Turkey
Twilight Zone
May 09, 2007

By Serhan Cevik | Istanbul

Turkey has suffered a major blow to institutional credibility, in my view.  One of the most important aspects of normalization is institutional development away from changes out of the blue. Unfortunately, the Turkish military’s unexpected venture into politics has altered the country’s political and institutional landscapes so that no one really knows what is going to happen next. Take, for example, the presidential election process. The Constitutional Court annulled the first round of the presidential election and imposed a new quorum requirement that is almost impossible to meet under the current conditions. Indeed, with 352 seats out of 550, the ruling AK Party could not elect the president on its own, and its candidate, Abdullah Gul, has (unofficially) withdrawn from the election process. Under normal circumstances, this would lead to the immediate dissolution of parliament and early general elections. However, parliament has also voted for holding the elections on July 22 and ratified a series of constitutional amendments (including the public vote on presidency) that would radically change Turkey’s political system. Of course, perhaps unsurprisingly, there is yet another debate on whether a parliament that is about to dissolve itself can approve such a complex amendment to the constitution and whether the outgoing president would approve these changes.  In other words, there could be a new legal battle staged at the Constitutional Court and even a public referendum on constitutional amendments before or after the elections.  The situation is now full of institutional and political uncertainties.

It seems that market participants do not care much about deteriorating institutional predictability.Some of the key assumptions market participants have had about Turkey’s future direction are now, to say the least, weaker and questionable. But asset prices reflect no change after recent events: the lira is as strong as ever and interest rates are back to the level before the political turmoil. It seems that strong global appetite for ‘risky’ assets is the driving factor for the time being.  Even though I still believe in the fundamental strength of the Turkish economy, it would be imprudent to ignore the blow to institutional credibility and deepening political uncertainties.  I have always argued that bringing elections forward would help to shorten the period of ambiguity and thereby support a stronger economic performance.  However, the risks Turkey now faces are no longer simply related to domestic politics within the realm of democratic institutions.  We do not know how the voters will react to all these peculiar developments and, more importantly, how the European Union will treat the fragility of Turkey’s democratic regime.  Needless to say, we need to better understand the reasons behind the political turmoil in order to assess the fallout on multiple fronts ranging from the voting behavior to the future of accession negotiations with the EU.

Secularism is not under threat, but a deep-rooted fear is still prevailing in certain circles. It is easy — and even appealing — to conclude that recent events are a result of a clash between secularism and religion in Turkey. Even though there is a grain of truth in such arguments, it is still too simplistic, in my view, and ignores a plethora of economic, social, ideological and political factors.  One of the widely quoted figures showing the rise of religion is the number of Turks identifying themselves as Muslims, which indeed increased from 35.7% in 1999 to 44.6% last year. However, to a trained economist, this figure alone does not tell much about the risk of religious fundamentalism in Turkey. And that is why I highlighted the details of a comprehensive, reputable survey in an earlier briefing note. Even with the strengthening of Muslim identity — a global phenomenon taking place in all Muslim countries — the number of Turks in favor of a religious state declined from 21% in 1999 to 9% last year. Put differently, survey results show that the overwhelming majority of Turks — 76% — stands against a regime based on religious principles (see The Litmus Test for Liberal Democracy, April 9, 2007). Nevertheless, there is a deep-rooted fear among certain circles that a party like AKP with historical linkages to political Islam represents a threat to the secular principles of the republic.

The risk is not religious fundamentalism, but isolationist nationalism.Turks, by and large, are against a regime change towards a structure based on even loosely defined religious principles. This may come as a surprise, but the ‘Turkish version’ of Islam has long become ‘secular’ over the centuries and arguably reflects personal attitudes rather than a political agenda. Even so, Turkey is a big country with more than 70 million people and therefore it would not be surprising to find individuals and groups in favor of radical ‘Islamization’. This is probably why there is still a lack of trust between the country’s so-called ‘secular establishment’ and political parties (like the ruling AKP) with a greater propensity to play religious overtones. Indeed, even though all the existing evidence suggests that the AKP leadership does not have a ‘hidden agenda’ to establish a Sharia-based state, its occasional mismanagement (such as attempts to criminalize adultery, to create alcohol-free zones, and to appoint the CEO of an Islamic financial institution as the governor of the Central Bank of Turkey) has undermined its credibility earned though integrating Turkey with the EU. Consequently, fear-driven politics remains a valid currency in the political realm and results in polarization in the society. However, the real problem is not radical religious fundamentalism, in my view, but isolationist nationalism seeking to keep Turkey out of the EU as a closed economic and political system. In other words, recent developments are a reflection of the status quo’s resistance against greater openness.

