For Akbank, Turkey’s largest lender, the timing of its first-ever bond issue this summer was inauspicious from a political perspective. The bank began marketing the offering to investors as the country’s foreign relations were deteriorating on two crucial fronts. Turkish ties with Israel, a once-close ally, frayed to near the breaking point after Israeli commandos raided a Turkish-led aid flotilla to Gaza in late May, resulting in the death of nine Turks. Shortly after that incident, Turkey was one of only two countries to vote “no” on a United Nations Security Council resolution renewing sanctions against Iran over its nuclear ambitions, straining relations with Washington and European capitals.
The diplomatic firestorm over those events didn’t derail Akbank’s financing plans, though. Far from it: The bank sold a $1 billion, five-year bond — the largest ever by a Turkish private sector borrower — at a yield of 350 basis points more than comparable U.S. Treasuries. The deal was easily oversubscribed, with investors submitting $2.5 billion worth of bids.
Akbank’s experience suggests a striking shift in investor perceptions of Turkey. For much of the past decade, the country’s economic revival has depended largely on political factors — namely, the stability of the government of Prime Minister Recep Tayyip Erdoğan and its reform agenda aimed at taking Turkey into the European Union. Better economic performance and the prospect of integration with Western Europe attracted record inflows of foreign direct investment, especially from major international banks such as HSBC Holdings, Citigroup, BNP Paribas and UniCredit.
Lately, however, Turkey’s EU ambitions have stalled because of political opposition in France and Germany, while Ankara’s foreign policy has tilted noticeably toward the Middle East. Erdoğan’s visit to Tehran in May with Brazilian President Luiz Inácio Lula da Silva to negotiate a deal with Iranian President Mahmoud Ahmadinejad to swap nuclear fuel was regarded as a diplomatic triumph at home but angered officials in the U.S. and Europe, who saw the agreement as undermining their efforts to contain Iran’s nuclear ambitions. Some officials and analysts question whether Erdoğan’s Islamic-based Justice and Development Party, known by its acronym AKP, is shifting Turkey away from its traditional Western, secular orientation. “The perception of the AKP rapidly distancing itself from the Western camp, however broadly you define it, is there,” says Atilla Yesilada, an analyst in the Istanbul office of Global Source Partners, a U.S.-based economic and political consulting firm. “A few months ago it was just an annoyance to the West. Now it feels like something more serious.”
Those political concerns don’t appear to have dampened Turkey’s economic prospects, though. The economy, which contracted by 4.7 percent last year, expanded on the strength of domestic demand by a heated 11.7 percent in the first quarter from the first quarter of last year, the highest rate of all the Organization for Economic Cooperation and Development member countries and second only to China among Group of 20 countries. The stock market, which is 70 percent owned by foreign investors, has staged one of the strongest rebounds among emerging-markets countries; the Istanbul Stock Exchange’s National 100 index has nearly tripled from its November 2008 low, reaching 58,154 last month, about equal to its 2007 record high. Credit default swap rates on Turkish debt, meanwhile, continue to tighten, standing at about 160 basis points, lower than the rates for Greece, Italy and Spain. Many investors and analysts even regard the new Middle East orientation of Turkey’s foreign policy as potentially positive, giving the country access to new markets and sources of capital in the region.
“I don’t remember any point in time when the view of the political establishment in the West and of the markets has been so disparate,” says Murat Gulkan, a hedge fund manager at Arma Portfolio, a recently established Istanbul-based firm. “Ordinarily the political establishment would help guide investor views on Turkey. That’s not the case now. The disparity is quite striking.”
Christian Keller, chief economist for European and Middle Eastern emerging markets at Barclays Capital in London, says investors are focusing anew on Turkey’s strong economic fundamentals. “The Turkish market looks good, with the kind of domestic demand potential you don’t see elsewhere in emerging Europe right now, combining a healthy banking system and a young population,” he says.
