Turkey debate: How Turkey can be kept on a sound growth path

Turkey debate: Learn more about the panelists

Simon Brady Let’s start with Turkey’s recent impressive performance relative to other emerging markets and indeed the developed markets.

PYD, Garanti This time last year we were discussing why Turkey was performing so badly. Now we are discussing why the country is performing relatively well. I believe that there are two basic reasons for this: the strength of its financial sector and its fiscal discipline. The Turkish financial sector is very strong thanks in part to the response to the 2001-02 crisis. That crisis also led to significant public sector reform in the country, which in turn improved Turkey’s overall financial position. In addition, in September 2009 the government stated its intention to implement the fiscal rule and a three-year programme. I think this was very timely and it helped perceptions improve. Importantly it allowed Turkey to achieve a fall in real interest rates. The question is, will fiscal discipline be maintained?

More generally, the Banking Regulation and Supervision Agency (BRSA) has done a very good job and that should continue. Its independence is important. And the central bank is also doing a good job; it has been very brave in its actions and should continue to be brave in monetary tightening.

The only issue is the current account. This might become a medium-term to long-term problem and now it is the turn of the policymakers to announce a plan on how to deal with that problem on a structural basis. It is not something that the Central Bank of Turkey can deal with on its own; there should be a master plan on how to increase Turkey’s competitiveness on a long-term basis.

TE, Garanti The interest rate is an interesting issue. Before the crisis people said that whenever real interest rates are negative in Turkey, it is a sign of problems to come. But the response – and I agree – was that this time it is different. In 2000 the fall in real interest rates was directly a result of hot money inflows that crowded out the market and artificially lowered the real interest rates.

TT, JPMorgan If you look at the fiscal situation at that time, the numbers were not reliable. What was reported as a budget deficit of 8% to 10%, because of the way certain items were accounted for, was more likely to have been between 20% and 25%.

TE, Garanti In 2000, the indebtedness of the government was increasing dramatically and yet real interest rates were falling. What is different today is that real interest rates are falling because of the improvements in the indebtedness of the sovereign, the fiscal performance of the government and the success of the financial sector. All these positives suggest to me that Turkey’s improvements are sustainable this time.

TT, JPMorgan But it is crucial that in the absence of its traditional anchors, Turkey can maintain self-discipline and maintain the improved perception of the country. For a decade the anchor was the IMF. Then it was the IMF and the EU and then one or the other. In the absence of both, which has only been the case for the past two years or so, the country needs to prove it can create its own anchor.

TE, Garanti Self-discipline is extremely important, although, as Fitch announced, and I agree with it, we have to see the implementation of the fiscal rule. If it is executed then I believe sustainability will no longer be a problem in Turkey.

Simon Brady Michael, what is the EBRD house view on Turkey?

MD, EBRD Most of our perspective on Turkey comes from what we see within businesses while we are building a portfolio here. This allows us to identify the opportunities for the EBRD to be engaged, and those occur where there are gaps in the market. It is clear that the relative competitiveness of Turkish industry is one of its strong points. This competitiveness comes from a number of things, including regional location, the engineering base, the rapidly growing technology base and labour productivity – and by that I don’t simply mean cheap labour. The banking sector is another positive, clearly. But there are still actions and reforms needed. The fiscal rule is one thing; the medium-term plan is another; completion of reform in the energy sector is critical; completion of the infrastructure privatization programme is extremely important.

We are seeing remarkable levels of confidence from investors that these reforms will be completed despite the amount of work still to do. For Turkey to take advantage of all of these positives, it needs to be able to deliver the finance. Again we are seeing this narrowly from our perspective.

One of the lessons for Turkey during the past two years has been when international financial flows stopped, as Tolga mentioned, you are on your own; the IMF does not have a current programme; the EU is very important for the reform process, but that is now being increasingly internalized. Capital flows to support investment are critical. The growing confidence we are starting to see now with interest rates coming down and longer-term monetary stability should lead to longer-term savings, delivery of capital from domestic capital markets and a deeper, broader banking sector able to fund what is a very ambitious programme.

Simon Brady It is often said that Turkey’s banks have fared particularly well through this period. But is this the view of impartial observers such as the ratings agencies?

