“I’ve been in this business for 15 years and I have never seen investor sentiment turning so sour in such a short period of time,” says Cevdet Akçay, chief economist at Yapı Kredi in Istanbul.
It is easy enough to see why Turkish asset prices took an almighty beating in the summer. The country’s perennially high current account deficit means that is regarded as being especially vulnerable to the global impact of US Fed tapering. This vulnerability was seen most clearly in the performance last year of the Turkish lira, which in the first three quarters of 2013 fell by around 17% versus the dollar.
As ING put it in a recent research bulletin, the lira ranks “among the worst-hit emerging market currencies amid expectations of reduced US monetary stimulus.” Turkish equities, meanwhile, retreated by 15% between early May and September — albeit after a sharp rise in 2012.
While worries about Fed tapering sent ripples throughout the emerging market universe in the summer, investors in Turkish assets were also unsettled by the potential impact of the conflict in Syria and by the unrest in Turkey’s major cities.
One local economist insists that the protests that erupted in Istanbul’s Gezi Park at the end of May were misinterpreted by the international media. He argues that they were a representation of continued normalisation of Turkish politics, rather than a harbinger of political instability in the country. Nevertheless, he concedes that the damage done to investor sentiment was extensive, and that the fall in Turkish asset prices in the summer probably had more to do with concern about Gezi Park than tapering. “I would attribute two thirds of the price falls to Gezi Park and a third to tapering fears,” he says.
Many economists and strategists say that the pity of these external pressures on Turkish asset prices is that they have been allowed to distort the country’s long term story, which they say remains compelling. “The way I view Turkey is that there is a big difference between the short and long term stories,” says Timothy Ash, head of EM strategy ex-Africa at Standard Bank in London. “Although there are obviously a number of short term challenges, over the long term Turkey remains a great story. Strong public finances, clean banks, entrepreneurial zeal, a good strategic location, increasingly diversified trade, healthy demographics and a stable and pro-business government are all positive elements in a good long term story.”
The seductive growth story is apparent enough from the basic data. Having grown at an annual average rate of 3.1% between 1993 and 2002, Turkey turbo-charged its economic performance between 2003 and 2012, during which GDP grew at an annual average of 5.1%. “The official growth forecast for 2014 is 3.6%, but it will probably be closer to 4%,” says Selim Cakir, chief economist at TEB BNP Paribas in Istanbul. “That may not look high by recent historical standards, but there are very few developed economies in the world that will manage a growth rate of 4%.”
The bad news for Turkey is that not enough of this growth has been driven by domestic savings. İzlem Erdem, manager of the economic research division at Işbank in Istanbul, identifies a savings rate of just 12.6% of GDP as one of Turkey’s main vulnerabilities and the reason why it is so dependent on inward investment flows.
The most notable by-product of this weak savings rate, which is a legacy of high Turkish inflation, coupled with a dependence on imported energy, is a yawning and persistent current account deficit of about $60bn. After narrowing in 2012, the deficit expanded in 2013. As the IMF noted in an update published in September, Turkey’s domestic demand-led recovery is exerting upward pressure on the current account deficit and on inflation. “The current account deficit is projected to widen to above 7% of GDP in 2013, in part on account of an increase in gold imports, and is likely to stay close to that level again in 2013,” says the IMF.
Turkey’s unflattering current account numbers have been aggravated by the turmoil in Syria. For more than two years after the start of the crisis, Syrian refugees were irrationally classified as tourists, and therefore as a source of export earnings. Reclassifying refugees from the Syrian conflict as domestic consumers has already reduced Turkey’s tourism revenues by more than $1bn, widening the current account still further.
The fear, which is straightforward enough, is that a spiralling current account deficit will continue to leave Turkey hostage to international capital flows. If and when those flows are choked, currency weakness will force Turkey to hike rates in order to prevent inflation shooting back to double-digit or even triple-digit territory, which was reached in the bad old days of the early 1990s.
