Turkey: A rising power bridging Europe and Asia

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The paragraphs below come courtesy of Carlos von Hardenberg, Istanbul-based head of frontier market strategies at Templeton Asset Management.

Turkey is a dynamic country with over 73 million inhabitants, of which 75% live in cities with a median average age of 29 years. Turkey has developed into a popular destination for investments not only because of its competitive export sector, particularly in automobiles and consumer goods, but also because of its large domestic consumer market. Now Asian, European and American consumer-oriented companies are moving into Turkey to capture this large and growing consumer market.

On the macro-economic front, Turkey stands out as a country that appears to be fundamentally strong, despite its chronic current account deficit arising from imports such as energy. Although inflation has been very high in the past, it has now finally come under control, which provides more confidence in the Turkish economy and its policy makers. Inflation in Turkey, as measured by the consumer price index, averaged around 8.6% in 2010 compared to an average of 72% in the years from 1993-2002. The Turkish lira has been generally stable, and the central bank has enacted various initiatives to seek to ensure this stability, trying to dis-incentivize speculative inward investments (the carry trade) by keeping policy rates low.

Since the implementation of the customs union agreement with the European Union (EU) in 1996, Turkey’s trade with EU countries has grown substantially in certain areas. In particular, the Turkish automobile sector has been growing at a fast pace and has become highly competitive. Between 1999 and 2008, auto production in Turkey grew by 285% to 1.15 million vehicles per year, and a large proportion of that production was for the export market. Leading international manufacturers have invested heavily in the Turkish auto sector along with local Turkish partners, and a diverse range of auto component producers have also been attracted to establish operations in Turkey. One advantage driving these investments is the skilled and well-educated Turkish labor force, a factor that has sharply improved productivity in this area over the years.

Moreover, Turkey has a healthy and transparent banking sector. After learning hard lessons in 2000-2001 when there was a near-collapse of several major banks, today, both the regulation and risk control of Turkish banks stand out as among the best in the region. Banks are generally well capitalized, and through the past years they have generally managed to keep the proportion of non-performing loans at a low-level. Today, Turkish banks serve as a role model for many other banks in emerging markets. Meanwhile, the retail banking system in Turkey has become, to a large extent, one of the most sophisticated in the world. Household indebtedness in Turkey remains comparatively low, and mortgages have just begun to develop, pointing to further growth opportunities in the coming years. Several major international banks have sought to partner with local Turkish banks for a participatory share. Further privatization of the remaining few state-controlled banks are likely to further improve the positive outlook for this sector.

The energy sector in Turkey also presents significant potential for investors. The country has begun to privatize its power generation and transmission operations, with local as well as foreign investors competing for licenses and existing infrastructure. There are plans to further develop traditional energy sources such as gas, oil and coal, as well as various initiatives to build outTurkey’s capacities in solar and wind energy.Turkey’s regional importance as an energy corridor is highly significant, not only because of the Nabucco pipeline, which will stretch all through Turkish territory, but also because ofTurkey’s proximity to swiftly developing energy-producing countries such as Iraq,Kazakhstan andAzerbaijan.Turkey is also exploring potential for its own oil and gas fields along the Black Sea shore.

Last but not least, Turkey has a large and fast-growing tourism industry and boasts a long heritage in this sector. The country has two pristine coast lines along the Mediterranean and Black Sea, with unspoiled beaches and world-class sports facilities such as golf courses and sailing marinas. Tourism income has grown year by year, and Istanbul’s Ataturk Airport acts as a major hub connecting Europe and Asia. Both transfer traffic and traffic into Turkey have grown in excess of 20% per year over the past few years.

Living in Turkey, I have been struck by the country’s diversity (Turkey has more than 70 ethnic groups) and its long and colorful history. Since Ataturk’s reforms,Turkey has developed into a modern society. For centuries, it has been a country of tolerance, allowing several minorities to live freely in its territories, and it continues to benefit from this openness and diversity in many ways. Geographically at the center of Europe and Asia, with the Levant and Gulf regions at its doorstep, Turkey has realized that its orientation toward Europe is just as important as its role as a regional power in the Levantine and Gulf regions. I believe we will continue to see exciting developments and interesting opportunities in this country.

Source: Mark Mobius, Investment Adventures in Emerging Markets, June 20, 2011.

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Turkey: The month of one-offs

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This post is a guest contribution by Tevfik Aksoy of Morgan Stanley.