GO, Fitch In general, yes. The main strength of the banking system is the low loan-to-deposit ratio of Turkish banks, with assets funded by well-diversified deposits rather than wholesale funding. Although those deposits tend to be short-term, behaviourally they are long-term. The sector has also benefited from the regulatory and legal developments that have taken place since the crisis 10 years ago. There are some concerns. For example, Turkish banks have been growing very rapidly and this has driven a sharp deterioration in asset quality. One mitigating factor is that banking system penetration is still very low. In the mortgage market, in consumer lending and especially in the corporate sector, Turkish banks are still lending to good borrowers. This is evident in the corporate sector’s non-performing loan ratio, which is the lowest among the other segments in Turkey. Also, when I say sharp deterioration in asset quality, that deterioration is still below our expectations: we were expecting the NPL ratio to peak at around 6% to 7%. This has not happened. Of course, some regulatory easing and restructuring schemes have helped but this has been done all around the world.

Looking forward the key issue for the Turkish banking system is competition. There will also be some pressure on margins of course as monetary easing cannot go on forever. Last year banks benefited from the sharp decline in interest rates and this is over.

MD, EBRD One of the things that has impressed us most in Turkish banks is the strong product diversification on the asset side. This was happening relatively recently, before 2008 and as a result of that the NPL situation on retail and the SME commercial portfolios during the crisis was not at all a shock. What happened here was well within the boundaries of what we would have expected to see, given the size of the economic contraction, and it has been very well managed.

Competition is an issue; there is perhaps too much competition between banks for the top assets. It is not unhealthy competition but we are seeing an awful lot of focus on particular sectors and corporates.

ESI, BRSA For me the numbers speak volumes. I would like to give brief information about the current situation of the industry and the industry’s performance during the crises. As of May 2010 the capital adequacy ratio of the industry is 19.5%. The tier 1 ratio of the industry is also at a very high level of 17.7% yet the Turkish banking industry has the highest capital adequacy ratio, return on equity and return on assets among G20 countries and it is one of the two systems that has the lowest leverage. Yes, NPLs increased to 5.4% at the height of the crisis, but now it is 4.3%. Last year total losses increased by 7%, which is low compared with preceding years, but in the first seven months of 2010 the loan portfolio has increased 16.5% and we are seeing improvement in all of the segments, including SMEs. It is also worth highlighting the profitability performance of the industry. With the contribution of interest rate decline and the cost control efforts of banks, industry’s profit has increased by 50% in 2009 and by 14% in the first five months of 2010. Among other things, strong prudential regulation and supervision structure, strong risk management practices, not being reliant on wholesale funding (62% of liabilities are composed by deposits and 14% by equity) and not being exposed to toxic products have helped Turkish banks during the crises.

TE, Garanti When I tell investors about our figures and performance I highlight the fact that most of our revenues come from our customer-related activities, which is more or less true for the whole industry. That is the real success of the Turkish banks. In any industry companies have sustainable revenues if and only if they make money from their own business. In Turkey, that is extremely important – we make money from customers. And we make these ROEs despite our extremely high capital ratios, again a sign of sustainability.

ESI, BRSA That is very important. As BRSA we do not want banks to engage in bet-like leveraged activities that neither have any benefit to the customer nor anything to do with core banking activities. That was our point of view even before the crises.

TT, JPMorgan The point about increased competition was well made, though. Excessive competition is very dangerous. If banks have to decrease their lending standards because they have too much capital and they have to lend in order to sustain their return on equity, that could have a negative impact. Competition will always be there, that is why we need the regulators to fix the boundaries in the playing field and to state the rules and terms of engagement. The success comes from the banking system, from the macroeconomic management of the country and from the regulation. If these things work together in harmony we will always have a strong economy.  

MD, EBRD When you compare the financial performance of the banks in Turkey with those in western Europe and the US you realize the strength of the underlying corporate base in the country. We just won’t see the type of recovery and growth in western Europe’s automotive sector, for example, that we have currently seen for Turkey and this comes from the fact that Turkey is very well positioned to grow in that sector, despite the big hit it took last year. The industrial sector here is diversifying and growing quickly and you don’t see that in western Europe. There are lots of things that have a real base to grow on.

Simon Brady Is consumer lending growth an issue? After all, that was a key part of the crisis elsewhere.

ESI, BRSA We monitor that and adjust our policies based on the economic conditions. For instance, a few years ago we saw the increase in credit card lending, we noticed instalments increase too much and so we have increased the risk weightings of that. And remember, household indebtedness is still very low.

MD, EBRD One of the things that confuses me a little on this issue is that there is a real blurring of the line between consumer retail finance and small business finance. Is it correct that a lot of informal business is using it? A lot of that is healthy borrowing, which is properly intermediated – but still.

TE, Garanti That is true. Some individual borrowing is in fact the borrowing for the owner of a small company. But that is not the worrying type of consumer lending we have seen elsewhere – lending to finance holidays or unaffordable luxuries.

Capital markets

Simon Brady The banks have done a great job, but the creation of a corporate bond market and that infrastructure has been much less successful.

