procurement to combat corruption and reduced barriers to foreign investment. The AKP’s record has largely assuaged the initial fears of many secular Turks and Western governments that Erdogan, a devout Muslim and a former member of a now-banned Islamic party, harbored a secret agenda to impose a fundamentalist Islamic regime.

“The quantity of reforms we were able to achieve in the past two years is much more significant than the reforms that were done in the past 40 years,” Ali Babacan, the country’s youthful and energetic Economy minister, says in an interview with Institutional Investor. “We do these reforms not because the EU asked for them, but because we need them. We want a better-functioning democratic society.”

“The government has been consistent. It believes the future of Turkey lies in Europe,” says Andrew Vorkink, the World Bank’s country director for Turkey, who has been advising the Erdogan administration on reforms of the pension system and banking supervision. “The changes in the military, the constitution and the penal code go beyond anything any previous government has been able to do.”

Erdogan has overseen Turkey’s transformation while doing a delicate balancing act in foreign policy. Despite immense political pressure from the administration of George W. Bush and an offer of $8 billion in aid, the Turkish Parliament declined to let U.S. forces use Turkey as a staging area for the invasion of Iraq in 2003. But far from paying any penalty for that stance, Erdogan has skillfully used his country’s geopolitical importance and long-standing NATO membership to maintain close relations with the U.S. It was President Bush who made an impassioned plea for the EU to open its doors to Turkey in a June speech in Istanbul.

THE TRANSFORMATION OF TURKEY’S economic and political landscape over the past three years is hard to exaggerate. In late 2000 and early 2001, years of corrupt and ineffective coalition governments, hyperinflation and rising deficits finally caught up with the country; the Turkish lira collapsed, triggering a run on the banks. The economy went into free-fall, with output declining by 7.5 percent in 2001, forcing the government of thenprime minister Bülent Ecevit to go cap in hand to the IMF for a $16 billion bailout.

Ecevit recruited a senior World Bank official, Kemal Dervi¸s, to oversee an IMF-backed reform program of drastic spending cuts, a $25 billion bank recapitalization and the granting of central bank independence. Dervi¸s’s fast footwork stopped the crisis and put Turkey back on a growth path. But the real change came one year later with the stunning November 2002 victory of Erdogan’s AKP party, which swept away the old order and put Turkey on a credible path toward EU membership. Europe first dangled that prospect before Turkey in 1963, when the thenEuropean Community signed an association agreement establishing closer economic and political ties with Ankara, but it wasn’t taken seriously by either side in subsequent decades.

Using his overwhelming parliamentary majority as head of the country’s first single-party government since the late 1980s, Erdogan ran through the checklist of EU criteria for opening membership talks. The government established a reform monitoring group headed by Foreign Minister Abdullah Gul to promote human rights initiatives, including a zero-tolerance policy on torture; abolished the death penalty; enacted a public procurement law and adopted new rules for civil servants to root out corruption; revised the penal code to toughen penalties for assaults on women, mandating life sentences for so-called honor killings of women who commit adultery or refuse arranged marriages; and asserted control over the military by appointing a civilian to head the National Security Council and allowing auditors to vet the military budget.

Economically, the government has maintained a primary budget surplus (before interest payments) of 6.5 percent of GDP, which has kept downward pressure on inflation and shrunk the nation’s debt to just over 80 percent of GDP from a peak of about 105 percent early this decade. It has given foreign investors the same legal standing as domestic ones, solicited the advice of major multinationals on ways to improve the investment climate and slashed red tape to enable entrepreneurs to register new companies in a single day.

The economy has responded impressively. After two major recessions in 1999 and 2001, Turkey’s growth rate averaged a robust 7 percent in 2002 and 2003 and accelerated to nearly 9 percent in the first three quarters of 2004. Exports have surged by more than 50 percent since 2001, and manufacturing productivity has grown at an annual pace of nearly 10 percent. The government fulfilled the economic conditions attached to its 2002 IMF bailout -- for only the second time in the country’s eight IMF programs over the years -- and Babacan reached a preliminary agreement last month on a new three-year standby deal stretching out repayment of Turkey’s $20 billion debt to the agency and committing the government to further budgetary restraint and economic reforms.

