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One step back, two steps forward

12 Jun 2006

There is no doubt that Turkey suffered more than most from the turmoil that hit the global markets in May. But unlike previous economic upheavals, Turkey is well placed to recover quickly thanks to low inflation and political stability. Philip Moore reports.

Did the rating agencies jump the gun? Six months ago they were collectively painting a very pretty picture about Turkey and its economic prospects.

Moody's set the ball rolling in December when it distributed a glowingly positive bulletin on the outlook for Turkey. At the time, the agency noted that "vibrant growth and progressive structural adjustment have strengthened the resiliency of the economy and placed the government's debt and debt service burden on a fast track towards the pre-crisis levels of 2003."

Moody's added that with inflation and interest rates heading down, the once-struggling financial system on the road to recovery and EU accession talks proceeding as planned, the conditions had been met to warrant an upgrade in Turkey's long term foreign currency bonds to Ba3 from B1.

The following month, Standard & Poor's revised its outlook on the Republic of Turkey from stable to positive, commenting that "in the past three years, Turkey has met challenging fiscal and inflation targets and real GDP has grown at an average of almost 7% per annum. This has strengthened domestic and international confidence in the economy, further reinforcing domestic demand, improving Turkey's financing conditions, and strengthening the currency."

The agencies' positive tone echoed the Turkish government's own observations, when it wrote to the International Monetary Fund late in 2005 reporting that "economic performance under our programme remains strong. Inflation is in single digits and growth, though moderating, remains robust. Financial markets have performed well, supported by favourable global credit conditions, the timely start of EU accession negotiations, and successful privatisation of key state economic enterprises."

A mad May

What a difference three or four months make. In the first two weeks of May alone, the Turkish lira depreciated by 12.8% versus the dollar and by a whopping 14.5% against the euro. Over the same period, the yield on Turkey's April 2008 Treasury Bill widened from 13.7% to over 15%, while the spread on the sovereign's outstanding 2030 bond widened by 39bp to 223bp. Turkish equities, meanwhile, plunged by more than 8% within a single trading day later in the month.

Then, at the beginning of June, the real fireworks began. Turkey's inflation figure for May hit 9.86%, prompting a fresh sell-off in Turkish stocks and the lira. The central bank had to act decisively, and it did.

Meeting on June 7, it raised interest rates by a market-startling 175bp. The immediate effect was salutary. Investors concluded the bank was serious about tackling inflation.

Turkey's 2030 bond gained 1.375 point, that day to close at 7.827% — though it widened back on June 8 to 7.91%.

The lira strengthened to 1.508 against the dollar on the day of the rate hike, though it fell back to close at 1.563. The following day it began to steady, closing at 1.559.

Much of this sudden bout of weakness was a by-product of the turmoil that rocked all global markets in May, and which had especially negative ramifications for emerging markets.

But there were also a number of Turkey-specific influences that acted as a double or even triple whammy for investors exposed to Turkish assets. Foremost among those were inflation and the uncomfortable increase in the Turkish current account deficit, which the government had originally indicated would reach $22bn, or 5.7% of GNP, in 2006.

By May it had reached $26.7bn, or 7% of GNP, prompting ABN Amro, for one, to note in a report that "the widening current account deficit has been a blot on an otherwise rosy economic picture". But the same report also argued that the recent fall in the lira should help to stabilise the deficit.

"We were already looking for exports to stage a revival later in 2006," ABN Amro said, "but the lira's lower level should add to the momentum. The associated upward move in real bond yields should also have some dampening effect on consumer demand and consequently imports."

Other concerns specific to Turkey included a presidential veto of proposed social security reforms, a courtroom wrangle over the privatisation of the steel making company, Erdemir, and misgivings over the re-emergence of political risk in advance of presidential and parliamentary elections in 2007. Throw in a bout of angst about Turkey's relationship with the EU, arising from a spat over customs union, and it is easy to see why external commentators had started to become edgy about Turkey by early summer.

Good news hard to find

While none of these influences led to a serious danger that the rating agencies would reconsider their earlier pronouncements, analysts accept that there has been something of a hiatus in the flow of good news about Turkey. "The outlook for Turkey has probably deteriorated somewhat over the last couple of months," says S&P's Turkey analyst, Farouk Soussa.

"We have always said that Turkey's current account deficit leaves it vulnerable to reversals of investor confidence and capital outflows, and we are seeing evidence of both at the moment. The combination of an unwinding of global liquidity set against recent negative news emanating from Turkey does not make for an atmosphere that is conducive for an immediate ratings upgrade. But fundamentally the Turkish credit story remains strong."

Perhaps. But the recent indicators lead analysts such as Matthew Vogel, head of Emerging EMEA strategy at Barclays Capital in London, to believe that there may have been too much optimism regarding Turkey's economic and political outlook, and that the recent market weakness is a sign of the country's vulnerability to global risk reduction.