TE, Garanti True – there is a weakness in the banking and financial sectors and that is the lack of long-term local-currency funding availability for both financial institutions and corporates. If there is one weakness in banking it is the potential maturity mismatch on the local-currency balance sheet of the sector, which is the result of making long-term consumer loans in local currency when there is a lack of long-term local-currency deposits and/or bonds. Currently one of the ways to avoid a major mismatch is through swaps. But consumer lending is growing faster than the availability of the swap markets, where using swap instruments to create long-term Turkish lira funding eats from your swap lines in a way.

TT, JPMorgan And in the swap market you raise Turkish lira by providing dollars, so you have to raise long-term dollars as well.

TE, Garanti Exactly. That is true for the financial institutions. There is also no efficient corporate local-currency bond market. Yes, at Garanti we have managed to be the leading bank in helping corporates issue local-currency bonds in the past two or three years. But we need more investors inside Turkey.

TT, JPMorgan We feel that the government is a little reluctant to open up this route for the private sector because they are concerned that their borrowing market will be affected adversely. Perhaps in the past, when Turkey’s debt to GDP ratio was high, this was a legitimate concern. These days it should be less so – and even less so if they are truly committed to fiscal discipline for the future.

In Russia and in Latin America we have seen corporates and banks going back to their local market and borrowing in their local currency. It is something that Turkey has to develop and it is vital for the further development of the corporate sector.

TE, Garanti This has been a problem for many years and the alleged causes have been the same: the government does not want to cannibalize the T-bill market; BRSA has not approved a single local-currency bond issue request by a Turkish bank; there is withholding tax on these issues. However, my view is that none of these is really the problem. The problem is lack of an investor base.

TT, JPMorgan It is true. At the moment it is small. If I am not wrong, in the private pension scheme we have roughly $8 billion to $10 billion accumulated so far. Compare this with Kazakhstan, which has around $14 billion, or Chile, which has about $100 billion, and the total outstanding debt of the country is about $30 billion, so you can imagine how many resources are available, even if you finance the government, left for the private sector.

MD, EBRD Turkey lacks the insurance industry and private pension industry that are needed. We see a very good understanding and willingness from the government, from the authorities, the Capital Markets Development Board and BRSA and so on, for ensuring that private sector participation in the capital market is substantial. The government’s programme of giving the big expenditure mandate to the private sector through concessions on roads, ports, the power sector and so on is very clear. We do have confidence that the government wants to make room for the private sector and the capital markets. But there are structural and institutional issues. Turkey’s institutional investors need long-term savings instruments. This is not a criticism, but I see dysfunction in terms of how interest rates work: the banking sector needs to move off the very short-term deposit base to something more structured. Clearly for that we needed to see inflation fall so that people’s inflation expectations could change. We’re at that point. So what will the banks do to get a more structured liability side? There is no interbank money market. It is very important that that develops. It is very important we start to see an interest-rate structure that is a real response to liquidity in the market between the banks.

TT, JPMorgan One other reason the government should feel more confident about developing local-currency capital markets is that the size of the financial system compared with GDP is much larger than it used to be. There is more local money available for these kinds of investments. The cannibalization issue is not a concern any more.

ESI, BRSA I would like to say that BRSA is not categorically against this type of bond issue but our board just says that first of all we need to understand its effect on interest rates, on the real sector, on government borrowing, on investors and also on the liability side of the banking industry. Deposits make up 62% of total liabilities. These bond issues could change the sectors’ liability structure. So we need to analyse that. Remember that we approved Akbank’s $1 billion international bond issue so we have no categorical position. This is simply part of our continued commitment to maintaining the strength of the industry. As you know in 2006 our board, the BRSA, introduced a new capital adequacy target ratio of 12% and said to banks, "You cannot open new branches if you cannot maintain a 12% capital adequacy ratio." All the banks were very critical of BRSA. In 2007, our chairman announced that the compensation scheme of the banks should be transparent and again the bankers criticized it. Now the rest of the world looks at the construction of capital reserves in a similar way and discusses the need for transparency of banks’ compensation schemes. So we are simply saying, "First we need to understand any new developments in the industry."

TE, Garanti If you don’t have a regulator that makes the industry complain, you don’t have a good regulator!

PYD, Garanti On the subject of local-currency funding it is important to note that something that has not happened before is happening right now – the dollarization ratio in the economy is decreasing. This will increase local-currency deposits though not yet their maturity profile.

Economic dynamism

Simon Brady There is certainly plenty of good news in the banking industry. Let’s look in more detail at the economy. We’ve heard from Pelin that the present situation is, generally speaking, positive. Can you expand on that?