Whereas previous Turkish governments have eased policy at the first opportunity, leading to fresh economic turmoil, the economy’s strong performance has convinced Erdogan and his team to stick with the discipline of the IMF program. “Politicians are convinced that the program is working,” says Fatih Özatay, vice governor of the Central Bank of Turkey. “It’s the most positive factor.”

THERE IS NO SMALL IRONY IN THE fact that it has taken Erdogan, a devout Muslim, to bring Turkey to Europe’s doorstep. The Istanbul native went to an Islamic secondary school and studied business at Marmara University and then rose through the ranks of the Welfare Party, an Islamist party. He was elected mayor of Istanbul in 1994, one year before Welfare leader Necmettin Erbakan formed the first Islamic government in modern Turkish history.

While Erdogan developed a reputation as an honest and effective local politician, getting the garbage collected and the streets paved, Erbakan riled the country’s secular establishment with his anti-Western rhetoric and calls for Turkey to lead an Islamic NATO that would include Iran and Libya. The military, determined to defend Turkey’s secular state, forced Erbakan’s resignation in 1996. Three years later Erdogan was jailed for four months after being found guilty of attacking the country’s secular system by publicly reciting a poem whose lines included, “The mosques are our barracks, their domes are our helmets/Minarets are our spears, the faithful are our army.”

Far from being radicalized by his experience, Erdogan emerged from prison determined to chart a more moderate course. He and a group of former Welfare Party colleagues formed the AKP around a no-nonsense platform of cracking down on corruption, getting the economy back on track and taking Turkey into the EU. The party stormed to victory in the 2002 election, winning two thirds of the seats in Parliament with just over one third of the vote, thanks to a rule requiring parties to win 10 percent of the vote to gain representation. The previous coalition partners -- Ecevit’s Democratic Left Party, the Motherland Party and the Nationalist Action Party -- failed to pass the threshold as voters punished them for the economic crisis, rampant corruption and a dismal response to the massive earthquake that hit the country in 1999, killing 17,000 people.

The Welfare Party’s failure was instrumental in Erdogan’s more pragmatic evolution, explains Tusiad adviser Ozel, a professor of international relations at Bilgi University in Istanbul. “When the military ousted them, suddenly Turkish Islamists discovered that the rule of law is very important, and you only find that in the West,” he says, adding that the prospect of membership in the European Union offered the best guarantee of maintaining civilian control over the military and respect for human rights.

Some secular Turks still harbor suspicions that Erdogan is using the political cover of the EU to pursue a hidden agenda -- overturning Turkey’s secular state and installing an Islamic regime. The government supported the case of a medical student who went to the European Court of Human Rights after she was barred from Istanbul University’s medical school for wearing a head scarf. (The student lost in May when the court ruled that the ban was a valid way to enforce the country’s secular traditions and blunt Islamic fundamentalism.) More controversial still, the AKP introduced a measure to criminalize adultery as part of its overhaul of the penal code last September, abandoning the idea only after Guenther Verheugen, then EU enlargement commissioner, warned it could kill the country’s bid for membership.

“They disguise their faces very well, but they made themselves very clear,” says Yusuf Kanli, editor of the Turkish Daily News, who calls the adultery proposal “an ill-timed, ill-thought, uncalculated gesture to Erdogan’s base.” But the most important thing about the dispute was the way it was resolved, Kanli says. “The military didn’t say anything,” he notes. “Civil society staged a marvelous, coordinated opposition. This is a victory for civil society. Turkey is not just reforming its laws. It’s reforming its society.”

Erdogan also hasn’t lost his penchant for inflammatory rhetoric. He criticized the U.S. assault on Fallujah in November and eulogized the insurgents who died there as “martyrs,” prompting a blunt request from the U.S. State Department for the prime minister to tone down his language. But despite the continued deep policy differences over Iraq, Washington remains one of the biggest supporters of Turkey’s EU ambitions, believing membership will reinforce the country’s role as a bulwark against Islamic fundamentalism.