Election uncertainty is a risk, but my main concern is about Turkey’s relationship with the EU.What has happened over the past week has undoubtedly increased the degree of uncertainty in parliamentary elections, and I will focus more on political maneuverings (including mergers between center-right and left parties) in the coming days. However, my main concern is about Turkey’s already fragile relationship with the EU. No candidate country has experienced what Turkey is going through now, and that makes the EU’s response to the military’s role even more critical for the future of accession negotiations. As an important part of the political criteria to start membership talks with the EU, Turkey has introduced a series of legal and constitutional changes to address democratic deficiencies and to demilitarize the political landscape. Indeed, Brussels has emphasized the “stability of institutions guaranteeing democracy [and] the rule of law” as well as the normalization of civil-military relations in Turkey as a key requirement for membership. Even though the Copenhagen criteria leave room for flexible interpretation of civil-military relations, the Turkish case has always been uniquely problematic. As a result, given the history of military intervention, the EU has kept communicating concerns about the extent of convergence in Turkey’s civil-military relations towards a platform that is in harmony with liberal democracy and European standards. Unfortunately, just as the EU is waiting to see “full, effective and comprehensive implementation” of legal and constitutional changes, the military’s foray into politics as an autonomous and powerful actor has undermined the process of institutional reforms and accession negotiations between Ankara and Brussels.

Turkey now stands at a crossroads for democratization and greater openness. Thanks to the abundance of global liquidity and attractiveness of carry trades, market participants have so far dismissed the fallout from political shocks in a number of countries like Thailand, Ukraine, Romania and Turkey. However, I am not so inclined to ignore what could become a fundamental shift in the political landscape.  The military’s reaction has certainly sparked a serious political debate and introduced a risk that was not present in the past five years.  This is why, from a fundamental point of view, I am more cautious, even with my enthusiasm about Turkey’s macroeconomic strengths to withstand shocks. Of course, institutional change is never easy and always takes place with occasional setbacks.  Therefore, I am also in favor of treating the current impasse as an opportunity to narrow Turkey’s democratic deficit and accelerate the evolution towards liberal democracy — a challenge only the voters can now tackle.

Japan
Aging in Asia
May 09, 2007

By Robert Alan Feljdman | Tokyo

Introduction

Investors around the world tend to see Asia as the land of growth, a region with huge potential and a will to achieve. Although this image is correct in many ways, a recent conference in Tokyo dealt with a troubling but less discussed truth about much of the region:  Aging is a serious problem for many nations in Asia, not just Japan. Indeed, it is becoming common to ask whether Asia can get rich before it gets old.

The jury is still out. Asia clearly has some strengths in the area of aging, but also some glaring weaknesses. Moreover, Asian nations differ quite a bit, and the differences matter for where exchange rates and stock markets will go. In addition, the context in which aging occurs will change over time, as markets for capital, goods and labor integrate at different speeds. And all this will occur in a world of accelerating technological change. Financial market performance will have to tussle with aging constantly over the next decade, as the region grows and ages at the same time.

Economic theory: Key issues from new angles

As the issues of aging emerged during the conference, some often-overlooked factors were brought to light. Most discussion of aging focuses on the old age dependency ratio, i.e., the ratio of the old to the working age population. However, this ratio by itself does not capture some key factors. For example, the dependency ratio can rise either because fertility falls or longevity increases, but the reason matters. If a decline of fertility is the cause, then the number of workers available to support the old will fall rapidly, but the number of old may not rise. However, if longevity extension is the reason, then the number of workers need not fall, so long as longer life comes with longer working life too.

These distinctions become crucial when the macroeconomics of aging are discussed. For example, some scholars see the aging of the population as necessarily causing a decline of the savings rate. With more old people and few workers, so the idea goes, a larger share of total income will go for consumption. A few moments’ reflection will raise doubts about this conclusion, however. If retirement age is constant, then an extension of total life will indeed lower savings. But what if longer life is accompanied by longer working life? Savings rates need not go down. And what about the kids? If children see their parents living longer with no extra resources for support, the children may decide to save more. Moreover, as some scholars point out, the decision to retire is a matter of wealth and income, not just age.

Some other important macroeconomic issues are less clear than one might think. For example, in the case of Japan, household savings rates have fallen quite sharply in recent years, from above 20% in the mid-1970s to less than 5% now. Moreover, the government is running a large fiscal deficit. Normally, such trends would imply that a nation would fall into serious deficit in its international balance of payments, from the usual savings-investment identities of macroeconomics. However, in Japan, the current account surplus of 4% of GDP is at a record high. This has happened because the corporate sector is saving so much. Nor has corporate saving occurred because of extremely low investment. In fact, investment has been leading the recovery for five years. Clearly, the relationship between household saving, government saving and corporate saving needs a re-examination, before drawing any conclusions about the effect of aging on current balances and the need for recycling.