Turkey’s economic rebound is a major factor in Erdoğan’s foreign policy assertiveness, just as Lula is using his country’s newfound economic might to claim a bigger voice for Brazil on the world stage. Mehmet Şimşek, the country’s youthful Finance minister, points to a clear link between the two realms. He notes that the AKP has governed for seven years, an unprecedented period of one-party rule for a country that in previous decades had been used to unstable coalitions lasting 16 months, on average.
“With political stability came economic performance. With economic performance came self-confidence. And that is reflected now both in politics and in international relations,” says Şimşek, 43, who previously worked for seven years as chief economist and strategist for the emerging Europe, Middle East and Africa region at Merrill Lynch in London. “They all reinforce each other. We used to be in a vicious cycle, and now we have entered a virtuous one.”
Which isn’t to say there aren’t risks. Bankers and analysts caution that the government’s apparent shift in emphasis toward relations with the Middle East shouldn’t come at the expense of Western ties. The bulk of Turkey’s trade is with the European Union, and the prospect of EU membership is still one of the biggest attractions for foreign investors, they note. In fact, FDI inflows took a nosedive in the recent downturn, dropping to $7.6 billion last year from a peak of $22 billion in 2007. Such investment totaled just $1.7 billion in the first five months of 2010.
Investors also want to see the government stick with its economic reform agenda. The most important issue here is a proposed fiscal rule aimed at limiting the government budget deficit to 1 percent of GDP within ten years and trimming the government’s outstanding debt to 30 percent of GDP. The government had promised to adopt such a rule after it ended talks with the International Monetary Fund on a possible standby credit facility earlier this year, and many investors see the rule as vital to binding the government to budgetary discipline; but officials said last month that the measure would not be adopted before 2012. Some investors worry that the delay could signal a spending binge by the Erdoğan government ahead of the July 2011 parliamentary elections. Such splurges were common in the past, and recent opinion polls have suggested that Turkey’s largest opposition party, the secularist Republican People’s Party, is gaining ground on the ruling AKP.
“It’s important that there is no backing away from fiscal discipline,” says Davide Lombardo, the IMF’s resident representative in Turkey. “I think, without the fiscal rule, or if it took long to pass that rule, some doubts among investors could emerge that the country would actually stick to a prudent and countercyclical set of policies on its own.”
Şimşek says the government intends to reintroduce the rule later this year, or next. “We are committed to sticking to our medium-term fiscal framework, which essentially is in line with what we would have done had there been a fiscal rule,” he says. “This government is committed to a prudent fiscal path.”
Erdoğan has moved to improve relations with Turkey’s Middle East neighbors since taking office, and the overtures have intensified under Foreign Minister Ahmet Davutoğlu, who took over the post from Ali Babacan in May 2009. Davutoğlu, a former professor of international relations, believes Turkey should take full advantage of its location and Ottoman-era ties to engage more deeply with countries in the Middle East, Central Asia and the Balkans.
Ibrahim Kalin, Erdoğan’s chief foreign policy adviser, says the government’s strong position domestically enables it to advance Turkish interests more assertively in the world. “It’s no longer a narrow nation-state agenda,” he says. “It’s a regional agenda. It’s a global agenda.”
Şimşek insists that the government’s focus on the Middle East is simply restoring balance to Turkish diplomacy and doesn’t represent a move away from Europe. “There was a perception that to acquire European standards you had to turn your back to the east and south, that you couldn’t associate with these regions,” he says. “This country needs investments to utilize its demographics, to utilize its labor. Investment has been predominantly from the West, which is most welcome, and we have done many reforms to facilitate this. But Arab capital is employed in many countries, and we are trying to lure some of that capital to Turkey.”
Turkey’s trade has been shifting in tune with its diplomacy. The economic and financial crisis hit the country’s European markets hard. Although the EU remains Turkey’s largest trading partner, its share of Turkish exports dropped to 46 percent last year, from 56.3 percent in 2007. By contrast, the Middle East’s share of Turkish exports jumped to 19.5 percent, from 12.3 percent, over that same period.
