Surfing global liquidity

IFR Turkey Special Report May 2013
12 min read

Turkey remains an investor darling. It benefits from a young population, a stable government committed to market-orientated reform, a bold Central Bank and declining inflation. What could possibly go wrong?

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The past 10 years signalled an economic transformation. “Turkey is collecting the fruits of the work it has been doing for at least a decade, and especially since 2008–09, in terms of reducing inflation, implementing fiscal discipline and pushing through reforms,” said Emre Akcakmak, portfolio manager at East Capital.

Luck has played its part too. While Turkey has at times been rocked by the financial crisis, it has also benefited from the unfettered pumping of liquidity into the system that constitutes the regulatory response.

A significant proportion of this liquidity has found its way to Turkey. Although yields on three-year bonds have come down from a high of 24% in 2008, they were still paying 5.7% in early March, not a bad return for a country with Turkey’s risk profile.

Yet there are some dark clouds on the horizon. One is the stubbornly high current account deficit. This remains manageable while global interest rates remain low, which is likely to be the case while economic conditions in Europe and the US remain weak. However, as the global economy improves and rates rise, Turkey may find it becomes more difficult to finance its deficit. Austrian bank Erste Group forecasts the CAD will reach 6.8% this year.

Risk of complacency

Another problem facing Turkey, as with many emerging markets, is political risk. In the past the country has seen its fair share of coups and it would be unwise to discount the possibility of further political upheaval that might undermine economic activity, said Akcakmak.

These days the concern is less about the power of Turkey’s politicised military, and more about an increasingly powerful and centralised government. Trouble could be brewing in the form of proposed constitutional reform, with the AKP, Turkey’s leading political party, looking to switch to the presidential system from its current parliamentary one, as part of a package of changes. There is talk of a possible referendum to circumvent parliamentary opposition, and a general concern that as the country orientates itself more and more towards its Middle Eastern neighbours, it is becoming increasingly authoritarian.

Mixed record

The AKP has at least been consistently pro-business. For many, political risk is a declining concern. “It is not clear how much investors care about politics as long as there is stability,” said Christian Keller, head of emerging markets research at Barclays.

The government has notched up notable successes, such as encouraging a much greater degree of savings and pensions that should ultimately improve the CAD. It has also presided over a period of considerable job creation.

“Turkey is collecting the fruits of the work it has been doing for at least a decade, and especially since 2008–09, in terms of reducing inflation, implementing fiscal discipline and pushing through reforms”

“Since the financial crisis Turkey has performed as one of the best economies in the world from the perspective of job creation,” said Murat Ulgen, senior economist at HSBC. Turkey has increased the employed population by around 4.1m since the end of 2007 to nearly 25m in late 2012.

But some feel its actions have not lived up to its talk, with tax and labour market reform two specific areas that require further reform, said Keller.

The government’s main focus appears to be elsewhere. Turkey needs to diversify its energy sources, which may explain its enthusiasm for nurturing its relations with its oil-rich neighbours. A deal with Kurdish Northern Iraq, if it materialises, could go a long way to resolving Turkey’s energy conundrum, reducing its reliance on the energy markets, a major cause of its persistently high CAD.

The country’s commitment to privatisation has also won plaudits. The public sector debt-to-GDP ratio plunged from about 80% in 2001 to around 37%.

“The privatisation agenda is loaded and may help beat the 2013 fiscal targets,” said Nilufer Sezgin, chief economist at Erste Securities Istanbul. “That would aid in lowering the domestic debt rollover ratio.”

There is scope for a lot more to be done, according to Keller. “The authorities understand the issues the country faces, but there is certainly more enthusiasm for the big investment projects than for the more subtle and painful reforms,” he said.

The Central Bank of Turkey has also won admiration. Its bold and unorthodox monetary policy has found a good balance between attracting foreign capital, and preventing the economy from overheating. Where Brazil achieved that goal with capital controls, Turkey has instead created an interest-rate corridor, a band within which the Bank actively manages rates, increasing or decreasing liquidity to maintain stable economic conditions.

The CBT’s blended cost of lira funding appears somewhere in the interest-rate corridor. “If the CBT is not happy with the currency’s appreciation, they cut the lower boundary of the interest-rate corridor to prevent excessive appreciation,” said Sezgin, usually amending the upper and lower limits of the boundary simultaneously.

He expects to see reserve requirement ratio hikes and interest-rate corridor cuts as the bank looks to contain credit growth and limit lira overvaluation.

