Ask strategists and investors to identify the most vulnerable emerging economy and one name stands out towards the top of every list: Turkey.
Turkey could be a “bellwether for global risk appetite”, says Gene Frieda, senior emerging markets strategist at Royal Bank of Scotland, who rates the country below its two high-yielding rivals, Brazil and Indonesia. Turkish economy has a “high degree of sensitivity” to changes in the world economy, comments David Lubin of HSBC. Alia Yousuf, manager of Standard Bank’s emerging markets fund is even more categorical. “Turkey will be one of the first countries to be negatively affected by global rate hikes,” she says.
All are agreed that a bulging current account deficit is the problem. The government is the sixth-most credit hungry in Europe, expected to issue $35 billion in medium- and long-term debt in 2006. The current account gap jumped 50% last year to $23 billion and might hit $30 billion this year. The government’s most common excuse, that the bulk of the deficit results from the rocketing price of oil imports, doesn’t change the fact.
easy years
Turkey has fattened up in the easy years since the current account gap exploded in 2001. Indeed, the sheer scale of foreign investment in the country, in an environment of little differentiation between individual emerging markets and tumbling risk premia, may have made the country’s situation even more precarious.
Recognizing that the situation couldn’t get much better, the government seized on favourable conditions at the start of the year to blaze through the bulk of its annual debt issuance. Equity markets have also rocketed, climbing 50% last year. Investors pay almost 20% more on a PE basis to acquire the same underlying profits in Turkey as in the UK.
Now tightening monetary policy in the major economies is hastening on the day of judgement by absorbing the surplus of liquidity which has fed Turkey’s borrowing habit. An appreciating currency, as counterpart to the swelling deficit, means that the prospect of a soft landing is receding.
Blaming the IMF
With the country’s economy at stake, tensions run high and old wounds are being reopened. Gazi Ercel, who served as governor of the Turkish central bank during a turbulent five-year period ending in 2001, blames the IMF for straitjacketing policy, preventing action necessary to resolve the deficit. He argues that central bank intervention, even just an oral warning to the markets, to push down the lira would help to deflate the threat from the current account.
Under the terms of the IMF’s $10 billion loan package the government must let the market steer the currency.
“I personally disagree with the IMF,” Ercel declares. “The IMF insists on a free floating exchange rate, which means very limited intervention. The hot money holders can easily understand the meaning of that. It means the lira will appreciate.” Without the flexibility to guide the currency, engineering a smooth landing will be difficult, he predicts.
Ercel says that with the government unwilling to slow growth or accept higher interest rates, a depreciation of the lira is the most viable means of stimulating exports and moderating imports.
Turkey trap
Hugh Bredenkamp, the IMF’s senior representative in Ankara is frank when asked whether Ercel’s argument has any basis: “Absolutely not”, he says. “This is a trap which many countries, including Turkey, have fallen into in the past.” Bredenkamp expresses confidence that the government will resist the temptation to dabble in the currency markets, urging prime minister Recep Tayyip Erdogan to keep the reins on spending instead.
Private-sector investors and analysts side with the IMF. Turkey’s new-found exchange-rate flexibility means that rather than throwing away foreign exchange reserves in futile attempts to oppose the markets, the central bank can hold on to them, alleviating the threat of default, observes HSBC’s Lubin. He sees a benign outcome as the most likely scenario in the event of a turnaround in the flow of funds.
“The exchange rate would depreciate and the Turkish economy would adjust,” Lubin argues, noting that the economic reforms encouraged by the EU and IMF have made the economy much more flexible than it was when a financial crisis struck five years ago.
Standard Bank’s Yousuf recommends corporate tax cuts and more liberalized labour laws to make exporters more competitive, in tandem with cuts in public expenditure. While the rising lira may encourage flows of so-called hot money that could result in a sudden shock for Turkey, government attempts to meddle with the money markets would most likely end in disaster, she predicts.
The stability of the government and the attraction of EU membership have been crucial in encouraging investors to continue financing Turkey’s deficit. With no sign that the trade gap will narrow soon, the government’s position, already compromised by dithering over the appointment of a central bank governor, could remain in the spotlight as elections loom in the coming year. It is a poignant reminder, Ercel says, that domestic, as well as international factors, could trigger the current account powder keg.
“Politics in Turkey is always a problem, and most of the crises have been generated by political mismatches and political uncertainty,” he warns.