“He’s a work in progress,” one Western diplomat says of Erdogan. “His own views have changed from his time in prison. I think they’re still evolving.” Surveys show a majority of Turks oppose the head scarf ban, and the adultery proposal had wide support within the AKP. But, the diplomat adds, “he’s not pushed these things when it became apparent he was meeting resistance.”

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AKP officials bristle at the characterization of their party as Islamist. “We are not an Islamist party. We are conservative democrats,” says Economy Minister Babacan. “We value tradition, morality, religion and ethics.” He acknowledges that the government blundered on adultery but insists the mistake was corrected quickly. “What we were concerned about was protecting the family,” he explains. “Punishing adultery is not the only way to do it. We need to come up with sounder policies and approaches.”

People like Babacan are the greatest reassurance of the AKP’s Western orientation and the reason for its economic success. The 37-year-old Ankara native earned an MBA at Northwestern University’s Kellogg School of Management and did a two-year stint as a financial consultant at Chicago-based Quantitative Risk Management before returning to Turkey to run his family’s textile trading business. He joined the AKP out of a desire to end the corruption and mismanagement that was hindering business, especially small and medium-size enterprises that lacked political connections. By contrast, many of the country’s big family-owned industrial holding companies have long taken advantage of protectionist policies that used taxes and tariffs to favor Turkish production over imports.

“These guys didn’t owe that much to the state for protection, and they make their money in markets,” says Tusiad’s Ozel. “Their interests were in further integration with the West.” Turkey today sends roughly 55 percent of its exports to EU countries.

The three-year budget, negotiated with the IMF late last year, calls for reducing the deficit from 7 percent of GDP this year to 3 percent in 2007 and cutting the national debt down to 70 percent of GDP. “We are taking the Maastricht criteria as our ultimate goal,” Babacan says.

To achieve those targets the minister needs to carry out far-reaching reforms of the country’s tax and social security systems while repaying its IMF debt. Babacan had hoped to have a new IMF standby agreement in place before the EU decision last month, and the fact that he was able only to sign a letter of intent hints at the difficulties of making further reforms.

Take the issue of taxes. The complexity and high rates of the country’s tax system encourage a vast underground economy -- estimated by the World Bank and the IMF to account for up to 50 percent of the declared economy -- that aggravates the perennial budget deficit. Fewer than 7 million people out of a work force of 22 million pay income tax. The corporate tax rate, at 33 percent, is well above the 10 to 19 percent that prevails in many Central European countries with which Turkey competes for investment, but a plethora of investment allowances and other deductions reduces the Treasury’s corporate tax take to a modest 2.1 percent of GDP. The bulk of revenues come from a value-added tax and other levies.

Erdogan had argued the case for tougher tax enforcement combined with a cut in the VAT, but he gave way under pressure from the IMF, which argued that such a move would imperil the Treasury’s biggest source of revenue. Instead, the new IMF program calls for Turkey to cut the corporate rate to 30 percent this year, eliminating a 3 percent surcharge imposed during the 2001 crisis, and to close loopholes. It also calls for unifying the existing tax regimes on earned income and capital, which tend to discourage the reporting of income. The government will create an independent revenue authority to enforce the new regime. The plan looks good on paper; whether Babacan can implement it effectively remains to be seen.

Turkey’s pension problem is one of the saddest legacies of the profligate politics of the 1990s. Half of the country’s 70 million people are under the age of 30, yet generous benefits combined with a shortage of contributors mean the system runs a deficit of 3.5 percent of GDP. “This is a very young country. Having a pensions crisis is insane,” says Serhan Cevik, an economist at Morgan Stanley in London.

Reforms enacted in the 1990s will eventually raise the retirement age from as young as 42 to about 60, but to reduce the deficit, the government needs to trim the growth of benefits by tying them to productivity. As part of the IMF agreement, Babacan is committed to reducing the combined social security and health deficit to 1 percent of GDP from 4.5 percent, but that could take a generation.

Tax and pension reforms will take years to bear fruit. In the shorter term, Babacan’s biggest challenge is to encourage an inflow of investment. Investors have been putting money into Turkish stocks and bonds over the past year in anticipation of the EU decision, which has boosted the lira, but long-term investment in productive capacity has been minimal because of the country’s record of instability.