A familiar international complaint is that the response of the Central Bank of the Republic of Turkey (CBRT) to this threat has been too dovish. The IMF, for example, advised in September that “in the short run, monetary policy needs to be tightened further to meet the authorities’ inflation target and provide an adequate nominal anchor.”
Strategists say that they are encouraged by an apparent recent change of monetary policy at the CBRT. “The central bank’s unorthodox monetary policy worked very well in a world of QE where there was plenty of easy liquidity running through the system,” says Mohammed Kazmi, emerging market strategist and lead Turkey analyst at RBS in London. “When we began to see outflows, investors were left confused by dovish monetary policy.
“What we’ve seen in the central bank’s last few press conferences has been a suggestion that it may move towards a more orthodox monetary policy framework. Such a move would be taken very positively by investors.”
One reason why the central bank will be able to implement a tighter monetary policy, says Kazmi, is the improved growth outlook. “At the height of the Gezi Park protests, there were major concerns that domestic unrest would have a significant negative impact on growth,” he says. “Because these concerns have not fed through, the healthy growth estimate of 3.5% or 4% for 2014 gives the CBRT an opportunity to be more hawkish and orthodox.”
Local economists counter that there tends to be too much emphasis among international observers on Turkey’s external vulnerabilities when external conditions weaken. “In good times investors focus on what they see as the positive elements of the Turkish story, such as its compelling growth potential,” says Cakir at TEB BNP Paribas. “When global investor sentiment weakens, everybody focuses on the twin vulnerabilities of the current account deficit and inflation, as well as on our high external financing needs. On these ratios, Turkey does not score very well.”
“But the ratings agencies were very well aware of these vulnerabilities when they assigned investment grade ratings to Turkey,” Cakir adds. “They argued that the strength of the government’s balance sheet and the health of the financial system would act as mitigating factors in a negative scenario.”
Cakir agrees with the ratings agencies’ interpretation. “Whatever people think about the Turkish government, one thing everybody agrees on is that it has been fiscally responsible,” Cakir adds. “The budget deficit is low, debt to GDP is on a declining trend, and there are no contingent liabilities in the financial system. Banks are well capitalised and do not have high open foreign exchange positions as those in other CEE economies do. So there is no danger of contingent liabilities suddenly adding 20% of GDP to the debt burden.”
Robust banking system
A number of analysts echo Cakir in identifying the robustness of Turkey’s banking system as one of the anchors of its investment grade credentials. In its most recent analysis, Fitch comments that “Turkey has a robust banking system and ranks as one of only 16 emerging markets with an investment grade banking system indicator. The system is well capitalised, profitable, mostly funded with deposits and boasts only modest non-performing loans of less than 3%.”
The banking system also appears well positioned to withstand the impact of tapering. In its most recent analysis, Moody’s comments that Turkey’s banks face “a somewhat greater reliance on foreign funding since 2009, and the resulting increase in the Turkish banking system’s vulnerability to potentially volatile wholesale market conditions.” But it adds that “Moody’s considers the system’s likely exposure to the effects of QE tapering to be moderate and its liquidity resources to be sufficient.”
Others agree that fiscal prudence in Turkey is reflected in a manageable debt burden that leaves plenty of room for fiscal manoeuvre. “We believe Turkey will continue to implement prudent fiscal policies which will support a continued reduction in the country’s debt to GDP ratio from 35% to 30%, in line with the government’s recently announced Medium Term Plan (MTP),” says Erdem at Işbank.
Erdem echoes other Istanbul-based economists when she says she is more relaxed about Turkey’s current account deficit than some of her international counterparts. She describes the deficit as “a fact of life” that is a natural by-product of Turkey’s powerful growth story. “It is important to analyse the factors behind the current account deficit,” she explains. “Almost 70% of our imports are intermediate goods, most of which are energy-related, which we need in order to maintain production levels. As long as economic growth continues to be driven by this production, it will be very hard to reduce the current account deficit.”
Although maintaining price stability is the CBRT’s principal mandate, policymakers in Ankara are also reported to be less concerned about the immediate threat of a resurgence of inflationary pressures than some overseas commentators.