Between 2002 and 2009, Turkish exports to Iran rose to more than $2 billion, from $300 million; exports to Syria grew to $1.4 billion, from $266 million; and exports to Iraq jumped to just over $5 billion, from $800 million. “Iran, Iraq and Syria are providing a kind of hinterland for Turkish manufacturing, everything from automobiles to tomato paste,” says hedge fund manager Gulkan. “These three markets are crucial for Turkey. I think this imperative explains some of Turkey’s eagerness to expand relations with Syria and to not support sanctions against Iran.”
The Erdoğan government has also sent a number of high-level trade delegations across the region, particularly to the Gulf countries, and encouraged Turkish companies to develop business there.
Akbank opened up a representative office in Dubai at the end of 2009, making it the first Turkish bank to have a presence in the Gulf. “In the past, even though we were thinking such things, the environment or climate wasn’t suitable enough for those concepts or approaches,” CEO Ziya Akkurt tells Institutional Investor.
“The government’s idea, which has worked well, was that Turkey should diversify to the Middle East, to Africa, and not only trade with Europe. Turkey should maintain its links to Europe but not be stuck with one market,” says Suzan Cailliau, regional coordinator for the Middle East with Turkey’s Foreign Economic Relations Board, a nongovernmental agency that facilitates Turkish trade. “There is a lot of sympathy for Turkey in the Arab world right now, and all the doors are being opened to Turkish entrepreneurs.”
Turkey’s growing trade in the region is drawing interest from farther afield. In October, Canada will open its first consulate general in Istanbul because of demand from Canadian business executives. “They are noticing Turkey as an emerging power,” says Mike Ward, Canada’s senior trade commissioner for Turkey. “More Canadians see Turkey as a regional hub. It’s a crossroads. Companies come here, and they see it’s not just Turkey.”
“The kind of geopolitical changes that Turkey has undergone or is currently implementing are on balance a positive — it means more trade, more finance,” says Barclays Capital’s Keller. “Look at how all of the Western world is courting sovereign funds in the Middle East. The fact that Turkey now has better relations with these countries could have a big influence not only on trade but also on capital flows.”
John Lomax, an emerging-markets equity strategist with HSBC in London, says Turkey is making the right move to reorient itself toward an economically dynamic part of the world at a time when Western Europe is struggling with slow growth and heavy debts. “I think that’s at the heart of what we are seeing in Turkish politics these days,” he says. “The commentary is focusing on Turkey’s political interface with the Middle East, but it is ignoring how Turkey’s economy is benefiting from that interaction. We’re getting caught up in the political noise and missing the powerful economic story.”
Still, some observers worry about the government’s Middle East activism. The attempt to break Israel’s naval blockade of the Gaza Strip, which ended bloodily in May, as well as Erdoğan’s negotiations with Iran in defiance of its U.S. and European NATO allies, reflected mismanagement and overreach by Ankara, says Soli Özel, professor of international relations at Istanbul Bilgi University and an adviser to the chairman of Tusiad, the Turkish Industrialists’ and Businessmen’s Association. “I’m perfectly happy with the goals of Turkey’s foreign policy and the vision on which it was built,” he says. But, he adds, “the country right now is conducting its foreign policy like a chess player that constantly focuses on his own game without watching the game of his opponent.”
Keller expresses concern that the government will step up its war of words with the Israeli government over the flotilla incident. Turkey has recalled its ambassador in Israel and has said that relations will not return to normal unless Israel apologizes for the incident and compensates families of the victims. “Such steps seem to provide the government with immediate popularity gains domestically,” he says. “But over time anti-Israel populism could also nurture attitudes in the Turkish population which then may be difficult to reverse. This would take away something that makes Turkey so special in the region and allowed it to be an important partner for Western and Middle Eastern nations at the same time.”
