Copying and distributing are prohibited without permission of the publisher.


EU key to Turkey’s borrowing prospects

10 Jun 2004

By the end of January, Turkey?s state Treasury had completed nearly half of the $5bn of international borrowing it needed to do for 2004. That has given the Treasury the luxury of sitting out the recent wave of volatility in emerging market bonds. By the time the sovereign returns to market, all attention will be focused on the EU summit in December that will decide if Turkey can begin negotiations to join the Union. By Kathryn Wells

There are less than six months to go before the EU summit in Rotterdam this December that will decide the fate of Turkey?s European ambitions. Hopes of joining the club of European countries has been the main motivator behind many of the AKP-led government?s policy decisions since it won power at the end of 2002.

Now that the first wave of EU accession in central Europe has been completed, with 10 countries having joined the club on May 1, bond investors are turning their attention more than ever to higher yielding sovereigns that offer the same possibility of convergence ? no matter how far down the road. Spreads on debt from Bulgaria, Croatia and Romania ? widely regarded as the strongest candidates for membership in 2007 ? have tightened sharply in recent years, largely becauseof this premise.

But for Turkey?s application to become a reality, divisive issues such as the reunification of Cyprus ? at present divided into Greek and Turkish halves ? need to be resolved.

Public opinion in Turkey is strongly in favour of membership. ?We do not think the electorate will be forgiving if the AKP government, which has pushed the EU dossier harder than any previous administration, now undermines Turkey?s accession prospects,? wrote Sevin Ekinci, an analyst at WestLB in Istanbul, in a recent research report.

?The government has worked hard to overcome excuses for the summit to deny Turkey the go-ahead. Its strategy over the Cyprus talks was a good example. The international community blamed the Greek side for the latest failure in reunification.?

Harder to judge, though, is the degree of genuine opposition within the EU itself to the potential membership of a country of more than 70m people, mainly of Muslim faith. Much has been made of France?s supposed opposition to Turkish membership, although other key EU members such as Germany and the UK support its application.

Bankers and analysts agree that the promise of eventual EU membership, no matter how far in the future, is vital to cement continued political and economic progress in Turkey. ?The procedure would be lengthy and arduous, probably exceeding 10 years, and with much scope for things to go wrong along the way,? argues Fitch in a research report. ?However, it would offer the government a strong incentive to continue with the reform process, not least because of many of the economic criteria needed to secure eventual EU entry and subsequently euro membership. We believe that it would also cement political stability, and bolster foreign investment flows into the country, an area where Turkey has performed abysmally over the past decade.?

The agency believes markets might remain volatile, as fiscal problems would still take time to solve, but long-term expectations would be guided by an eventual EU joining date, so the type of swings in investor sentiment that Turkey has suffered since 2001 would become less frequent.

Spreads widen as market slumps
It is not surprising, therefore, that spreads on Turkish sovereign debt have widened from as low as 307bp over Treasuries on its benchmark 2030 bond to more than 500bp over Treasuries.

The wider emerging markets sell-off, triggered by expectations of earlier than expected US interest rate rises, has combined in investors? minds with a loss of confidence in a speedy resolution of the Cyprus issue.

But a spread of 500bp over the US government is still impressive in the context of recent years. The same bond was trading as wide as 917bp over Treasuries only one year before.

Bankers agree that the prospects of a resolution in Cyprus remain one of the biggest drivers of Turkish spreads, because of the island?s role as an obstacle to Turkey being given a date to begin EU membership negotiations. Not all are hopeful of a positive outcome.

?In the first half of the year, Turkey was in a prolonged phase of spread tightening, due to expectations over its chances of getting a date from the EU to begin negotiations, and the likelihood of a resolution of the Cyprus issue,? says Jonathan Brown, global head of emerging market syndicate at JP Morgan in London. ?However, a solution for Cyprus has become less clear, and we have had a widespread emerging markets sell-off.?

But regardless of Cyprus?s impact on Turkey?s future in the longer term, it is not expected to hamper the sovereign?s immediate borrowing. ?Turkey has been making very good progress and despite the current interest rate environment and some scepticism about whether it can get a date to begin EU negotiations, its remaining funding requirement of around $2.3bn for the year looks very manageable,? says Dennis Holtzapffel, head of emerging markets syndicate at UBS in London.