"Many investors seem to classify Turkey among the convergence economies of central Europe, but it faces a much more complicated structural and institutional reform agenda," he says. "If emerging market investor sentiment continues to weaken, investors are likely to make a more sober assessment of the outlook for Turkish financial markets. Given the magnitude of inflows to Turkey over the past few years, reversals in portfolio investment cannot be ruled out."

Much of that reassessment of Turkish risk will inevitably focus on the recent weakness in the currency and the ramifications for Turkey's disinflation trajectory, which has been a striking success story in recent years.

Tevfik Aksoy, Deutsche Bank's Istanbul-based chief economist for Turkey, points out that the relationship between the performance of the lira and Turkish inflation is strong. "According to Central Bank models, a 10% permanent depreciation in the currency leads to a 3% increase in CPI," he says. "Given the government's inflation target for this year of 5%, which will probably be missed anyway, an additional 2%-4% in the CPI is obviously high."

IMF relationship remains strong

Importantly, economists say that they do not believe that this will lead to a deterioration in the relationship between Turkey and the IMF. In May, the government successfully concluded discussions with the IMF on the third and fourth review of its stand-by agreement. "As long as any inflationary pressures are caused by exogenous factors such as the rise in the oil price, there is no reason why they should cause any problems with the IMF," says Aksoy.

Reinhard Cluse, emerging markets economist at UBS in London, agrees. "Following the recent IMF talks, the government is now required to tighten fiscal policy by 0.8%, which should be feasible as long as the political will is there," he says. "So there is a good chance that the IMF programme will continue over the summer without major difficulties."

Relations with the IMF and with external creditors are also being supported, over the longer term, by the consistent improvement in Turkey's public debt to GDP ratio, which many western European governments would envy.

JP Morgan notes in a recent analysis that it expects this ratio to fall to 63% of GDP in 2006, down from 69% in 2005 and 79% in 2004. "Thanks to continued fiscal discipline, lower borrowing costs, longer debt maturities and privatisation inflows, the Turkish treasury has become less dependent on the domestic market and more resilient against external shocks," notes JP Morgan.

In any event, champions of the Turkish economic story argue that short term fluctuations in macroeconomic indicators should be regarded as temporary and marginal details in a thoroughgoing and irreversible process of transformation. The key to that transformation is Turkey's new-found political stability, insists Serhan Cevik, executive director of emerging markets economic research at Morgan Stanley.

"It is important to step back and recognise that the turnaround in Turkey began after the crisis of 2001," he says. "That crisis led not just to very significant changes in the economic landscape but also to unprecedented political consolidation. In the 1990s we had one fragile coalition government after another, which did not allow for any kind of coherent policy implementation. The 2002 election gave us Turkey's first single party majority government for over a decade, which in my view has acted as the backbone of economic stabilisation in Turkey. It paved the way for the IMF-supported stabilisation programme and for the acceleration of talks on EU accession."

Underlying strengths

That process, says Cevik and others, has underpinned an economic metamorphosis which is now strong enough to withstand short term influences such as the market upheavals of the early summer.

"Growth rates are not just much higher than in previous years, they are also more sustainable," says Cevik. "At the same time inflation is down from 80% to 8%, the budget deficit has fallen from 16% of GDP to below 2%, and the previously heavily indebted Turkish Treasury has become a net debt payer."

Although political stability appears to be more entrenched in Turkey than ever before, it is a mistake to interpret that as a signal that EU accession is a done deal.

There have been plenty of roadblocks en route to Turkey's accession talks, the most recent of which has been the thorny issue of the EU protocol on Customs Union, which calls on Turkey to open its ports and airports to all EU members — which now include Cyprus.

Analysts say that in the run-up to elections in Turkey, that could be politically perilous. "If Turkey doesn't open its ports and airports it will lead to a fairly critical report from the EU later this year," says Cluse at UBS. "That would be the perfect excuse for those who oppose quick Turkish progress towards EU accession to call for a slowdown or even a temporary halt in the talks."

"Temporary" is the operative word here, because Cluse and other analysts say that the long term prognosis is for constructive dialogue on Turkish EU accession to gather momentum.

In its latest analysis, JP Morgan acknowledges the seriousness of the rift over Customs Union, and accepts that the accession negotiations "are still expected to be long and complicated". But the same report concludes that "nothing has changed in our view; we believe that Turkey is on the path towards EU convergence and that with time this anchor will help solidify the country's outlook of sustainable growth and political stability."

In other words, it seems probable that Turkey will continue to take more steps forward than it takes back on the road to EU accession. "Although there is a risk of escalating tensions with the EU later this year, Turkey's credit is solid enough to withstand the sort of stress it is now facing," says S&P's Soussa. "The structure and maturity profile of its debt has improved already, initiatives are being set up that will widen the tax base, and we expect the social security reform will eventually go through which should cap expenditure."

That view is supported by other observers. "Turkey is much more resilient to internal and external shocks than it has ever been," says Cluse at UBS. "The huge progress that has been made in the last four years has transformed Turkey from a third league player to the top league." 

12 Jun 2006