The CBRT’s official target for inflation is 5%, but the general consensus is that Turkey will come nowhere near achieving this objective in the foreseeable future, with the IMF forecasting 8% in 2013 and 6% in 2014 and 2015. RBS, meanwhile, advised in a recent note that inflation forecasts for 2013 were likely to overshoot “significantly”.
In the absence of a sharp upward movement towards double-digit inflation, however, economists say an immediate interest rate hike is unlikely. Besides, as Cakir points out, in a historical context an inflation rate of 7% or 8% is not to be sneered at. “Turkey has done a very good job in bringing inflation down from triple to single digits, but it hasn’t been as successful in bringing it down to 7% and keeping it there,” he says. “It has been a successful long term deflation story, so I don’t see the central bank tightening in 2014 in an attempt to bring inflation down to the 5% target.”
Some economists argue that to focus purely on conventional monetary policy as a means of countering inflation is not necessarily appropriate in the Turkish context. “Monetary policy may appear to be looser than fiscal policy,” says Cakir. “But instead of hiking rates, the authorities are using macro-prudential measures to limit the growth of consumer loans in order to reduce the pressure on the current account deficit.”
It is easy to understand why the authorities have been queasy about credit growth. Credit card debt alone surged from TL14bn in 2004 to TL82bn at the last count, in October 2013. Consumer loans, meanwhile, have reached TL240bn, compared with just TL13bn. While about 45% of this total is accounted for by housing loans, about 49% is represented by personal loans. As deputy CBRT governor Turalay Kenç concedes (see interview on p21), although the growth of credit in Turkey has moderated recently, consumers continue to spend well beyond their means.
The obvious danger associated with monetary policy that is too loose — either in reality or perception — is the downward pressure it risks exerting on the Turkish lira. “There is some tolerance of currency weakness because it can support exports and discourage imports and therefore help on the current account deficit front,” says Cakir. “But because the pass-through from exchange rate weakness to inflation is high in Turkey, there is a limit to how much lira weakness the central bank can tolerate. If we see another 10% or 15% depreciation it will put the inflation target at risk in a very big way.”
At RBS, Kazmi points out that there is also some element of political risk associated with allowing the lira to devalue too far. “One barometer of economic strength that voters tend to look quite closely at is the level of the currency,” he says. “So if the central bank turns more hawkish, not only will it be well received by the investor community as a sign that the authorities are committed to fighting inflation. It will also be viewed positively from a political perspective. In 2011, we saw the CBRT intervene in the currency market quite aggressively to defend the lira at the end of the year, and I wouldn’t be surprised to see it do something similar this year.”
More broadly, however, economists generally appear to be confident that Turkey will resist any temptation to adopt any potentially damaging populist monetary or fiscal policies in the run-up to the upcoming local and parliamentary elections, for two reasons. First, because the current government has established a healthy track record for fiscal prudence which is unlikely to be jeopardised for the sake of short-term political brownie points.
Second, because in spite of (or perhaps because of) the Gezi Park protests, the AKP administration is widely expected to be returned to power in the election. “The Gezi project is dead,” says one local economist. “It failed to accomplish anything, and it is likely that the AKP will win 50% of the vote — which is more than it did last time around.”
Economists base their confidence in the AKP’s electoral prospects largely on its economic track record. “The AKP remains the dominant political party, and has been a hugely successful machine which has delivered growth, jobs, housing and infrastructure,” says Ash.
The strength of the government’s economic management credentials twinned with confidence in Turkey’s longer term growth prospects explain why international demand for exposure to Turkey remained resilient during the summer — surprisingly so, in light of the combination of internal unrest and anxiety about tapering. “Given that portfolio inflows reached a record high in May, the outflows in the summer were relatively muted,” says Ash at Standard Bank.
Such outflows as there were during the summer may have been a function of profit-taking rather than a direct commentary on the political or economic climate in Turkey. At IŞbank, Erdem says the reason inflows peaked at $9bn in April was in anticipation of Turkey’s upgrade to investment grade by Moody’s. “There was an outflow immediately after the upgrade, but this is a familiar pattern in emerging markets,” she says. “The same happened in Brazil.”
