[PEN-L:31515] Morganstanley.com on Turkey war "dividend"

[Louis Proyect <lnp3@xxxxxxxxx>]

Turkey: War Dividend

Serhan Cevik (London)

No doubt, a war on Iraq would have political and economic consequences 
for Turkey. Leaving value judgements aside, an attempt to topple Saddam 
Hussein's regime would not only open a Pandora's box in Iraq, but may 
also have unintended consequences for Turkey and the Middle East, in our 
opinion. The Turkish authorities remain unconvinced and have deep 
reservations about a war on Iraq. They fear that the creation of an 
"independent" Kurdish state may have economic, political, and security 
consequences for Turkey. Nevertheless, we reason that Turkey would not 
shy away from participating in a multilateral operation. Of course, in 
the current context shaped by economic difficulties and political 
uncertainties, the financing of the economic costs of a war, which could 
be as high as $15.5 billion, is the most important item on the Turkish 
government's agenda. Americans may offer a military debt forgiveness 
scheme and a free trade agreement, in addition to political support for 
Turkey's EU membership bid and an IMF agreement.

The Gulf War is not a valid benchmark for the possible action against 
Iraq today, in our view. Although the war rhetoric has definitely become 
more intense in recent days, the policy vagueness is still a source of 
uncertainty. In the face of the lack of international consensus, the US 
appears to be struggling to present its case to the world. In addition 
to the reluctance of Western allies, Arab states are publicly against a 
military action. The main problem is the lack of an unquestionable 
military objective. In 1991, it was driving Iraq out of Kuwait, another 
Muslim country, which was quite clear and widely supported by 
international community, including the rest of the Islamic world.

The presence of global economic troubles today is fueling the anxiety. 
Contrary to the global outlook in the early 1990s, which represented a 
period of optimism on the back of the end of the Cold War, we are now in 
an epoch of anxiety, which has certainly diminished the peace dividend 
and increased the risk premium. The presence of a hawkish (and 
fragmented) Israeli government that has failed to peacefully deal with 
the Palestinian uprising is also a concern, in our view. Last but not 
the least, the lack of a clear exit strategy is a reason for wavering. 
Thus, we reason that a military action and the subsequent attempt to 
install an interim government in Iraq may inflame the conflict in the 
Middle East rather than bring it to an end, and thus boost the risk 
premium to new heights.

Is the occupation of Iraq by an "international" force a viable post-war 
option? If the objective of post-war policy is to conciliate and 
democratize the vanquished state, it is far-sighted, in our view, to 
provide financial support rather than to penalize. Therefore, similar to 
the post-war occupation of Germany and Japan, a "nation-building" 
operation in Iraq may be one of the viable post-war options. 
Nonetheless, replacing the Saddam regime would be an extremely 
challenging exercise that would require a long-term commitment, 
thousands of allied soldiers, and deep pockets. Regarding financial 
costs, the good news is that Iraq is a rich country (unlike Afghanistan) 
and may therefore be able to finance itself by simply pumping more oil. 
However, we are more concerned about the political risks of a 
nation-building exercise in post-Saddam Iraq.

Sustainable political reconstruction is a difficult endeavor. Especially 
in a country with deep ethnic and political factions, political 
reformation is a challenging undertaking, we think. Even though 60% of 
the population is Shiite and 20% Kurdish, the task of de-Baathizing may 
cause a painful disintegration. The six opposition groups that are 
officially recognized by the US have failed to reach a consensus on a 
post-war strategy. The possibility of a chaotic environment is in fact 
the most worrying issue for Turkey. Undoubtedly, a war against the 
Saddam regime would not only open a Pandora's box in Iraq, but it may 
have unintended consequences for the whole region (even similar to the 
magnitude of change in the aftermath of World War I), in our opinion.