TE, Garanti In general I think 2011 will be a year of very strong growth. The government is going to pump money into the market before the election although they may well not announce it as an overt stimulation programme. They will use the state banking system or other sector-related mechanisms. With the help of this stimulation, added to the already positive situation, the economy will perform well for at least the next 12 months.

TT, JPMorgan And you can argue that the government is doing the right thing if they do introduce a certain amount of stimulus.

TE, Garanti I suppose there is a worry that such stimulation will benefit fiscally careful European countries rather than fully benefiting Turkey. Again it is my worry about our capacity for domestic consumption and the knock-on effects with imports and the current account. In a world in which every other government and household is squeezing their budgets, which limits the scope for Turkish exports, then if we inject money into the economy perhaps all that will happen is that Turkey will increase its purchases of foreign goods. Clearly in the long term the answer is to increase domestic production of the goods Turks want to buy, but in the short term a stimulus could have some negative side effects.

PYD, Garanti On the budget side our reflection is that the government should not be increasing current expenditures. It should be increasing investment expenditures and usually coming up to elections what we see is that governments increase their current expenditures. What we are going to watch starting in the third quarter of this year is whether current expenditures are increasing or not. So far nothing has happened, but it is very likely that they will be on an increasing path.

TT, JPMorgan We should still keep in mind that we are living in an environment globally where inflation is pretty much zero and Turkey is still experiencing 6% or 7% inflation. Our debt levels are low, yes, but still hovering around 45/50%, so we have to be careful. Our budget deficit is still around 4%, so perhaps all these numbers look relatively good compared with the developed world, but it is not where we want to be. There is still room for us to improve. There is a limit on how much you can achieve with macroeconomic policy – that is why the structural reforms we talked about, which will increase the competitiveness of the economy, are quite important in order to bring down inflation and make the country’s macro condition more sustainable.

TE, Garanti That is going to have to be the top priority for the next government, the 2011 government. It is unreasonable to expect the introduction of tough measures from a government in its last year going into an election.

TT, JPMorgan It is a five-year to 10-year programme, so you cannot do it overnight. I totally agree, they have to have a mandate for four or five years.

Simon Brady You have the demographics to grow.

PYD, Garanti That is why we need a master plan; you need to give the people and economic agents that perspective on how they are going to grow, consume and spend.

TT, JPMorgan Yes, policies such that we just don’t invest in real estate, but more on agriculture or tourism.

PYD, Garanti That is also the only way we can expand in maturities in Turkey. So far stability has increased and that has brought the stability of the Turkish lira and confidence in the Turkish lira. The way they extend the maturities and everything in Turkey is through giving a long-term perspective to economic agents, and only the government can do that.

TT, JPMorgan Well, we have a balanced economy: external trade and domestic consumption make on average similar contributions to economic growth. You need both and Turkey historically has a good balance of that.

PYD, Garanti Yes, but let me play devil’s advocate here. During the crisis domestic companies could have done better. Yes, they did rebound very quickly but if you look at our largest companies their performance is not being driven by their core activities. That means that their profitability is likely to fall in the medium term. Another observation is that when looking at gross value added, domestically owned companies were not as good as foreign-owned companies.

TE, Garanti Why is that?

PYD, Garanti When the crisis started Turkish companies tended to have very large inventories. Also, foreign companies were able to keep their export activities at a more sustainable level.

TE, Garanti So that is why Turkish companies are not benefiting from the current inventory rebuilding growth cycle, because their inventories were already very high, unlike the foreign-owned institutions.

PYD, Garanti Yes. I don’t think they predicted the severity of the crisis as accurately as the foreigners.

TT, JPMorgan You also mentioned infrastructure. The point Tolga made at the beginning is important. You can have a strong macroeconomic policy and banking system and a good regulator but in order to take the economy and the country to the next stage you have to have a master plan, you have to define your competitive advantages and work on it. I always give the example of Turkey being strong in tourism but when you go to the south of Turkey we have very small, nice towns, but we don’t make enough investments there to attract the highest spenders. Agriculture is another example: Turkey could be very big in agriculture but it has to be a state policy and the private sector should get the right stimulus and the right incentive. This kind of master plan and developing the country’s competitive advantage is very important.

MD, EBRD We agree and when I earlier talked about gaps, this is what we see. Agriculture is one of the biggest. We have seen huge interest in investing in agriculture here, but there is perhaps not enough being done to make that a reality.

Simon Brady There is one small cloud on the horizon. Neither Europe nor the US look likely to recover strongly for some time. How much does that external environment affect your forecasts for growth?