Some big foreign investors in Turkey are skeptical that closer Middle East relations will have an economic payoff. “Often we are asked by potential foreign investors how we see Turkey’s role in the region,” says John McCarthy, chairman of ING Bank in Turkey (the product of the $2.67 billion acquisition of Oyak Bank by the Dutch banking and insurance giant in 2007), which ranks seventh among private Turkish banks, with 15.6 billion lira ($10.3 billion) in assets. “Many of them consider investing in the country as a hub for the region. Yet we generally stress they consider coming to Turkey for the Turkish market. Everything else is add-on.”
Other investors worry about the long-term consequences if the government allows ties with Europe to languish. For Italy’s UniCredit, which entered the Turkish market by forming a financial services joint venture with Koç Holdings in 2002 and today jointly owns Yapı Kredi, the country’s fifth-largest bank by assets, closer economic ties with Europe inspired its entry into the local market and remain crucial to its business strategy. “We were looking at an important market that was integrating into Europe,” says Federico Ghizzoni, the bank’s head of Central and Eastern European operations. “The idea of joining the EU has helped mobilize people around the idea of reforms. Maybe without the idea of joining the EU those reforms would have been hard to implement.”
Efforts to join the EU are at a virtual standstill because of political opposition in France and Germany and Turkey’s support of the breakaway Turkish Republic of Northern Cyprus. Since opening accession talks with the EU in 2005, Turkey has managed to provisionally complete negotiations on only one of 33 so-called policy chapters, that on science and research.
Turkey’s increasingly assertive foreign policy, particularly in the Middle East, is forcing the EU to take a closer look at Ankara’s diplomatic movements and strengthening the resolve of those opposed to Turkish membership, says a European diplomat based in Ankara. “It is more difficult to deal with Turkey than it was three, four or five years ago, and you have to take note of that,” the diplomat says. “It is less predictable in the way that they will always act in line with what is considered the Western mainstream. The focus from Europe will be on foreign policy much more than before. Up until now it was much more on domestic issues.”
“It’s really stalled,” says Hugh Pope, Turkey analyst for International Crisis Group, a nongovernmental organization that seeks to prevent or resolve conflicts, of the EU accession process. Although relations with Europe have experienced plenty of ups and downs in the past, Ankara’s recent Middle East overtures raise fears of a permanent rupture. Pope cautions that Turkey’s newfound self-confidence shouldn’t lead it to believe that there is a viable alternative to joining the EU. “Half of Turkey’s exports still go to the EU, which makes it a very important partner, and the EU standards are still the universal standards you need to aspire to in order to attract business,” he says. That holds true even in the Gulf states, where Ankara is keen to deepen political and economic ties, says Cailliau of the Foreign Economic Relations Board. “Arab countries very much want to have a European neighbor,” she says. “One of the most important things for them is that Turkey join the EU.”
Foreign policy adviser Kalin insists that Turkey hasn’t given up on its EU bid, though he makes it clear that the government’s more immediate priorities lie elsewhere. “Let’s admit it, the hot action, the headline-capturing events, are taking place to our east, not to our west,” he says. “It’s happening in Iran, Iraq, the Caucasus, in Palestine, etcetera. You get involved there, and it looks like it’s the only place you spend your time on.”
Finance minister Şimşek says EU membership remains “the reference point” for government policy and blames European opposition for halting progress. “There is no alternative to Europe,” he says. “We still aspire to it. But the European stance is making our job very difficult in terms of selling this story to the public and rallying them around these reforms.”
Turkish officials frequently tout their country as a bridge between East and West. That may be a cliché, but it neatly describes the unique position Turkey holds and the role it can play. The challenge for Ankara as it pursues its new, more independent foreign policy is to not lose sight of its Western interests even as it pursues greater economic and political influence in the East.
“I believe there should be a balance between East and West,” says Mustafa Alper, secretary-general of the International Investors Association of Turkey. “The eastward shift is a benefit for the economic side as long as the politics don’t hurt our European friends too much. As a country that wants to join the EU, you shouldn’t turn your back on these countries.”