Turks fear that the fall-out effects may get out of control, causing 
disintegration in Iraq. The Turkish government and the military 
apparatus understandably remain doubtful about military action. As US 
ambassador Mark Parris highlighted in recent congressional testimony, 
"[Turks] lack confidence that Washington understands Iraq's internal 
dynamics well enough to give credence to repeated US commitments to 
maintain Iraqi territorial integrity. Even if Washington does understand 
the situation better than Turks suspect, they worry that the process of 
replacing Saddam could at some point lead the US to make tradeoffs at 
Turkey's expense. They remain concerned that the US will not see things 
through if its plans go awry, leaving Turkey to once again face a 
neighbor that is either hostile or in chaos."

The Turkish government is firmly against the formation of a Kurdish 
state. Turkey's major concern is the creation of an "independent" 
Kurdish state in northern Iraq that could pose economic, political, and 
security problems for Turkey and potentially destabilize the region. 
There are over 30 million Kurds living in four countries in the Middle 
East. Indeed, Kurdish groups controlling northern Iraq have already 
agreed on a draft constitution for a federal structure. Furthermore, in 
light of the rising popularity of the pro-Kurdish party in Turkey, 
mainstream politicians and the military establishment believe that even 
an autonomous Kurdish entity in the "new" Iraq would present a clear and 
present danger for the territorial integrity of Turkey. The government 
is also concerned about the Kurdish control of Kirkuk, one of the most 
important oil zones and the Turkomens' stronghold in Iraq. Minister of 
Defense Sabahattin Cakmakoglu has already declared that "Turkey, under 
all circumstances, does not want a war. However, if the US is determined 
to intervene [in Iraq], then Turkey has to take steps to protect its own 
interests." The minister argued that the rough terrain of the 
Turkish-Iraqi border would require a buffer zone to be set up within Iraq.

Turkey has always had a Realpolitik approach to foreign policy issues. 
For decades, Turkey pursued a cautious and low-profile foreign policy 
with the principle of not intervening in regional conflicts. However, 
its traditional policy stance significantly shifted with the decision to 
participate in the Gulf War. Turkey moved from a diligently vigilant 
foreign policy approach to a strong stance against the Saddam regime. 
For Turkey's establishment, the Gulf War was an opportunity to 
demonstrate its geo-strategic importance and make it a key player in the 
region. In /The Grand Chessboard, /Zbigniew Brzezinski argues that 
Turkey is indeed one of the most important countries to US strategies in 
the Middle East and Eurasia. In our view, Turkey's alliance with the 
West is not limited to strategic and diplomatic factors. It is also an 
outward manifestation of a deep structural transformation within the 
country that commenced over 200 years ago. Besides, Turks are aware of 
the fact that winners of wars have always shaped institutions and trade 
patterns. Hence, although it has deep reservations about war, Turkey 
would not want to be left out of the prospect of redesigning one of its 
most critical neighbors, in our view. Furthermore, Turkey's 
geo-strategic importance may be diminishing in the future, as Americans 
find new "allies" in Eastern Europe, the Caucasus, and the Gulf.

What would be the economic cost for Turkey of a war in Iraq? Calculating 
the cost of a still-undeclared war is a strenuous mission, in our 
opinion. Although the economic effects of war and the associated 
increase in defense spending cannot be generalized across countries, we 
are sure that "military Keynesianism" -- that is, a positive multiplier 
effect of higher military spending on aggregate demand -- does not work 
in the case of a country that lacks a military-industrial complex. This 
means that for the Turkish economy, which is still in the midst of 
financial and political turmoil, the costs are likely to outweigh the 
benefits, which would come, if at all, in the form of multilateral 
and/or bilateral compensation.