Some believe that Turkey missed an opportunity by failing to bring a third deal before the recent emerging markets sell-off. ?I think they?ve missed a trick,? says one syndicate head in London. ?The Treasury has been so used to seeing spreads come in that they may have forgotten that the opposite could happen. They should have looked to bring another deal before the summer ? this would have left them with only minimal borrowing requirements for the rest of the year.?

The syndicate official advises the Treasury to take a pessimistic approach to spreads this year. ?For the rest of the year, Turkey needs to assume that its credit spread will stay at current levels, at best, and access the market whenever possible,? he says.

Early bird advantage
Turkey?s Treasury began the year in the international debt markets with its traditional flurry of activity ? looking for early bird advantage by bringing $1.5bn and Eu1bn of paper before the end of January.

Since then, the republic has been quiet, mainly because of severe withdrawals of investor cash from emerging markets that began in the second quarter.

Maturity composition of Turkey's new domestic borrowing (January 2002-March 2004)
Maturity period2002 (%)2003 (%)Jan-March 2004 (%)
1-3 months25.320.612.5
4-6 months15.75.214.8
7-9 months11.99.40.0
10-12 months15.936.949.7
Up to 2 years8.78.114.8
Up to 3 years0.09.82.4
Up to 4 years2.10.50.0
5 years0.80.01.8
non-cash (non-market)
Source: WestLB

Turkey?s $1.5bn offering was its first 30 year Eurobond for four years, cementing a remarkable return to favour with emerging markets investors that had begun just over a year before.

Lead managers Citigroup and UBS attracted nearly $8bn of orders and priced the deal with an 8% coupon to yield 8.23%.

?With Treasuries at these levels, an 8% coupon is a historically low level for any issuer to be able to lock in on a 30 year deal,? UBS?s Holtzapffel said at the time.

Two weeks later, Credit Suisse First Boston and Dresdner Kleinwort Wasserstein brought a Eu1bn 10 year bond, giving investors a rare chance to buy par priced euro denominated paper.

According to bankers at the leads, most of Turkey?s euro bonds were trading at cash prices of around 115.00. Nearly Eu3bn of orders were reported, of which half came from Turkey.

Looking to return
With Turkey having been absent from the market since February, talk turned again at the end of May to the prospect of new deals. The short end of the curve looked most likely, although bankers were split between recommending dollars or euros.

?The euro curve has done really well recently,? said one syndicate head. ?Because of the difference in interest rates between euros and dollars, it could be an interesting trade. The rally on the euro side is more driven by real buying.?

However, the confidence that did build up as May progressed was quashed by the end of the month, as various investment banks including JP Morgan and Citigroup released research reports advising clients to sell emerging market sovereigns.

Some analysts do not now expect Turkey to return to the bond market until the last quarter of the year.

Making progress on domestic debt
Extending the maturity of Turkey?s primarily short-term debt has been an endless preoccupation for Treasury officials, and in recent months they seem to have been winning the battle through diligent management of the country?s economy.

This has been partly due to the relative stability of the currency against the dollar. Between January and the middle of April 2004, the Turkish lira traded in a range of TL1.3m to TL1.35m to the dollar. But by the middle of May it had fallen to TL1.5m.

In the first quarter, Turkey?s central bank had cut the overnight interest rate twice, by 2% each time, taking the rate down to 22%, and investors were expecting further rate cuts ? until the emerging markets sell-off that ensued in early May, which hit heavily indebted sovereigns such as Turkey particularly hard.

Domestically, there were also concerns about the high current account deficit the government was running in January and February. ?We see the deficit widening through April, followed by a marked improvement thereafter as the tourism season gets under way,? wrote WestLB analysts Sevin Ekinci and Gregory Kronsten in May.

But they do not believe this will hit the country?s borrowing abilities dramatically. ?In our view, a 2000-style external financing crunch is not ahead,? the report continued. ?Nevertheless, given the weak sentiment, the Lira/$ exchange rate moved briefly north of TL1.55m/$, while benchmark domestic bond yields rose for a short period by almost 500bp to a peak of 29%.?

Official predictions for Turkey?s domestic debt service for 2004 are at TL164.6qd. Payments in the first quarter were TL40.5qdn. This, analysts say, means the Treasury achieved a rollover ratio of 95%.