The headline deficit exceeded forecasts significantly, but there is a reason behind this: Turkey’s current account deficit is high and it has been widening decisively over the past year. A deficit of approximately 7.5% of GDP this year is very likely, and we believe that it is fully priced in. With the recent rise in commodity prices, Turkey’s C/A came under the spotlight and all numbers are being heavily scrutinised, given the unorthodox monetary policy approach by the CBT. There is nothing new here. However, when the March headline current account deficit came out at a record US$9.8 billion against the expected US$8.2 billion, there was a significant negative reaction in the market and the currency weakened some 1%.

Likely to be a one-off issue: Looking at the details of the balance of payments data, we noticed two issues that made the weak headline number look somewhat less worrisome. First, the income account posted a sharp outflow of US$1.9 billion in March that was highly unusual, reflecting the repatriation of profits (such as dividends) on foreign investors’ investments in Turkey. We do not know details of any specific transactions. However, we know that under normal circumstances the monthly reading of this account should have been around US$0.5 billion. Hence, the US$1.4 billion deviation here resulted in the main surprise about the headline. We think that this will be a one-off issue and will not be repeated any time in the near future. Second, foreign direct investment (FDI) posted the highest monthly inflow of the past three years at US$2.6 billion in March, more than offsetting the adverse impact of the outflow posted in the income account. Since there were some banking sector-related transactions in March, we associate this FDI inflow with that. Indeed, there is a possibility that the high FDI inflow and the surprise outflow in the income account might have been related. At any rate, the high FDI inflow is also likely to be a one-off matter, as we do not expect any sizeable FDI transactions to materialise soon.

Looking at the details of the balance of payments, we see the following points to be noteworthy to mention:

1) The headline deficit: At US$9.8 billion, the deficit was a record high, but as we mentioned earlier this is likely to be a one-off matter and will correct starting with April data. That said, even the consensus expectation of US$8.2 billion would be considered a very high monthly print, and it seems clear to us that Turkey’s current account deficit is too high. The 12-month rolling current account deficit reached a massive US$60.6 billion (around 7.5% of GDP) and is unlikely to decline any time in the next six months, in our view.

2) The non-energy component of the deficit is reaching worrisome levels and should be addressed more forcefully: It is a fact that Turkey’s widening current account deficit had been on the back of rising energy prices. However, with March data at hand, we see the non-energy component also hitting a record-high number (even if the one-off factors are corrected for).

3) FDI inflows reached a 40-month high: At US$2.6 billion, FDI inflows helped financing to a significant extent and was a partial relief to the pain associated with the headline print. However, this is likely to be a one-off jump in the near term and not the beginning of a trend, we think.

4) Portfolio inflows also posted an all-time high: At US$5.2 billion, there was a massive inflow of capital that funded the current account deficit to a significant extent. At first sight, the number might look worrisome and suggest that the deficit was being financed by ‘hot money’. This is not the case, in our view. Out of the US$5.2 billion figure, US$2.2 billion was associated with the recent 10-year Samurai bond issue by the Republic of the Turkey. We would not consider this financing as short term or hot. Hence, this was also a one-off jump, in our view.

5) Net errors went through some revision: The unaccounted flows in the first two months of the year stood at a significant US$5.5 billion. With the March data release these were revised down to US$3.4 billion and spread around certain capital account items. The March net error term was also positive but slightly lower at US$950 million, which brought the 1Q11 cumulative number to US$4.3 billion.

6) Reserve accumulation at record high as well: Overall, despite the record-high current account deficit, the inflows from FDI, portfolio flows and other financing (corporate and banking sector borrowing) were very strong and resulted in a monthly rise of US$3.1 billion in reserves. The 12-month rolling cumulative reserve rise amounted to US$15.8 billion.

Source: Tevfik Aksoy, Morgan Stanley, May 16, 2011.

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Turkey: Still a growth star

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This post is a guest contribution by Tevfik Aksoy & James Lord of Morgan Stanley.

Rate Cut Threat Still on the Table

The main reason for expecting further short-term weakness in TRY is the threat of a further rate cut from the CBT in the coming months. The CBT made it clear in its latest Inflation Report that the future policy mix will continue to involve low interest rates combined with higher reserve requirement ratios (RRR). This dual approach is designed to help meet multiple policy objectives, including a weaker currency, slowing credit growth and a narrower current account deficit. Accordingly, we expect a further cut in the policy rate at the next meeting in February (see New Approach to Monetary Policy: Will Creativity Be Rewarded? January 26, 2011, by Tevfik Aksoy). What’s more, even if the CBT does not cut, we think the market will trade poorly ahead of the meeting, given the risk of a further reduction in the policy rate.