The fact that Turkey’s investment grade ratings emerged unscathed from the recent political and financial turbulence speaks volumes for the country’s economic resilience. As Fitch commented in November, “retrenchment of global risk appetite in the face of the US Federal Reserve’s forward guidance on QE3 has refocused the spotlight on Turkey’s outsize current account deficit, triggering a re-pricing of Turkish assets.” But it added that it “believes that Turkey’s sovereign creditworthiness is resilient to these shocks, bolstered by its underlying credit fundamentals that can contain a wider financial fallout.”
Moody’s agrees. In an update published in early December, it noted that “a potential tapering of the US government’s QE programme is likely to result in higher funding costs, greater funding outflows and a reduced availability of credit across global financial markets.” Moody’s, which assessed the likely implications for Turkish banks and corporates, also reassured investors by adding that “the impact on various sectors of Turkey’s economy will likely be limited and short-lived.”
Investors’ confidence in Turkey’s capacity to withstand external shocks has been underscored since the crisis in their collective response to the republic’s tightly priced €1.25bn 2021 transaction in November, which generated demand of some €3.75bn from more than 200 accounts.
It is just as well that the international investor community continues to have faith in Turkey’s long term prospects, given the number of highly ambitious targets the government has set for 2023, the year in which it celebrates the centenary of the foundation of the Turkish Republic.
In 2012, Turkey was the 16th largest economy in the world, with a GDP of $786bn, or about $10,500 per capita. By 2023, it plans to the 10th largest worldwide and the third largest in Europe, with GDP reaching $2tr, or $25,000 per capita. To achieve these targets, it will have to increase exports by an annual average of 12% and encourage a rise in private sector investment to GDP from between 18% and 20% today to 23% or 24%.
Escaping the middle-income trap
Some economists are doubtful that these targets will be attainable without thoroughgoing reform. “The only way to achieve the sustainable GDP growth we need to meet these goals is through structural reform,” says Cakir. “The first generation of reforms after 2001 was very successful in bringing our fiscal house in order and introducing financial sector reform. Now we need second generation reforms that will increase productivity by encouraging more labour market flexibility, reducing the energy-intensity of industry, improving education standards and strengthening the rule of law. In the absence of these reforms our annual growth will be restricted to 3% or 4%, which won’t be enough to bring Turkey out of the middle-income trap and achieve the 2023 goals.”
That may be. But even if some of the objectives enshrined in the agenda for 2023 are rose-tinted, it is churlish to dismiss the progress that Turkey had made in building the foundations for sustainable long term growth and job creation. At Işbank, Erdem points to recent trends in Turkish trade as a good example of this progress. “Since the crisis Turkey has been very successful in diversifying its export markets,” she says. “Although growth slowed to 2.2% last year, the contribution of net exports was up by 4.1%, with a rise in exports to countries such as Iraq, Russia and China more than compensating for the slowdown in demand from Europe. Ten years ago Turkey’s top 10 export markets accounted for 62% of the total. That share has now fallen to 48%.”
Some believe that over the much longer term, the significance of Turkey’s economic relationship with Iraq can hardly be overstated. At Yapı Kredi, Akçay says that northern Iraq, which has oil reserves estimated at about 45bn barrels, is a “Qatar in the making”, which will see its GDP per capita rise from $7,000 to $50,000 over the next 10 years. “By then, I believe that the Turkish-Iraqi border will be like the Dutch-Belgian border is today, allowing for the free movement between the two countries of goods, services and people,” he says. “That will create enormous opportunities for Turkey.”
Equally important as the increased geographical diversification of Turkey’s trade, says Erdem, has been the change in the structure of the country’s exports in recent years. “Ten years ago, our exports were largely labour intensive,” she says. “Today, exports of auto parts, machinery and mechanical products are all rising, so we are moving away from labour intensive exports and towards capital and technology intensive sectors. This means that in the long term we’ll see an increase in the value added from the export side.” s