Apart from macro, there remains a major debate about the effect of aging on the return to capital. The standard approach, accepted by most conference participants, is that aging makes labor the scarce factor of production. With standard assumptions about marginal productivity of the different inputs to the production function, this means that the addition of an extra unit of capital — when capital is already relatively abundant — should have a low marginal product. In short, the return on capital declines. But does it really?

One conference participant, to my great delight, joined me in a small minority on this issue:  Aging actually increases the need for investment, in order to maintain the living standard of the population. With fewer workers, each one has to work more productively, and so the effective capital stock must rise. If this is so, there must be a mechanism to keep the return on capital high; otherwise, living standards would fall. That said, it would violate the basic tenets of neoclassical economics to see higher marginal product for capital as the capital stock rises. The answer to this conundrum is that investment need not take the form of more capital, but may be smarter capital, i.e., capital that raises total factor productivity. Investment in education is another way to square this circle. Such investment raises the productivity all inputs, and thus need not reduce the marginal product of capital per se.[1]

Even portfolio theory has given very little guidance. There is virtually no empirical work on the portfolio preferences of people as they age. Indeed, I find it amusing that my colleagues who sell equities think that Japan’s baby boomer retirement payments will go to equities, my real estate colleagues think real estate, and my forex colleagues think foreign assets. The common mantra is ‘demand for risky assets’. Think again. Virtually no one wants risky assets for their own sake. Rather, investors want higher income, and are willing to accept higher risk in order to get it. Fine, there are several crucial but more subtle questions:  Does the trade-off between higher return and higher risk rise with age? What happens to risk preferences when life span lengthens?  When healthy life span lengthens? Do investors who expect to live longer and work longer raise their share of risky assets or lower it? Very little is known about these crucial issues.

From theory to markets

All this may sound very theoretical. Nothing could be further from the truth. These issues about savings trends and returns on investment are crucial to today’s debate about both equity and bond investments, not to mention foreign exchange markets.

For example, a decade ago, there was a common theory that the yen would crumple because of aging. With an older population, so the theory went, the savings rate would collapse, the current account would go into deficit, and the yen would fall. True, the yen is very weak now, a decade later with an older population. The prediction may look good, except for one thing:  The current account deficit has actually risen. We need better theories of savings and of forex determination.

Equity markets face similar issues. If the return on capital falls with aging, then corporate earnings should be weak, and interest rates low. However, if aging generates high productivity, though some social mechanism that enhances total factor productivity, then the marginal product of capital will rise. Earnings would rise, and stock prices would rise with them.

I would argue that precisely such a mechanism has been at work in Japan for the last six years. As the lost decade wore on, the Japanese population feared that living standards would fall unless resources were used more efficiently. As a result, politicians embraced structural reform. Note that the push for structural reform did not start with former PM Koizumi. Although inadequate at the start, deregulation packages were a constant feature of economic response from the early 1990s. The continuing boom in M&A suggests that such gains of total factor productivity in Japan will continue.

Designing institutions

A important insight for Asia emerges from this discussion:  The problem with aging is not longer life spans; the problem is that social and economic institutions are not designed to cope with longer life spans. The challenge for countries in Asia (and the rest of the world, for that matter) is to redesign institutions to accommodate longer life spans. The exact redesigns will depend on local conditions. For example, China, where capital markets remain underdeveloped in much of the economy, requires a very different type of pension system at this stage than Japan or Australia, where capital markets are very developed.

Institutional adjustments outside pensions will also be crucial. For example, medical systems will have to learn to cope rationally with larger shares of people over 70. This means that there must be a different balance between preventive care and treatment of disease. National health insurance systems need redesign too. Asia has the advantage of being a late mover, and can examine the successes and failures of other nations.

The key insight for institutional design is to break the link between age per se and benefits. Institutions need to be designed around the issue of dependency, not age. If people can work productivity into their 70s, as many do already, then social and economic systems should encourage them to do so. Financial markets are highly likely to gain if inefficiencies shrink.

The final insight is that response to aging is not fundamentally a question of defining welfare programs provided by government or by companies. Rather, the fundamental question is how to use available resources to best enhance productivity. In this sense, the best response to aging is a set of policies that improves resource use, e.g., improvements in technology, corporate governance, capital market efficiency, regulatory structure and social security system incentives.