Turkey’s economic convergence hangs in the balance
Turkey has transformed, in a matter of a few weeks, from the poster child of emerging market excellence to a volatile economy, with an uncertain macroeconomic and political backdrop, that threatens to reprice the sovereign risk premium. The truth lies somewhere in between.
A sell-off of stocks and government debt has sent borrowing costs spiralling higher amid civil unrest and the baffling response of the ruling AK Party government, punching a dent in the Turkey growth story.
The yield on two-year government bonds has virtually doubled to around 9%. The sell-off has helped pull down the lira currency around 10%, hitting a record low in early July.
In a recent trade, the currency was changing hands at 1.92 to the dollar, recovering some of its losses on a central bank pledge to raise interest rates. The central bank has, however, spent heavily – as much as $6.4 billion – to support the currency.
The economy also faces headwinds from slowing growth, rising inflation, high unemployment, accelerating credit growth and rising energy costs.
The piling on of risk factors contributed to capital outflows of more than $1.4 billion in June, according to data from EPFR, a worrying development for an economy with a $57 billion current-account deficit sustained by short-term financing from abroad.
Imports are rising much faster than exports and the trade deficit will hit $95 billion this year. Turkey’s economy is less than $800 billion but total foreign liabilities stand at $220 billion, including $163 billion international debt due in one year, according to the central bank.
Capital inflows totalled $4.4 billion in the first five months of the year, down 35% year-on-year, prompting the International Investors Association of Turkey to warn that the country might miss its 2013 investment target.
The sell-off is affecting emerging markets around the globeas investors fret that tighter US monetary tightening would spark the beginning of the end of a decade-long migration out of the low yields of developed economies into higher-yielding developing economies.
The fallout in Turkey is all the more dramatic because it has been consistently among the top destinations for developing-nation funds.
“I’m quite concerned,” says Julian Rimmer, a trader in Turkish and Russian stocks at CF Global Trading. “Turkey is having to pay a significant premium for the additional risk posed by all the uncertainty. This whole crisis is really the result of [prime minister Recep Tayyip] Erdogan’s autocratic style of government.
“Risk-free rates have jumped from [between] 5% to 5.5% to around 7.5%. Whether the risk premium has already been priced in depends on whether Erdogan becomes more accommodative and flexible and concentrates on improving the economy, or continues along his current path, which is bound to, at some stage or other, run into serious, concerted civil disobedience.”
Two regulatory investigations into what Erdogan has characterized as an international financial conspiracy to destabilize Turkey has added a bizarre twist to events that is having a corrosive effect on market confidence.
The first, by the Capital Markets Board, is into whether what the government calls the “interest rate lobby” caused the stock market to drop 24% in May to June, its largest correction in two years.
The second investigation is into alleged currency manipulation that has seen the lira drop as low as 1.97 to the dollar. The Banking Regulation and Supervision Agency has reportedly asked Turkey’s main banks for detailed information on clients who sold the lira and the sums and profit margins involved.
“It’s irresponsible to throw around conspiracy talk and it makes for a triple whammy with the unrest and US yields edging higher, hitting the lira from both sides,” says Michael Hewson, senior market analyst at CMC Markets.
“The tapering talk is what’s spooked investors most – if you trace the lira’s fall you see it starts on May 22, the day of [Fed chairman Ben] Bernanke’s testimony to Congress.”
He adds: “To cry ‘conspiracy’ because the lira depreciates from 1.83 to the dollar to a high of 1.97 and back to 1.91 is ridiculous. You might be able to manipulate Turkish lira prices in the very short term, but in the long term foreign exchange markets trade very much on fundamentals.
“Overall, the direction is driven by central bank policy and capital flows, and that’s why the Turkish lira has been as weak as it has been. It’s easy to blame the evil speculators because it diverts attention from the real problems in your economy. I would be very surprised if this investigation throws up anything manifestly untoward.”
Hewson believes if the lira breaks below 1.92 it could strengthen all the way back to 1.83 on a “head and shoulders reversal” he sees forming on the dailies.
Turkey has been riding an extraordinary 10-year bull run that has seen annual growth average more than 5% and per capita GDP triple to more than $10,000.
As recently as 2011, the economy grew at 8.5%. It was a similar story in the equities market, where the Istanbul 100 surged from less than 10,000 in 2001 to peak at 93,000 before the sell-off. The country received investment-grade ratings from Fitch in November and Moody’s in May.
However, growth slumped to 2.2% in 2012 and is forecast by the IMF at 3.4% for this year.
“Since the end of May, the situation has deteriorated significantly,” says Naz Masraff, an analyst at Eurasia Group. “The protests are still ongoing and although they’re smaller, they’re going to continue.
“The market uncertainty is a short-term consequence because, in the long term, opposition does constrain the government’s room to manoeuvre on policy, for example, introducing controversial legislation.
“There are capital outflows, but it’s not to the degree that the current-account deficit won’t be financed this year – the central bank still has gross reserves of about $100 billion.”
She adds: “But given that two-thirds of the current-account deficit is imports of gas and oil – the price of which is rising – clearly, as the lira depreciates this becomes more expensive, hurting the deficit. This is why the central bank is committed to protecting the lira and will continue to do so.
“Sentiment has improved a bit on comments from the central bank hinting at a measured increase in the upper band of the interest rate corridor, currently 3.5% to 6.5%, sending a clear signal to investors.”
However, Masraff says that with growth still the main priority for the government as Turkey heads into a busy election cycle starting in March, there will be increasing political pressures not to raise rates.
“We may see some measured hikes – maybe 50 or 100 basis points – to protect the lira going forward, but it won’t be to the extent of what the market or participants are expecting,” she says.
Hewson at CMC concludes: “This will all blow over. With any emerging market you’re going to have teething problems because as more and more people get used to higher and higher incomes, when you hit bumps in the road, reactions tend to be quite extreme.”
Indeed. Turkey has pulled itself out from far-worse economic dilemmas. It remains a dynamic economy in which trade and manufacturing continue to be strong drivers of growth. It scores highly for economic freedom and its financial sector is gaining in competitiveness.
Add in favourable demographics, a solid fiscal position, low household and corporate debt, a good record of job creation, strong well-capitalized banks, and substantial foreign-currency reserves, and it’s clear that, provided it can maintain growth, it should not be written off just yet.