The CBT has been able to pursue its rate corridor policy effectively because of increased gross reserves it has accumulated in recent years, especially in foreign currencies and gold. The Bank created a mechanism allowing banks to deposit FX in lieu of their Turkish lira reserve requirements. Turkish banks can keep more expensive lira liquidity in-house, and the CBT boosts its foreign currency reserves.


However, “the composition of the financing of the CAD and a shortage of FX reserves remain Turkey’s largest vulnerabilities”, said Gillian Edgeworth, chief EEMEA economist at UniCredit Research.

“The CBT’s approach to maintain a wide interest-rate corridor and use its reserve option mechanism has worked well so far,” said Keller. “It allowed the CBT to keep lira volatility low and to boost its gross FX reserve position, while on the macro side the CAD narrowed and inflation moderated in parallel.

“We will have to see how effective it will be now as domestic demand is re-accelerating, and there also remains the question how well it would work if capital flows were to reverse abruptly. People are not too concerned about this risk because the chance of a sell-off seems quite remote at this point, but it is still a risk.”

However, as this report went to press, the Central Bank announced the impact of events in Cyprus was already causing inflows to slow down.

Emerging markets curse

Managing inflation is usually the first thought of a central banker, the bedrock on which a strong economy is built. Here the CBT has also won plaudits. It targets inflation of 5.3%, according to Sezgin, as part of its strategy to anchor inflation expectations. While inflation is still high in global terms, it has been coming down over a long period, from around 30% 10 years ago to 6.7% currently.

Crucially, inflation expectations are now relatively low, said Ulgen. “The mix between growth and inflation is good.”

“Starting from late 2010, the CBT has modified the conventional inflation-targeting regime by adding financial stability as a supplementary objective,” said a spokesperson at Isbank. It is this change that enabled CBT to pursue the interest-rate corridor approach.

“This has given the market more confidence,” said Akcakmak. “In the past there has been some confusion regarding the CBT’s intentions, and this has led to higher yields, and thereby volatility in the lira. However, the CBT’s increasing credibility has contributed to yields and volatility coming down.”

Meanwhile, a host of other indicators in Turkey are becoming more favourable over time. The ratio of public debt to GDP has been reduced from more than 60% to about 35% over the past 10 years, and is still declining. GDP is growing at a faster clip than debt, always seen as a major obstacle to its now distant dream of EU membership.


Although Fitch has assigned an investment-grade rating to Turkey, and S&P upgraded its long-term foreign currency rating to BB+ most economists had expected Turkey’s ascension into investment-grade status to arrive more quickly, said Akcakmak. Rating agencies remain cautious due to the short tenors on its debt issuance, which leaves it more vulnerable to changing market conditions, and its relatively high cost of funding.

However, they have given it credit for the strength of its banking sector, said Isbank. “Turkish banks are very well capitalised with a capital adequacy ratio of 17.9% as of end of 2012,” said its spokesperson.

Regardless of ratings, a look at CDS spreads suggests Turkish credit is investment grade. And foreign investors have voted with their feet, with foreign ownership of Turkish local bonds rising from less than 10% only three years ago to about 26%, a trend that is likely to accelerate should Turkey be upgraded by another agency.

This stability has encouraged a boom in bond issuance by corporates, both lira and foreign currency-denominated. This has been a gradual process, with corporates first issuing in lira, then increasingly via foreign currency Eurobonds. In January the first lira-denominated Eurobonds were issued.

Rapid growth

The market is growing rapidly. There are currently bank Eurobonds worth more than US$10bn in the market, of which more than half were issued since 2012. “The size of total issuance is still small but we see significant pick-up in activity and expect much more to come in 2013,” said Akcakmak.

Non-bank institutions are growing rapidly too, albeit from an even lower level, with less than US$500m of bonds in circulation at the start of 2012, to US$1.6bn at the end of 2012. There are forecasts of this reaching US$4bn in 2013.

Other factors point to a steadily maturing economy. Turkey is diversifying its export destinations and decreasing its reliance on Europe. Ten years ago 60% of its exports went to Europe; this has now come down to around 35%–40%, with the Middle East increasing its share from around 10% to 25% in that time.

While this is partly a result of EU weakness, it is also the result of Turkey’s efforts. Trade with the Middle East “would have increased even if EU economies remained strong since Turkey’s relations with the Middle East have improved considerably”, said Akcakmak.

Surfing global liquidity
Turkey's Central Bank headquarters in A