Further increases in the RRR are also likely to occur, to help offset the stimulus that a lower policy rate would create. We have to admit that the recent hike in RRR encouraged us in the sense that the notable extraction of liquidity from the system (TRY 9.8 billion), which will become effective as of February 18, could actually be considered as tightening despite the cut in policy rate. Nevertheless, the market is likely to focus more on the signal from the policy rate. And as long as there are risks that it could be cut further, TRY is likely to suffer. We think that USD/TRY could test 1.62 in the coming weeks, assuming a stable EUR/USD.

Watching for a Moderation in Credit Growth

The CBT’s new policy mix will address the ongoing rapid growth in loans, especially that of consumers, which has been expanding at a rate of around 40%Y and heading towards 50+%. Until inflation bottoms out and starts rising to a degree that causes a deterioration in inflation expectations and widens the credibility gap for the CBT to act, we think it is very probable that the policy rate will be kept low while successive RRR hikes are likely. In the past, we used to concentrate almost solely on inflation and the reasons behind it, but paid little attention to credit growth as interest rates were relatively high and the penetration rate was low. However, we will now be monitoring changes in the growth rate as well as the overall tendency in consumer loans to judge or predict if the CBT will make further moves.

Given the importance of credit growth to the future direction of monetary policy, any sign that credit growth is starting to moderate could be taken by the market as a sign that the CBT may think about shifting its stance. This shift in stance is required, we believe, to turn the TRY around. As such, we would take signs of moderating credit growth as a bullish signal for TRY.

Turkey Still a Regional Growth Star

Turkey’s strong economic fundamentals remain intact. Growth is strong, and we expect it to come in at around 4.7% this year following an estimated 7.4% rate in 2010. Fiscal policy is prudent, while upgrades from rating agencies look likely following the June elections. Accordingly, there are several fundamental reasons to expect TRY to appreciate. The ongoing widening in the current account does pose a risk to the TRY, particularly if external shocks materialise. The widening in the C/A deficit has been quite persistent, and deterioration in the non-energy component particularly noteworthy.

However, the financing of the deficit looks reasonably comfortable for now, given the strength of external borrowing from the local banking and corporate sector.

Gradual Recovery from 2Q?

Given the strong fundamentals, we see the monetary policy stance as the key variable to consider in anticipating a recovery in TRY. We do not think that the CBT will be able to sustain consistent policy rate cuts through the year. Indeed, the lower the policy rate goes, the greater the risk this poses to the currency, in our view. Forecasting monetary policy is fraught with uncertainty, and thus timing the recovery in TRY will be similarly difficult. However, we have pencilled in 100bp in policy rate hikes for later in the year and, as the market anticipates this, TRY should begin to recover. We are tentatively pencilling in a recovery in TRY in 2Q, though this will be assessed on an ongoing basis as developments take their course. General elections are scheduled for June, but we do not see this as a headwind for a recovery during 2Q. Indeed, political stability is likely to be maintained, and fiscal policy should stay prudent.

Stretched Momentum Suggests Tactical Opportunities

Speculative positioning in TRY is now low, and given the sharpness and size of the recent depreciation, we believe that there will be tactical opportunities to buy TRY, but only on a very short-term basis. Momentum is stretched and suggests that TRY is oversold on a technical basis, versus both the major G10 currencies and many EM currencies. Because of this, we could see temporary periods of TRY strength. Ultimately, we believe that this strength will be self-correcting, as the CBT would probably be more inclined to cut rates as the TRY appreciated, and thus place downward pressure on the currency again. We would fade any moves below the mid-January low of 1.53 in USD/TRY.

Risks to Our View

One of the features of the recent sell-off in TRY has been the lack of USD selling from the retail and corporate sector in Turkey. Typically, locals swap foreign exchange deposits for TRY as the TRY weakens, thus taking advantage of better levels. However, on this occasion, and reflecting the monetary policy uncertainty, locals have been less active. USD deposits have been reduced by around US$10 billion since the TRY started depreciating, reversing only about half of the accumulation in USD deposits since June, despite USD/TRY moving back to June levels.

Should USD/TRY head higher too quickly, it is possible that locals decrease their USD selling activity even more, thus increasing the downside risks to TRY. This is short-term downside risk for TRY.

On the flipside, a rapid deterioration in inflation expectations could cause the CBT to reverse course quicker than most in the market currently assume. This would provide some stability for the TRY.

Source: Tevfik Aksoy & James Lord of Morgan Stanley, February 1, 2011.

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“Europe’s Bric”: Turkey

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Turkey’s stock market has been one of the strongest performers among emerging economies this year as the country bounces back from a recession. The country has even been praised as “Europe’s Bric” by the British prime minister. In the video clip, Tevfik Aksoy, a senior economist at Morgan Stanley, talks to Barney Jopson about Turkey’s prospects.

Click here or on the image below to view the video.

Source: Financial Times, December 8, 2010.

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