An economic crisis that began in 1999 caused automobile production to collapse from 600,000 cars that year to 138,000 in 2000. Output recovered to an estimated 680,000 cars last year and could hit 1 million by 2010, predicts M. Ibrahim Aybar, general manager of Oyak Renault, a 50-50 joint venture between the French automaker and Oyak, the Turkish armed forces pension fund.

“The EU decision is very important because we need stability,” says Aybar, who served as an economic adviser to the liberalizing government of thenprime minister Turgut Ozal in the late 1980s. Renault is investing up to E250 million to produce a new midsize car for the Turkish and European markets, beginning in 2006.

“I don’t think we can expect foreign direct investment to immediately start pouring in,” says former Economy minister Dervi¸s, now a member of Parliament for the opposition Republican People’s Party. But he predicts that FDI could hit 2 to 3 percent of GDP, or E6 billion to E9 billion annually, within a few years.

The EU decision also should hasten a much-needed easing of Turkey’s high interest rates. Although nominal rates have fallen dramatically in line with inflation, the central bank’s short-term policy rate stands at 22 percent, or a steep 12 percent in real, or inflation-adjusted, terms.

Following the introduction of the new Turkish lira this month and a new consumer price index in February, the central bank plans to adopt an inflation-targeting policy in 2006. The bank wants to see inflation fall to 8 percent at the end of this year and to 4 percent in 2007, says vice governor Özatay. Rates will come down over time if inflation moderates. In the short term, however, rate cuts depend on continued budgetary restraint, he insists. “Fiscal discipline is a must,” he says. “If you can’t convince markets that debt is sustainable, you have a problem.”

Tension between the central bank and the government may well rise, just as it has across much of Central and Eastern Europe. Ömer Bolat, head of the Independent Industrialists’ and Businessmen’s Association, or Musiad, an Islamic organization that is a key supporter of the AKP government, calls current rate levels “intolerable.” Some analysts believe the tight policy risks are derailing the country’s economic turnaround. “The central bank’s monetary stance is too rigid, and it is turning into an obstacle to, rather than an instrument for, sustainable economic growth,” says Morgan Stanley’s Cevik.

The economic challenges are daunting, but manageable, if Turkey can stay on track for the EU. That is a big if, however.

The government still has to clear several hurdles before it can open detailed negotiations in many of the 31 different chapters, or policy areas, one EU official notes. The European Commission, the EU’s executive agency, is threatening to take Turkey to the European Court of Justice or the World Trade Organization to get it to enforce the patent rights of EU pharmaceutical makers, for instance.

Then there are the 80,000-odd pages of rules and regulations that make up the acquis communautaire, the body of EU law to which members must adhere. “We’re not ready,” acknowledges Tusiad’s Ozel. “We don’t have the slightest idea of how difficult it will be.”

Perhaps more important than the detailed negotiations is the broader political climate. Many Turks already resent what they regard as unfair treatment, with the EU imposing tougher conditions for negotiations than it did for Central and Eastern European countries.

“We think the membership process should continue, but Turkey should not bind its destiny only to the EU because the country could be disappointed in ten or 15 years by a veto,” says Musiad’s Bolat. He also wants the government to pursue closer trade and political ties with the Middle East and Russia.

Turkey needs to persuade a skeptical European public that it offers promise -- in terms of economic dynamism and geopolitical stability -- rather than simply the threat of uncontrolled immigration. “Europe thinks we are living in the 17th century,” says Dulger of the Parliament’s foreign affairs committee. “We need to try to break these prejudices.”

Babacan acknowledges the need to close the perception gap, as he calls it, between Turkey and the EU, but he refuses to worry too much about a potential EU veto. “In seven to ten years, it’s very difficult to estimate what kind of political winds will blow,” he says. “The natural benefit of Turkish membership should be obvious.” To make sure it is, he’s determined to push ahead with his economic reforms.

As he puts it, “This is an historic chance for Turkey. We are not going to let it go.”