PYD, Garanti We are seeing that impact immediately. Exports to Europe are not doing well, for example. However, there are offsetting positives. Companies have turned to north Africa and the Middle East and our exports to Asia are also increasing. The numbers are very small compared with total numbers but there are companies that understand that we will not be able to extend in Europe, and they have to diversify. That is a very good omen, but overall I think the fact that Europe is not going to grow as much as the previous year is going to be a limiting factor on Turkey’s net export growth.

Simon Brady What number does that take off your GDP growth?

PYD, Garanti The IMF estimate is that if Europe grows by 1% less, that affects Turkey by something like 0.6%. It will have an impact but that impact will be lower than the previous episodes.

TT, JPMorgan It’s clear that macroeconomic and fiscal policies in western Europe and the US will remain important for emerging markets. We all know that these developed countries have to cut their spending and start saving in order to bring their debt levels and leverage ratios to a sustainable level. That means lower growth rates. What has not yet been resolved is the social impact. Whether social issues will force the politicians to change their policies from what is required is unknown, although we have seen one set of consequences in Greece. Europe, the US and Japan are still the largest economies in the world so it is important that we see the continuation of prudent policies in all three.

TE, Garanti What worries me is that as a result of this focus on reducing debt levels at the expense of growth, our imports might increase. Our capacity for domestic consumption is very high. So we will not only lose as a result of decreasing exports but if we continue to spend – funded by the strong banks in Turkey – then you might see an increased level of imports and then a current account deficit two years later will start becoming a real problem.

Simon Brady You mentioned that at the beginning, that was one of the negatives. What are your forecasts for that?

PYD, Garanti Our forecast at the beginning of this year was that around 2012 Turkey would reach its current account deficit sustainability level.

TE, Garanti Is this 3/4%?

PYD, Garanti Above 4% is not sustainable.

TE, Garanti But we have seen 7%.

PYD, Garanti We have seen 7% but that proved to be unsustainable. What we are seeing right now is that we are reaching there faster. It is not going to be 2012; it is going to be much earlier.

MD, EBRD This is one good reason for getting agriculture sorted out. Agricultural imports are significant here and they do not need to be.

TE, Garanti Agriculture, unfortunately, is probably the only thing about which any country in the world cannot decide on its own. While the US is subsidizing soya and corn and the EU’s Common Agricultural Policy is being reformed, it is very difficult to act independently in Turkey. It is cheaper to import than produce domestically – this is a global issue.

Election

Simon Brady We haven’t talked about the election yet. It seems to be the general opinion in Turkey that whatever the outcome of the election, there is no danger of the positive developments in Turkey being derailed. Is that fair?

PYD, Garanti From my perspective the worst-case scenario would be fiscal loosening. The eventual winner may make little difference but if this government loosens when everyone else is tightening in the run-up to the election, then the incoming government would potentially face a deteriorating situation. That would be my macro worry. The best thing that can happen is that this government in October accepts the fiscal rule that will start in 2011. That would make Turkey relatively risk free, despite the elections.

TE, Garanti I totally agree. It will be the first time in almost 20 years that we are going into the elections without IMF control on government spending. Let’s all hope that the current government, which has proven its commitment to fiscal discipline, especially in its first period between 2002 and 2007, sticks to its policies. In its second period it was not as tight in my view, so that is definitely a worry. As for the outcome of the elections, we should all be proud that no matter what happens the economy will continue as it is. And this is Turkey’s real achievement – the isolation of the economy from politics. We have developed a set of independent institutions to manage the economy – independent regulators, central bank, an independent energy authority, and so on, and they have helped create an economic situation that no-one would have even dreamt of in the 1990s. And as I said before, my one worry is not an economic slowdown but actually overheating of the economy because of individual’s low debt levels and high domestic consumption appetite. Before the elections, excessive fiscal loosening might be dangerous, but being realistic governments everywhere spend in the run-up to elections. Markets are even discounting the fact that it is going to happen. If it doesn’t happen it is going to be a bonus for the markets – a positive surprise.

TT, JPMorgan Also the current global situation is helping us. When the general public read the headlines on newspapers and they see what is happening in Greece, what is happening in Europe and the US, everything they read talks about the problems caused by having a high budget deficit, unsustainable debt levels and so on. They are beginning to understand that governments cannot simply pay public-sector workers excessive wages or pay for unproductive jobs or companies. And that’s having an effect on the political debate now – even here. As a politician, if you go to your constituents and say, "I am going to increase public spending", which in the past would have got you votes, people now react to it negatively.

ESI, BRSA As my last remark I believe looking at the fundamentals, the country’s and accordingly Turkish banks’ ratings, should be higher than they are now. The market also seems to think the same.

Simon Brady Once again, thank you all very much indeed. 

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