Iraq was the second-largest trading partner for Turkey before the Gulf 
War. With an annual trade volume of $2.5 billion, Iraq was one of 
Turkey's leading trading partners prior to the Gulf War in 1991. The 
invasion of Kuwait and the subsequent Gulf War initiated a downward 
spiral in the Turkish economy. The war severed direct trade links with 
Iraq, reducing trade volume from $2.5 billion in 1989 to a mere $122 
million in 1991. In addition to a shortfall in services income (from, 
for example, construction business), Turkey also lost another important 
source of hard currency revenues. Until the Gulf War, Turkey was earning 
over $400 million a year from the operation of the Kirkuk-Yumurtalik oil 
pipeline. The tourism sector contracted by 7.6% in real terms, following 
8.8% growth in the preceding year. As a result, real GDP growth 
decelerated from 10.0% in 1990 to a mere 0.4% in 1991. All in all, the 
Turkish economy suffered a measurable economic loss that may have been 
as much as $45 billion in the 12-year period following the Gulf War.

The cost of the war could be as high as $15.5 billion in the first year, 
on our estimates. Although Turkey's direct economic links with Iraq are 
now limited, unlike the 1991 episode, we think the outbreak of war would 
wound Turkey's fragile economy. On our estimates, depending on the 
timing and duration of war, the cost of a military shock to the Turkish 
economy today would be in the range of $9-15.5 billion (excluding the 
possible increase in the cost of borrowing). It would suffer foreign 
exchange losses due to declining export earnings ($1-2 billion), 
transaction revenues ($0.5-1.5 billion) and services income ($500 
million), higher oil prices ($1-2.5 billion), plunging tourism revenues 
($2-3.5 billion), and last but not least, the rising import bill for 
military equipment ($1.5-3 billion). The extent of output loss would be 
determined by export performance and, more importantly, by the degree of 
downturn in domestic demand, and may not be less than $2.5 billion.

Rising oil prices are a harbinger of slow growth and inflationary 
pressures. The most consistent short-term effect of war is to push up 
prices. With a faster pace of currency depreciation and higher oil 
prices, the rate of CPI inflation in 1991 exceeded the 1990 rate by over 
16 percentage points. The rate of exchange rate depreciation accelerated 
from 28% in 1990 to 72% in the year of the Gulf War. Following the 
invasion of Kuwait in 1990, the price of crude oil doubled to $40 per 
barrel. Even after the end of the conflict, oil prices remained high for 
an extended period of time. For the time being, oil prices carry an 
estimated war premium of $8 per barrel. Given the principal goal of 
replacing Saddam's regime, Iraq's ruling authorities, who would be 
fighting for survival and have nothing to lose, may aim to destroy the 
country's own (and others') oil fields. Such an act would push oil 
prices to untested levels, we believe, creating a wave of currency 
volatility and inflationary pressures in countries that are net oil 
importers. On the other hand, a quick resolution of the conflict would 
likely aggressively drive down oil prices. Given the high degree of 
dollarization and inflationary inertia, we think the increased currency 
volatility and an oil shock would threaten the disinflation program.

The outbreak of war would have an injurious impact on public finances, 
in our view. The economic and political hardship imposed on Turkey (and 
the region in general) both during and after the operation would likely 
be endured for many years to come. The disturbance in the economic 
system may be detrimental not just to the standard of living, but also 
to public finances. For example, the central government budget deficit 
widened from 3.0% of GDP in 1990 to 5.3% in 1991. A war may imply a 
higher risk premium, which would worsen public finances through higher 
interest. With deteriorating economic activity, the Treasury's ability 
to collect (tax) revenues would badly diminish during a war. On the 
other hand, Turkey is already among the 15 major defense spenders and a 
war would cause an increase in military spending. Official figures 
(which underestimate the true level of defense expenditures, in our 
view) show that military spending stands at around 5% of GDP, almost 
double the average of other NATO countries. Coupled with rising military 
expenditures, the indirect costs of war could add to the government's 
bulging budget deficit.