?Rising domestic interest rates and lira depreciation will clearly add to this year?s domestic debt service,? says the WestLB report. ?Yet it is worth noting that foreign currency-indexed and foreign currency-denominated paper accounted for 22% of the domestic debt stock at March 2004, compared with 32% at the end of 2002 [see charts opposite]. The impact of lira depreciation to date on debt rollover requirements has, thus, been reduced.?

The report predicts that the lira will end the year only a little weaker at TL1.62m/$, because of strong tourism inflows, a new IMF agreement later this year and a go-ahead from the EU on accession, all of which should support the currency.

The maturity of the Treasury?s domestic debt stock has lengthened over the last 18 months. In the first quarter of 2004, nearly 50% of new borrowing from the market was in maturities of 10-12 months and only 27.3% was in maturities of one to six months. This compares favourably to 2002, when 39% matured after one to six months, and only 15.9% was in maturities of 10-12 months.

?In the current external market environment, we do not expect the Treasury to return to the market,? says a WestLB research report. ?If it is to meet its issuance target for this year, it is likely to wait for the market to settle down in the fourth quarter. A good progress report from the European Commission in October could serve as a trigger for a new issue.?

The government does have a US loan package, granted during negotiations over US troops using Turkish land during the war in Iraq, but the government is thought unlikely to turn to this. ?In our view, the government would only draw on the $8.5bn loan package granted by Washington last year as a last resort,? the WestLB report says. ?It can be used until September 2005 but includes political conditions which the Turkish government would prefer to avoid.?

In 2003, Turkey raised more than 75% of its total $5.4bn of external borrowings in the dollar market, in line with its usual strategy. After its Eu1bn deal in January, this year?s balance may be rejigged slightly in favour of the euro, although bankers predict that the dollar market will remain Turkey?s primary target.

?We may see Turkey bring a larger part of its issuance in euros this year compared to 2003, considering that it has already sold paper worth Eu1bn,? says Holtzapffel, ?but the dollar market is always going to be the republic?s core funding market. This is because dedicated emerging market funds, both in the US and Europe, are primarily denominated in dollars.?

Euro deals, Holtzapffel explains, are mainly bought by retail investors and banks, and fund demand for euro debt is often more driven by relative value. At the moment dedicated funds will have less appetite for euro debt as it trades at tighter spreads then dollar debt.

In the past, Turkey has accessed the Samurai market, but in recent years Japanese investors have proven more willing to buy deals from higher rated credits such as Hungary and Poland, both of which accessed the market in 2003 and 2004.

There has also been talk of a Turkish Islamic bond, but no deal has yet materialised. This is partly because of the relative newness of the structure. However, most Islamic bonds so far have come from borrowers that can boast solid investment grade ratings in the single-A to triple-A ratings band.

The return of the corporates
The last international corporate bond from Turkey ? a $200m five year deal by Vestel Electronics ? was priced in May 2002. Bankers are hopeful that 2004 will be the year that corporates begin to return to the market. ?Issuance from Turkish banks and corporates is definitely a possibility in the second half of the year,? says Holtzapffel.

Banks may turn away from their traditional source of funding ? the syndicated loan market ? to lock in low rates of interest before US rates begin to rise in earnest.

?Turkey?s banks are quite large and well capitalised compared to banks in many other countries of the region,? Holtzapffel continues. ?Because they are funded by a huge retail deposit market and have good access to the short dated syndicated loan market, they have not had much interest in Eurobonds before. But the current interest rate environment means that Eurobonds might be a more attractive alternative.?

Turkish petrol distribution firm Poas has mandated JP Morgan for a likely $200m five year deal, expected in the second half of the year. ?We could see as many as five or six non-sovereign names at least mandating deals, and possibly even accessing the market before the end of the year, with the majority of mandates coming from banks,? agrees Brown at JP Morgan. Banks such as Garanti and Is Bank are said to be considering deals.

But all this is dependent on the performance of the sovereign. ?Sovereign spreads are at around 500bp over Treasuries at the moment. If they come in to around 400bp over, then it could be time for some corporate names to come,? says one head of emerging market bond origination in London. 

10 Jun 2004