A strong rise in military spending endangers the stabilization program. 
Fiscal policy must remain the "nominal anchor" for the economic 
stabilization program. The Turkish government is required to run a tight 
budget that would produce a primary budget surplus of 5.5% of GNP in 
2002 and 6.5% next year. A significant rise in defense spending 
inevitably creates problems of economic stabilization and resource 
allocation. If the military budget is scaled up by new defense 
decisions, a further neutralizing fiscal move would be required to stay 
within the limits of the existing IMF program. Economic policy is 
therefore inevitably handicapped in a period of defense mobilization. 
Especially if a war turns out to be larger and longer than is initially 
anticipated, the neutralizing actions are bound to lag behind. Thus, an 
inflationary bias in wartime may be an inescapable consequence of 
preserving the flexibility of military response, in our view.

Turkey's "annus horribilis" is over, but what about a double dip à la 
Turca? The Turkish economy is halfway through a gradual recovery 
process. Real GDP grew by an impressive rate of 5.2% year on year in the 
first half of the year due largely to positive contributions from 
changes in stocks. Political jitters and uncertainties have already been 
a burden on the economy. The increased defense spending may become yet 
another obstacle. Considering Turkey's industrial structure and limited 
share of the domestic defense sector, we reason that the gross effect of 
military expenditures on growth is negligible. However, since defense 
spending is significantly less productive, the resource reallocation out 
of the private sector into the public sector is likely reduce the 
country's productivity growth. All in all, given Turkey's high debt 
burden and weak financial system, the risk of double dip à la Turca is 
not negligible in the current global milieu, in our view.

A multilateral burden-sharing scheme may be the only way out for the 
Turkish economy. History shows that war does not pay (at least for small 
democracies). One way the Turkish government may pay for the economic 
costs of war, which are, we believe, always likely to outweigh the 
benefits of expected reimbursements, is to raise taxes. That would in 
turn reduce private consumption and investment, leading to a contraction 
in economic activity. Another way to pay for war is to borrow money, 
which would of course increase public-sector indebtedness and probably 
become the straw that breaks the camel's back. A third way to fund war 
is to print more money, which would no doubt fuel inflation. Therefore, 
the most reasonable channel we see for Turkey to pay for the additional 
burden of war is a multilateral burden-sharing scheme, which would help 
to minimize adverse effects, in our view.

The Turkish government is preparing a dossier on estimated losses. Turks 
are reluctant to embrace the US strategy not just because of political 
considerations, but also due to the possibility of large economic 
losses. The Turkish government is preparing a dossier on estimated 
losses to present to the international community. Turkey's 
disappointment after the Gulf War is not helping the American cause. In 
order to secure Turkey's participation in the Gulf War, the US 
administration promised to compensate for economic losses through $1 
billion per annum in international aid. Unfortunately, Turkey has not 
received any direct reparation. This is partly why the authorities are 
approaching the issue with extreme caution and want to make sure that 
history does not repeat itself.

Americans may offer debt forgiveness and a free trade agreement. The US 
administration is actively lobbying legislators to bestow a 
comprehensive economic package on Turkey. In addition to putting 
pressure on multilateral organizations, the Bush team is pursuing the 
congressional ratification of a free trade agreement with Turkey, which 
is not as straightforward as it sounds. For example, the US Congress 
failed to approve a similar package for Pakistan because of the fierce 
opposition from American textile companies. The US government is likely 
to forgive Turkey's military debt (which amounts to about $5 billion). 
Besides, Turkish companies would no doubt benefit from rebuilding the 
post-war Iraq, while the government takes advantage of the normalization 
of Iraq's oil exports via the pipeline (which may bring at least $500 
million per annum). Meanwhile, we believe the US administration will 
continue to put pressure on European countries on behalf of Turkey's 
membership bid and become a more vocal supporter of the Turkish cause in 
the Cyprus dilemma. Nevertheless, Turks would ultimately pay the 
economic costs of a war. To limit the deterioration in public finances 
and the overall macroeconomic outlook, the new government may have to 
resort to unorthodox measures in addition to usual austerity instruments.

--

Louis Proyect
www.marxmail.org